Fixed Income Strategy

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1 Fixed Income Strategy The Practitioner s Guide to Riding the Curve Tamara Mast Henderson

3 Fixed Income Strategy

4 Wiley Finance Series Fixed Income Strategy: The Practitioner s Guide to Riding the Curve Tamara Mast Henderson Active Investment Management Charles Jackson Option Theory Peter James The Simple Rules of Risk: Revisiting the Art of Risk Management Erik Banks Capital Asset Investment: Strategy, Tactics and Tools Anthony F. Herbst Brand Assets Tony Tollington Swaps and other Derivatives Richard Flavell Currency Strategy: The Practitioner s Guide to Currency Trading, Hedging and Forecasting Callum Henderson The Investor s Guide to Economic Fundamentals John Calverley Measuring Market Risk Kevin Dowd An Introduction to Market Risk Management Kevin Dowd Behavioural Finance James Montier Asset Management: Equities Demystified Shanta Acharya An Introduction to Capital Markets: Products, Strategies, Participants Andrew M Chisholm Hedge Funds: Myths and Limits Francois-Serge Lhabitant The Manager s Concise Guide to Risk Jihad S Nader Securities Operations: A guide to trade and position management Michael Simmons Modeling, Measuring and Hedging Operational Risk Marcelo Cruz Monte Carlo Methods in Finance Peter Jäckel Building and Using Dynamic Interest Rate Models Ken Kortanek and Vladimir Medvedev Structured Equity Derivatives: The Definitive Guide to Exotic Options and Structured Notes Harry Kat Advanced Modelling in Finance Using Excel and VBA Mary Jackson and Mike Staunton Operational Risk: Measurement and Modelling Jack King Advance Credit Risk Analysis: Financial Approaches and Mathematical Models to Assess, Price and Manage Credit Risk Didier Cossin and Hugues Pirotte Interest Rate Modelling Jessica James and Nick Webber Volatility and Correlation in the Pricing of Equity, FX and Interest-Rate Options Riccardo Rebonato Risk Management and Analysis vol. 1: Measuring and Modelling Financial Risk Carol Alexander (ed) Risk Management and Analysis vol. 2: New Markets and Products Carol Alexander (ed) Interest-Rate Option Models: Understanding, Analysing and Using Models for Exotic Interest-Rate Options (second edition) Riccardo Rebonato

5 Fixed Income Strategy The Practitioner s Guide to Riding the Curve Tamara Mast Henderson

6 Copyright C 2003 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on or All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher. Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England, or ed to permreq@wiley.co.uk, or faxed to (+44) This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the Publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought. Other Wiley Editorial Offices John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA , USA Wiley-VCH Verlag GmbH, Boschstr. 12, D Weinheim, Germany John Wiley & Sons Australia Ltd, 33 Park Road, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore John Wiley & Sons Canada Ltd, 22 Worcester Road, Etobicoke, Ontario, Canada M9W 1L1 Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN Typeset in 10/12pt Times by TechBooks, New Delhi, India Printed and bound in Great Britain by TJ International Ltd, Padstow, Cornwall, UK This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production.

7 To Callum

9 Contents Acknowledgments Biography Introduction xi xiii xv PART I BASIC TOOLS FOR ESTABLISHING A FIXED INCOME STRATEGY 1 1 Fixed income basics Pricing a bond Market risk: The price yield relationship Yield curve risk: The yield maturity relationship Beyond theoretical value: Other sources of risk Sources of return Summary 16 Notes 16 Recommended reading 17 2 Fixed Income Securities: Beyond the Basics Spread risk: Evaluating bonds of different quality Volatility risk: Evaluating bonds with embedded options Interest rate derivatives Futures Options Swaps 32 Notes 36 Recommended reading 37 3 Economic Fundamentals The building blocks of economic analysis Interest rate theories: Forecasting market direction Yield curve models: Forecasting movements in the yield curve Spread theories: Anticipating changes in the risk premium 54

10 viii Contents 3.5 Volatility models: Anticipating changes in volatility The efficient markets hypothesis Chaos theory Economic fundamentals: Uses and misuses 60 Notes 61 PART II ENHANCED TOOLS FOR ESTABLISHING A VIEW ON INTEREST RATES 63 4 Government policy: The interface between economics and politics The political economy perspective Political business cycles Budget deficits and monetary policy Central bank independence Policy objectives The monetary policy mechanism Anticipating changes in monetary policy Fed watching ECB watching Implications for fixed income investors 73 Notes 74 Recommended reading 75 5 Human Factors Group behavior: A demographic approach The inherently human nature of markets: A psychological approach Information processing Attitude and mood: The effect on risk tolerance and judgment Social psychology: The herding phenomenon Implications for fixed income investors Limitations of the psychological approach 96 Notes 96 Recommended reading 97 Appendix: Summary of psychological phenomena 98 6 Technical Analysis: Applied Social Psychology Fundamentalists versus technicians The basic tools of technical analysis The contrarian approach The smart money approach Implications for fixed income investors The limitations of technical analysis 113 Notes 113 Recommended reading Other Techniques for Short-Term Analysis Flow analysis 115

11 Contents 7.2 Supply and demand analysis Seasonal analysis Quantitative analysis The limitations of statistical methods 125 Notes An Integrated Approach to Bond Strategy An interdisciplinary model The appropriate use of tools Resolving mixed signals Evaluating downside risk System checks A template for constructing a view on which to trade Limitations of the interdisciplinary approach 137 Notes 137 Recommended reading 138 PART III IMPLEMENTING YOUR VIEW Fixed Income Instruments, Investors and Portfolio Management Styles The fixed income universe Government securities Corporate securities Structured securities Fixed income derivatives Structured products Country and currency considerations Investor types Portfolio management Passive portfolio management Structured portfolio management (asset liability management or ALM) Active portfolio management 156 Notes 160 Recommended reading Fixed Income Trading Market directional bets Yield curve bets: Steepeners and flatteners Yield curve bets: Rising and falling curvature Spread bets Volatility bets Summary 172 Notes 174 Appendix: Bullets, barbells, and butterflies 175 ix

12 x Contents 11 Odds and Ends Asset allocation Individual bond selection Leverage Risk management Strategy management 182 Notes 183 Recommended reading Survival Principles for the Financial Battlefield Six pearls of wisdom Concluding remarks 187 Bibliography 189 Index 195

13 Acknowledgments This book in many ways reflects the journey of my life, which has had the benefit of many teachers and supporters along the way. I am particularly indebted to my parents, and to the late Abner Sachs, Tom Willett, Benedicte Vibe Christensen, and Rachael Wilkie all of whom had pivotal roles at key junctures. Many dear friends have accompanied me along this journey, no matter where it has led, offering tireless encouragement, humor and hugs. I have also had the privilege of working with an amazing group of supervisors and colleagues throughout my career. Thank you for your wisdom, inspiration, and thoughtfulness. This project has benefited from the input of many individuals, some of whom preferred to remain anonymous. Mohamed El-Erian, Amer Bisat, and Tsuyoshi Fukui introduced me to a number of the concepts presented here, well before there was any inkling about writing a book. Robert Minikin and Rashique Rahman patiently responded to numerous rounds of endless questions and provided comments on draft material. Karl Massey provided key insights on trading and the significance of the motivations behind the flows. Rob Drijkoningen, Bea Groeger, Robert McAdie and Wilfried Schnedler also took time from their busy schedules to participate in interviews. Everett Brown, Howard Friend, Darrene Hackler, Tracey Johnson, and Truman Mast provided valuable comments on portions of earlier drafts. Callum Henderson and Orlando Roncesvalles were kind enough to go through the entire manuscript. Frances Phillips and her team at Connaught Communications provided superb editorial support on the full manuscript. Bill Goldy and Glyn Bradney at Reuters and Chris Manuell at IDEAglobal graciously provided the technical charts. Chris Swain, Samantha Hartley and Alex Whyte at Wiley did a fantastic job of transforming this project into a book. I would also like to thank Alan Brown and Peter Smith for their reviews. Last but not least, I owe my deepest gratitude to my husband, Callum. This project would not have gotten off the ground, nor would it have stayed off the ground, if not for his unwavering encouragement, advice, and patience. Callum is not just my soulmate in life, but his character, dedication, and hard work are a daily inspiration to push for more and gut it out. Thank you.

15 Biography The author is a senior fixed income strategist for a leading provider of independent research and market analysis, responsible for European sovereign debt. Ahead of this, Dr. Henderson was deputy head of the International Monetary Fund s Investment Unit, responsible for the management of $11 billion in trust funds. Henderson has also worked as an economist for the US Department of Commerce, IMF and Salomon Smith Barney. She has a B.A. in Foreign Affairs and Economics from the University of Virginia, and a M.A. and Ph.D in Economics from Claremont Graduate University.

A Foreign Exchange Primer

A Foreign Exchange Primer For other titles in the Wiley Trading series please see www.wiley.com/finance A FOREIGN EXCHANGE PRIMER Second Edition Shani Shamah A John Wiley and Sons, Ltd., Publication Copyright