Bond Investing And Risks: 8 Quick Pointers


On Bond Risks in the Short-Run by David Merkel, CFA of Aleph Blog

From a letter from a reader:

Hi David,

I’ve been following your blog for the last few months and the articles are extremely insightful.

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I’ve been working with fixed income credit trading the last few years but I feel that I have not been measuring risk well. I only look at cash bonds

Right now I’m only looking at DV01 and CR01, but my gut tells me that there’s a lot more to risk monitoring that can be done on a basic cash bond portfolio.

From your experience as a bond portfolio manager, what other risk metrics have you found useful?

I’d really appreciate if there were a few pointers you could give or just a trail that you could show me and I’ll follow it.

First, some definitions:

Basis Point [bp]: 0.01% — one one-hundredth of a percent.  If you have $10,000 in a money-market fund, and they pay one basis point of interest per year, at the end of the year you will have $10,001.  In this environment, that’s not uncommon.

DV01: A bond valuation calculation showing the dollar value of a one basis point increase or decrease in interest rates. It shows the change in a bond’s price compared to a decrease in the bond’s yield.

CR01: Credit Sensitivity – Credit Default Swap [CDS] price change for 1bp shift in Credit par spread — same as DV01, but applied to CDS instead of a bond.

Now, onto the advice: when you manage bonds, the first thing you have to do is understand your time horizon.  Is it days, weeks, months, or years?  When I managed bonds for a life insurer 1998-2003, the answer was years.  Many years, because the liabilities were long.  That gave me a lot of room to maneuver.  You sound like you are on a short leash.  Maybe you have a month as your time horizon.

When the time horizon is short, the possibilities for easy profits are few, and here are a few ideas:

1) Momentum: yes, it works in the bond market also.  Own bonds that are rising, and sell those that are falling.  Be sensitive to turning points, and review the relative strength index.

2) Stick with sectors that are outperforming.  Neglect those that underperform.

3) If you have significant research that has a differential insight on a bond, pursue it with a small amount of money if it may take a while.  If the change might happen soon, increase the position.

4) Try to understand when CDS is rich or cheap vs cash bonds by issuer.  Look at the price history, and commit capital when pricing is significantly in your favor.

5) Set spread targets for your investing.  Decide on levels where you would commit minimum, normal, and maximum funds.  Be generous with the maximum level, because markets are more volatile than most imagine.

6) Look at the criteria for my one-minute drill:

(and look at the end of the piece, but the whole piece/series has value.)

7) Analyze common factors in your portfolio, and ask whether those are risks you want to take:

  • Industry risks
  • Duration risks
  • Counterparty risks

8 ) Look at the stock.  If it is behaving well, the bonds will follow.

Maybe your best bet is to trade CDS versus cash bonds, if the spread is thick enough to do so.  If not, I would encourage you to talk with more senior  traders to ask them how they survive.  Trading is a tough game, and I do not envy being a trader.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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