Trading Bonds: A Guide for Risk Management and Profit Generation

Advices from ex-FI professional trader

Investing in bonds can seem really confusing. Even though there’s lots of info online about bonds, it’s still hard to understand all the details. If someone told you that bonds could be a good way to invest your savings, you’re probably left with some questions.:

With so many securities available, where do I even begin? Should I seek guidance from a bank advisor, or should I listen to the insights of my uncle, a professional trader, who insists that Dell bond is promising?

To address these questions, I’ve prepared a simplified framework that cuts through the complexity and offers practical guidance for novice investors.

Intermediate level of article: I will not delve into the definition of brokers, types of bonds and why it is bad to keep money under your pillow.

Let’s go!

To embark on a comprehensive understanding of bonds, it’s essential to approach them from the dual perspectives of goals and risks.

Risks are essentially derivatives of the PnL of your instrument, they can both play in your favor and against you. I will give you definition though the impact on your Profit and Loss (Pnl). There are 3 types of risk in FI:

1. Interest Rate Risk leads into changing PnL with changing Key Rate (the same currency as the nominated bond)
2. Credit Risk leads into changing PnL with changing the reliability of the the issuer (probability of default)
3. Market Risk leads into changing PnL with changing the supply or demand curves for a specific security (for example, increased demand due to the aggressive sale of a new bond through tips in private banking)

If we talk about goals, I would single out 2 opposite in essence:

1. In a safe haven scenario, you’re seeking a temporary place to park your money. Here, good liquidity and predictability with time are paramount. You need a safe haven where your funds can be easily accessed when needed, without sacrificing the predictability of returns over a specified timeframe.”
2. The way to earn more than inflation can still be called conservative investment strategy, aimed at outpacing inflation, entails maximizing returns while still prioritizing safety. This approach suggests seeking relatively safe instruments that offer the potential for higher returns than the rate of inflation. However, it may involve sacrificing some liquidity and predictability for the opportunity of greater returns.

In this article, I will primarily focus on analyzing the second goal — conservative investing. In order to optimally determine a safe haven, it is necessary to understand well future or potential needs, such as mortgages, venture investments etc.

“Big coupon” syndrome

“Big coupon” syndrome is a term used to describe an irrational desire to purchase bonds with high interest payments (Mr. Zapolskii)

Let’s address experienced readers and newcomers by reminding them why neither the price of a bond nor its coupon alone can accurately determine its attractiveness as an investment:

Above you can see how the coupon, the bond current price and the face value are related to YTM — Yield to Maturity. YTM is the main parameter of the bond and in fact its “price” but vice-versa — more is better, less is worse.

Here is the place to read more.

Yield to Maturity (YTM) can be depicted as a sum of factors that depend on the risks mentioned above. Is the bond’s yield exceptionally high due to its junk rating? Or perhaps because you’ll need to hold it for as long as 40 years and won’t be able to manage risks along the way?

hyperbolic dependence of Bond Value on YTM

We have figured out why we are gathered here — now move on to action. Assume that your uncle, an experienced trader “Big” Joe Jr., advised you to buy an excellent bond with a large coupon called “Dell”38–2038 maturity year, ISIN US24702RAF82.

From now on, there will be plots where the X-axis sometimes represents historical time, and other times, it indicates the bond’s maturity time. Please do not confuse the two!

“Big” Joe Jr. left side, yourself right side

Let’s take a quick look, what have we been offered:

• coupon is really big, 6.5% 😎
• YTM — 5.9%, maturity — 2038. Not really bad, at least better than inflation
• Fitch Ratings affirmed the “BBB” for Dell last time
• Throughout the year, the yield has decreased. Therefore, if we had purchased a bond a year ago, we would have earned not only from the periodic payments but also from the appreciation of the bond’s principal value

But why has it been falling much faster since November’23? Will it keep falling or will we buy ones on maximum price? Let’s find out…

Risks : Credit Counterparty risk

In simple terms, counterparty credit risk refers to the possibility of the issuer of a security defaulting on its obligations. Agencies like S&P and Moody’s assist in quantifying this risk by assigning reliability ratings to companies and even countries.

For investors, this risk is reflected in the form of a premium over government bonds. Essentially, the riskier the security, the higher the premium it pays to attract investors. Otherwise, no one would be interested in buying it, correct? We refer to this premium as the credit spread, which is the difference in yield to maturity (YTM) between a corporate bond and a government bond with the same maturity.

Government bonds have almost 0 credit risk

Now take a look at Dell, how has his credit spread changed?

Dell’s 38 credit spread

What we’re observing here is the consistent demand of bonds over the past year. So if we had bought this bond a year ago, we would have benefited from the price movement relative to the treasure curve!

But why is this happening? Is it because Dell has become a more reliable company, or are there other factors at play?

Risks : Interest Rate risk

To understand the impact of interest rates, let’s turn to simple math 🤓

Help

However, it doesn’t matter, I won’t bother you. Moreover, this is not always necessary from an investor’s practical perspective.

Let’s zero in on the ultimate metric that aggregators and brokers utilize — the final risk measure DV01, which represents the change in bond price when the key rate shifts by 1 basis point (0.01%). Here is a methodology for calculating it yourself if you are interested.

An advanced reader should be aware that when purchasing a bond, we are essentially betting on a decrease in the key interest rate, while selling indicates a belief in its increase.

However, the crucial question remains: how much risk are we taking with this bet?! DV01 provides the answer by quantifying the bond price’s sensitivity to changes in interest rates, guiding our decision-making regarding the optimal duration of our investment strategy.

Bellissimo

Indeed, the question arises: “So what? How do we work with DV01?” The answer lies in understanding how to invest risk-neutrally along the curve. Simply put, by purchasing DV01 proportionally across the entire maturity curve, investors can achieve risk-neutral investment along the yield curve. This strategy ensures a balanced exposure to interest rate risk, allowing investors to navigate fluctuations in the market effectively.

What’s going on with our case?

• The bond will be matured in 14 years, and DV01 is quite large — ~$120 per 1 bp of face value — comparatively big number.
• If we buy 1 Dell 38 bond, we will bet on lowering the far end of the curve! Is anyone sure about this? and what will happen to the front one?

Make a simple mathematical proportion to understand DV01:

• 1 year maturity — $30 DV01
• 14 year maturity — $120 DV01
• 120:30 = 4:1 — ratio
• If we equip our investment portfolio as 4XBond_1year + 1XBond_14year, we will have the same effect of the rate change on the entire curve. More granularity means a more stable estimation

“Why has the price (YTM) changed so significantly in the last six months if the rate has remained constant?” you might ask. And indeed, that is a very valid question.

Risks : Market risk

Here we can observe the gradual decline in the yield of treasuries since the end of October, with a noticeable trend of more significant movement for long-term treasuries.

The discerning reader may already be inferring that a significant portion of the movement in Dell bonds occurred due to corresponding movements in Treasury bonds with the same maturity date. Undoubtedly, the narrowing of credit risk/market conditions also played a role, further reinforcing the overall effect during the year.

Market expectations dictate the price of bonds

At the end of last year, improved inflation data coupled with statements from Mr. Powell suggesting imminent easing prompted a surge in market optimism. As a result, investors began buying related bonds, causing their yields to converge as the market reached a consensus.

The consensus on the future key rate is calculated from futures on rates, which provide us with the probability of the Federal Reserve’s decisions. Here you can read numbers.

On the flip side, market risk also stems from the potential for significant movements driven by institutional players. For instance, a substantial number of “Horns and Hooves” bonds ended up in Goldman Sachs’ position. As bankers began aggressively marketing these bonds to the market, touting them as highly promising investments, the balance of supply and demand shifted accordingly.

Conservative portfolio — what is that?

We’ve covered a significant portion of the topic, nearing the conclusion. Let’s now summarize our key points and insights.

1. Interest Rate Risk quantified by DV01 and depends on Maturity curve
2. Credit Risk quantified by Credit spread and depends on the issuer characteristics
3. Market Risk can be approximately quantified using complex mathematical models that incorporate factors such as trading volume, market flows. However, for uninformed market participants, accurately accounting for this risk can be challenging and actually depends on the timing of bond trades.

The risk surface

In total, our portfolio lies somewhere in the space between these independent values. How to build it?

The mathematical expectation of profit

Yes, diversification remains a key strategy, but it’s important to be able to execute it effectively. The integral of yields and weights represents the weighted average of yields across different assets in a portfolio. Now that we understand all derivatives, we can easily construct our portfolio. Here is some rules for you.

1. Weighted DV01 volume of bonds though the maturity curve
2. Different sectors and issuers with varying credit ratings
3. Timing of buying and selling bonds evenly around important news: CPI, Nonfarm Payrolls, FedRes news.

And what about Dell and uncle “Big” Joe Jr.?

Well, at least we realized that he made good money on it and the market is still looking positively at this security, but whether he will earn money from Dell 38 bond in the future is still a question.

Indeed, the decision of what to buy or not ultimately rests with each individual investor. However, with a deeper understanding of the factors driving price movements in the bond market, we are better equipped to make informed investment decisions. By comprehending the dynamics of interest rates, credit risk, market sentiment, and the impact of various economic factors, investors can navigate the bond market with greater confidence and clarity.

P.S.

I can share how risks can be quantified using Python and the asynchronous Interactive Brokers API to find best bonds, so leave a comment if you are interested :)