Bond Trading

[CrushinFelt]

Anyone have any actual experience in Bond Trading. Preferrably not something like along the lines of buying and holding A or AA securities to diversify a portfolio. Any recommendations for books are welcome as well.

Basically, I pretty much know all there is to know abuot options and can't really learn more until I really start to trade them often and find out what market dynamics are really like. With bonds however, I know the mechanics of course, so I know how they're priced and what affects them (credit risk, yield curve, etc.), but I don't really know what makes bond trading profitable.

Any input/experience is welcome. I made my first bond trade on a countrywide bond that is basically a bet on their bankrupty probability being overstated as well as an expectation in fed rate cuts affecting the yield curve. Equities bore me and I feel like an analytical person can outperform the market using bonds moreso than using equities.

[censored] equities.

[DcifrThs]

[ QUOTE ]
Anyone have any actual experience in Bond Trading. Preferrably not something like along the lines of buying and holding A or AA securities to diversify a portfolio. Any recommendations for books are welcome as well.

Basically, I pretty much know all there is to know abuot options and can't really learn more until I really start to trade them often and find out what market dynamics are really like. With bonds however, I know the mechanics of course, so I know how they're priced and what affects them (credit risk, yield curve, etc.), but I don't really know what makes bond trading profitable.

Any input/experience is welcome. I made my first bond trade on a countrywide bond that is basically a bet on their bankrupty probability being overstated as well as an expectation in fed rate cuts affecting the yield curve. Equities bore me and I feel like an analytical person can outperform the market using bonds moreso than using equities.

[censored] equities.

[/ QUOTE ]

bond trading is just like anythiing else.

you see what the market is pricing in and then determine whether you agree or not and with what level of conviction you disagree (or agree).

for instance, looking only at nominal bonds, the yield curve is the main determinant of the prices of the bonds. if interest rates are expected to fall, holding bonds will result in a profit, if they are expected to rise, holding bonds will result in a loss.

that may seem obvious but it is the base. since you say you know how to price a bond, i'll assume that you know that back and forth.

so now look at the yield curve and how it has shifted over time. many profitable bond positions come from yield curve adjustment bets rather than just direction bets. these relative trades are sometimes called "steepeners" (for long the short end and short the long end of the curve) or some other name for the reverse bet....betting the curve will become less steep or invert.

knowing about duration and convexity is also important since that affects the overall risk you hold in your portfolio.

nominal bonds have 1 source of that (interest rates). convertible bonds, corporate bonds, inflation linked bonds etc. all have things that make the convexity and duration different from that of nominal bonds. you can make bets that these additions (i.e. the option to prepay in MBS) are overvalued or overvalued by shorting out the default risk (betting that fewer people will prepay mortgages than expected and thus MBS spread above treasuries will fall).

other types of relative value bets (or diff bets) involve either corporations or countries where you think one's rate will move more than the other's beyond what is priced into the market.

for instance, if you think that the US rates are too low and UK rates are too high on the near end of the yield curve, you can short the US tbill and long the UK 1yr bill (i don't think that is called a Gilt but i forget the name).

these positions need to be normalized to the same level of risk via duration and convexity analysis so that one leg doesn't move proportionally far more than the other.

so those are some examples of bond trading off the top of my head.

feel free to ask for more.

now in terms of the position you mentioned, i think you have gone about executing it incorrectly.

you have 2 views:

1) your bond's credit risk is overstated relative to treasuries

2) some theory about the future of interest rates (do you think the fed will cut more or less than priced into the market?)

when you have 2 views, you shouldn't execute them in 1 bet. you should execute them individually and take into account their correlation and individual riskiness in your actively managed portfolio.

for 1), you are betting that the compnay will be more able to pay back debt and less likely to default than priced in. therefore you are long the spread. so you purchase that bond and sell the US treasury security of similar duration (since company bonds typically have longer duration than treasuries you can either purchase more of the 10yr or maybe X*10yr + Y*30yr to arrive at some average between 10 and 30 years depending on yoru duration estimates. i'd think 15 yrs of duration should be ok for corporate bonds but i'm not sure about that)...or as stated, purchase enough of the shorter duration piece to equalize their moves in risk space.

for 2), you are simply directionally long or short the yield curve however you view it. you can execute that view in the US treasury market, the eurodollar market, the fed fund's futures market, options on fed funds futures etc.

this bet may correlate highly with your other bet depending upon the company's current and projected ability to pay down its creditors.

this post is probably getting long so i'll stop there.

hope this helps.
Barron

Barron

[DcifrThs]

my first post was a bit long but i wanted to address one other thing you mentioned:

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With bonds however, I know the mechanics of course, so I know how they're priced and what affects them (credit risk, yield curve, etc.), but I don't really know what makes bond trading profitable.

[/ QUOTE ]

profitability of bond trading is just like the profitability of any other type of trading: spotting inefficiencies or mispricings and pouncing. currently, markets may be overreacting to the level of economic pain that will likely be felt as a result of the credit crunch being felt by banks and finance shops. that can play out in a number of ways and you just have to pick your bet.

most directly, as i mentioned in another post, going long a put (or short a futures contract) on the fed funds sept. maturity future at 95.00 (trading now at like 95.08 or something) seems like a good bet. if the fed lowers rates by 25bps, that contract will mature at 95.00 and you'll have made 95.08-95=.08 - transaction costs.

if the fed doesn't lower rates, you end up with 95.08-94.75=.33 - transaction costs.

if the fed lowers by 50 bps, you lose 95.08-95.25=.17

so you can clearly see what you can gain or lose and adjust your bet accordingly.

profitability comes from one side of a trade being either misinformed, non-profit seeking, or panicy or some combination of the 3.

Barron

[CrushinFelt]

I guess I should be more clear about my "bet" on countrywide. One of the main factors that has hurt this bond (increased the yield) is the assessment of CFC's default probability. I hold a view that the market has overreacted and thus believe I am receiving a higher yield than I should for my assessment of their credit risk.

The yield curve play is more of a "kicker" that will help my trade rather than being a main factor. I believe that IF the market's assessment of countrywide's credit risk comes back to earth, the yield will of course drop, and any fed rate cuts that may be implemented between now and then will also help to decrease the yield.

Summary of my trade, worst case scenario I hold this bond 'til expiration earning the yield (receiving a higher yield than I "should" based on their probability of default, though I think there's very little chance the market lets them default). Best case scenario, their creditworthiness increases, the fed cuts the rate a few times over the next 12-18 months, and I sell the bond for a nice gain.

My next trade, if I were to make one which I won't because I'm taking things slow, would be to bet on the spread between the 10-year and 2-year treasuries tightening as the tension in the market eases. This is most simply done by just longing the 10-year and shorting the 2-year right? Would that fall under your "Steepening" (probably flattening in this case) category?

This stuff to me is much more interesting than plays on equities.

Thanks for the input.

Also, I'm not allowed to trade Fed Funds Futures because I work at the CME and I signed a piece of paper saying "NO FUTURES OR OPTIONS FOR YOU!" [img]/images/graemlins/tongue.gif[/img]

[CrushinFelt]

Also, a factor in my countrywide trade that I didn't mention is the lack of buyers in the market thus making supply/demand another big factor. I can take advantage of people's risk aversion levels by offering a lower price that they should sell it for because they want to get it off their books.

A lot of their bonds, though rated as BBB+ and the like, are trading at yields higher than a lot of junk bonds (in exces of 12%).

[CrushinFelt]

Also, if it gets to the point where I become more concerned about the credit crisis and I think countrywide is unlikely to recover or faces greater credit risks than they do now, I can sell some out of the money puts as some insurance.

[Phone Booth]

[ QUOTE ]
Also, if it gets to the point where I become more concerned about the credit crisis and I think countrywide is unlikely to recover or faces greater credit risks than they do now, I can sell some out of the money puts as some insurance.

[/ QUOTE ]

Are you sure you're able to get acceptable pricing/execution for those? What kinds of bid/ask spreads do you see and how much are you paying in commissions (in bp)? I doubt trading bonds on exchanges is an efficient strategy in the long run.

[CrushinFelt]

Puts on the stock futures. I can't use them as a strategy where I base my trade off of "material information" but if I need to hedge bond risk I don't think they'd make me flap in the wind.

[DcifrThs]

also, a new avenue is in the CDS market, where the waters are relatively new and you have some hedgers in there as well.

bond trades can be parsed out to default risk via the CDS market nowadays. can you trade that?

i know countrywide's CDS price soared to over 1.1mil per 10mil contract (i.e. spreads of over 1100 bps above treasuries). if you don't think they'll fold then a direct bet there coudl work.

basically i'm a big fan of taking bets as efficiently as possible based on your views. active management 101 imo.

but, your reasoning is sound so long as your facts are correct. especially given that markets tend to be most inefficient at times like these. i'm very happy to be living through and watching this now so i cna test my own thoughts.

and even more so since i've just done preliminary studying on mandelbrot's theories. lol @ "goldman's models telling them this would happen 1 time in every 100 millenia."

GL with that. price changes are fractal not only in scale but in time. we are in a fast time now and have been in a slow time for years.

Barron

[dazraf69]

DcifrThs you are a book of knowledge [img]/images/graemlins/tongue.gif[/img]