BOND TRADING STRATEGIES SERIES
Mastering Yield Tenor Spread with Leverage
A Guide to Enhanced Extra Returns in DeFi
Introduction
Welcome back to Secured Finance’s Bond Trading Strategies series, as part of our Test Pilot V3 Training Program. Building on our exploration of Carry Trade, we now introduce “Yield Tenor Spread with Leverage,” a sophisticated strategy combining Yield Tenor Spread with Leveraged Lending and Borrowing. This approach allows traders to exponentially increase returns by exploiting yield curve discrepancies, harnessing the power of leverage.
Recap on Zero Coupon Bonds (ZCB)
Zero Coupon Bonds (ZCBs) are traded at a discount and mature at a face value of 100, with no periodic interest. When you buy a ZCB, you’re effectively lending money; you pay out funds now and expect to receive more at maturity. The price of a ZCB is inversely related to its yield: the lower the purchase price, which means the greater the discount, hence the higher the yield. In order to maximize returns, the aim is to buy ZCBs at low prices (lending at higher yields) and sell at higher prices (borrowing at lower yields).
What is Yield Tenor Spread?
This investment approach leverages discrepancies in bond yields across various maturities of the same asset. It plays on the divergence of interest rates between shorter and longer-term bonds, aiming to profit from the yield ‘spread’. To put it simply, it is to buy the ZCB at a lower price and sell it at a higher price. In terms of yield, it means to lend at a high-yield and borrow at a low-yield.
What is Leveraged Lending and Borrowing?
Leveraged Lending and Borrowing intensify market presence beyond the initial capital outlay. Traders borrow at lower rates and lend at higher rates, employing leverage and looping techniques to enhance potential gains. Trader will borrow and lend out those borrowed funds, which allow him to borrow again. Hence, he will keep repeating this process of borrowing and then lending, thus earning more yield from the leveraged position than his initial capital outlay.
Understanding the Yield Tenor Spread with Leverage Strategy
At its core, this strategy involves two pivotal actions with the same asset: purchasing zero-coupon bonds at a lower price (indicating a higher yield) for one tenor and selling them at a higher price (lower yield) for another. Assets lent out also double as collateral, reducing the Loan-to-Value (LTV) ratio, thereby enabling further borrowing and creating a potent compounding effect.
Yield Tenor Spread with Leverage Strategy in Action on Secured Finance
Here’s how the Yield Tenor Spread with Leverage could play out:
- Yield Analysis: Conduct detailed yield curve analysis to pinpoint disparities between bond yields of different tenors. For example, a 6-month bond may offer a 1.5% semi-annual yield (or 3% annual), while a 1-year bond yields 5% annually.
- Lend High-Yield Tenor (1): Begin by lending at the 1-year tenor with a higher yield (or lower price), purchasing a $1000 zero-coupon bond accruing $25 in interest over 6 months (5%/2*$1000), reflecting the 5% annual yield.
- Lend Position as Collateral: Utilizing the lend position as collateral, you can borrow up to 80% of its value, which is subjected to a 20% haircut.
- Borrow Low-Yield Tenor (1): In this scenario, you borrow at the 6-month tenor, which has a lower yield (or higher price), by selling a zero-coupon bond valued at $800 (80%*$1000), anticipating a repayment of $12 (1.5%*$800) after 6 months, reflecting the 1.5% semi-annual yield.
- Lend again (2): You repeat the process with the newly borrowed funds. Lend again at the 1-year tenor, this time with $800 from the borrowed fund.
- Borrow again (2): With the new lend position as collateral, you can borrow up to 80% of its value again. So, you borrow a 6-month tenor, taking out a zero-coupon bond worth $640 (80% of $800).
- Lend again (3): You repeat the process with the newly borrowed funds. Lend again at the 1-year tenor, this time with $640 from the borrowed fund.
- Borrow again (3): With the new lend position as collateral, you can borrow up to 80% of its value again. So, you borrow a 6-month tenor, taking out a zero-coupon bond worth $512 (80% of $640).
- Lend again (4): You repeat the process with the newly borrowed funds. Lend again at the 1-year tenor, this time with $512 from the borrowed fund.
- (You can also continue this leveraging loop, carefully increasing your exposure while also managing risk. This cycle can be repeated as desired, balancing the aim to maximize leverage against prudent risk management considerations.)
- Cumulative Leverage Impact: In our scenario, you have lent out 4 cycles and borrowed 3 cycles, leading to total lending positions of $2952 (= 1,000 + 800 + 640 + 512) and borrowing positions of $1952 (= 800 + 640 + 512).
- Profit Calculation with Leverage: After 6 months, your interest income totals $73.80 (5%/2*$2952), with an expected repayment of $29.28 (1.5%*$1952). This yields a net profit of $44.52, translating to about an 8.9% annual return compared to $25 or 5.0% APR without leverage.
- Monitoring: Continuously monitor market conditions and the yield curve, adjusting positions as needed before bond maturities.
- Maturity and Netting Off: If the rollover is executed at consistent rates, the positions can be offset at maturity, with the final profit encompassing the initial spread and any additional interest rate gains during the rollover period.
Pros and Cons
Pros:
- Enhanced Potential Returns: The yield tenor spread and leverage combination can significantly amplify earnings.
- Market Agility: This strategy allows traders to capitalize on interest rate differentials and yield curve shifts swiftly.
Cons:
- Amplified Risks: The use of leverage increases the potential for larger losses.
- Complexity: Requires a deep understanding of both yield curve dynamics and leveraging techniques.
Disclaimer
The strategies discussed herein are intended for educational purposes and are not to be construed as financial advice. While you can practice risk-free on our testnet, real stakes apply on the mainnet. Fixed rates on Secured Finance remove interest rate risk, yet market price risks remain. Always conduct comprehensive due diligence.
Conclusion
Yield Tenor Spread with Leverage fuses two dynamic strategies to forge a path toward potentially higher returns in bond trading. While complex, this approach offers substantial rewards to those with deep market knowledge and astute risk management skills. Leveraging the capabilities of Secured Finance’s platform, traders can harness market subtleties in a more impactful way.
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