Banco Central de Reserva del Perú

Duration and Curve strategies

Marie-Laure Barut-Ethrington
Banque de France - Investment Division

12-13 March 2013 - Lima

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Duration strategies
Curve Strategies
Monitoring trades and performance

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Duration strategies

Curve Strategies
Monitoring trades and performance

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 Duration strategies

Duration strategies : Main concepts

A duration position is :

 An outright position or a position relative to an index or a benchmark;

 A directional position on the evolution of absolute yield levels : anticipation of an

increase or a decrease in yield levels;

 Taken by overweighting (long duration position = buying bonds) or underweighting

(short duration position = selling bonds) the interest rate risk exposure.

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 Duration strategies: long/ short positions (2)

Curve strategies: Long/Short

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Duration strategies: long/ short positions vs. a benchmark
Duration strategies: long/ short positions vs. a benchmark

 A long duration position is:

 based on an anticipation of a bond price increase, or a bond yield decrease;

 a position with an overweighted exposure to interest rates variations. If yields evolve in
the right direction for bond prices (namely a decrease in yields), the long duration
position will have a higher P&L than the reference position as it will be more sensitive to
yield variations

 A short duration position is:

 based on an anticipation of a bond price decrease, or a bond yield increase;

 a position with an underweighted exposure to interest rates variations. If yields evolve
in the right direction for bond prices (namely an increase in yields), the short duration
position will see its P&L decrease by a lower amount than the reference position
because it will be less sensitive to yield variations.

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UST 10y bond price variation (modified duration of 9.051), for a nominal of USD
100 Mio and an immediate decrease of 20 bps in its yield to maturity:
P&L = + 1,773,272 USD or + 1,83% of the initial cash amount invested

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UST 2y bond price variation (modified duration of 1.982), for a nominal of USD
100 Mio and an immediate decrease of 20 bps in its yield to maturity:
P&L = + USD 396,581 or + 0.40% of the initial cash amount invested

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 Market Bond Indices

Market Bond Indices are either proprietary (BAML, Barclays, JP Morgan, Citigroup,…) or provided
by data providers on the basis of multi-contributed prices (IBOXX, Bloomberg EFFAS)

 They reflect a wide range of asset classes including domestic, international and emerging
Fixed Income investment.

 For the Fixed Income, the main categories are :

 « Treasuries » (e.g. QW1A Index + <GO>, ITRROV Index +<GO>) : government bonds
issued in the national currency
 « Aggregate » : Investment Grade Government + IG Credit + Securitized
 Pure « Credit » : IG Corporates + Foreign Sovereigns + Agencies + Supranationals+
Securitized
 Dedicated to some asset classes, for instance :
 Securitized: MBS, Pfandbriefe, ABS,...
 High Yield, Emerging Debt
 Corporates ex-MBS
 Bond Indices
Bond Indices are freely accessible via the usual media to assess the performance of various asset
classes and to compare the performance of funds
 Initiating a long position: what do we need to check before?

Concepts

 Net carry

 Pick-up between the bond yield and its funding cost over the considered period of time.

 Roll-down

 The capital appreciation (lower yield, often expressed in bps) as a bond rolls down a
positively sloped yield curve through time decay.
(Be careful of negative slopes !)

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 Investment horizon

Investment horizon

 In order to be able to estimate the bond price variation, the investor must first fix an
investment horizon: the investment horizon will then be the same for the calculation of
the roll-down and for the calculation of the net carry of the position.

 Let’s assume a 3 month investment horizon. We must:

 Rebuild the yield curve in 3 months;
 And then determine the yield/ price of the bond with a 1 year and 9 months residual
maturity.

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 Net carry calculation: Concepts (1)

 Carry:
 Being long the bond provides a return = the yield at which the bond is bought.
 For the calculation of the net carry, the yield (given in bond market convention such as
ACT/ACT for US bonds) will need to be converted into a money market convention (ACT/360
for US bonds) in order to be compared to its funding cost expressed in the same convention.

 Funding Cost:
 The cash used to buy the extra bonds has a cost which can be explicit (repo rate, funding rate
charged by the treasurer) or implicit (opportunity cost).

 The funding cost or financing cost is the cost of the funds used to finance a long position. The
funding cost is different for each portfolio and for each strategy. In a benchmarked
environment, the funding cost will be the expected benchmark return or the expected return
of the reference index that is not replicated. It can also be the return of the bond that was sold
to finance the new long position.

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 Net carry calculation: Concepts (2)

 Net carry = Carry – Cost of funding

 If net carry is positive, it accumulates over time and the long position will accrue profit
as time passes (all things being equal).

 If net carry is negative, it accumulates over time and the long position will accrue a loss
as time passes (all things being equal).

 The net carry is usually calculated on an annual basis (making easier to compare various
positions). The net carry “protection” (positive net carry) can therefore be described as
a protection equivalent to a bond with a modified duration of 1. Then, if we initiate a
long position on a 2 year maturity bond, with a 3 months investment horizon), the net
carry protection must be adjusted to the average modified duration of the bond over
the investment period (mid beween the modified duration of a 2Y bond and of a 1,75 Y
bond).

 The adjusted net carry protection over the investment period can be estimated as:
Net carry over the investment horizon / Average modified duration of the bond over
the investment horizon
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 Net carry calculation: Exercise

Exercise

 As of June 5th 2014, you want to implement a long position by buying a 5y US Treasury
bond (UST 1.5% 05/31/19), settlement on T+1 (June 6th), and hold it for 3 months, ie up
to September 6th 2014 (investment horizon = 92 days).

 The yield on the 5y UST is 1.55% and the 3 months repo rate (rate at which you can
borrow the cash for 3 months to buy the bond) is 0.10%.

 The duration of this bond is supposed to be equal to 4.80 and the duration of a 4 year
and 9 month maturity UST (UST 1.5% 02/28/19) is supposed to be equal to 4.60.

 What’s the net carry and the adjusted net carry of this long position?

 What’s the breakeven yield on the UST 1.5% 05/31/19?

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 Net carry calculation: Exercise

Answers
 What’s the net carry and the adjusted net carry of this long position?
The net carry of this 5y UST long position for 3 months is calculated as:
[yield of the 5y UST (repo base/mm convention) – 3 months repo rate] x 92 days/360
= (1.55 x 360/365 - 0.10%) x 92 days / 360 = (1.529-0.10 ) x 92/360 = 0.365% or 36.5 bps

The long position is then said to be “carry positive”, which means that the carry accumulates
over time and the long position will accrue profit as time passes (all things being equal).

This net carry must then be adjusted by the average modified duration of the bond over the
investment period, in this case 4.70 ((4.80+4.60)/2), which means that the adjusted net carry
provides a protection of 36.5 bps/ 4.70 or 7.8 bps.

 What’s the breakeven yield on the UST 1.5% 05/31/19?

On September 6th 2014, if the yield of the UST 1.5% 05/31/19 is:
 equal to 1.628% (1.55% + 7.8 bps), the long position will be breakeven (P&L = 0);
 below 1.628% (1.55% + 7.8 bps), the long position will have a positive P&L;
 above 1.628% (1.55% + 7.8 bps), the long position will have a negative P&L.
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Net carry calculation: Bloomberg COC

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 Roll-down calculation: Concepts (1)

Concepts

– After 3 months, a 5 year maturity bond becomes a 4 year and 9 month maturity bond.

– If the curve is positively sloped and unchanged after three months, the bond will richen
by rolling down the curve (as its yield will decrease).

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 Roll-down calculation: Exercise (con’t)

 As of June 5th 2014, the UST 1.5% 02/28/19 (4 year and 9 month maturity UST) is trading
@ 1.47%.
What is the roll-down over 3 month ?

 On September 6th 2014, if the curve is unchanged after 3 months, the investor will have
benefitted from both the carry and the roll-down.
What is the total gain ?

 At the same date ,the yield of the new UST with a 5y maturity is 1.65%
Has the long position lost or made profit ?

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 Roll-down calculation: Exercise (con’t)

Answers
 As of June 5th 2014, the UST 1.5% 02/28/19 (4 year and 9 month maturity UST) is trading
@1.47%.
The roll-down over 3 month is then equal :
5y UST yield – 4y and 9 month UST yield = 1.55% - 1.47% = 0.08% or 8 bps

 On September 6th 2014, if the curve is unchanged after 3 months, the investors will have
benefitted from
carry (7.8 bps) + roll-down (8 bps) = 15,8 bps

 The breakeven yield of this position is :

1.55% + 7.8 bps + 8 bps = 1.708%
If the new UST 5Y trades at 1,65% the long position has a positive P&L
(above 1.708%, the long position will have a negative P&L)

The sum of the carry and the roll-down is the amount of protection an investor – with long
positions in bonds – has against an upward parallel shift of the yield curve, assuming that
the slope of the curve is unchanged at its investment horizon.

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 Forward Rates in Duration Strategies (2)

Understanding FWCV function

 For a given yield curve, he FWCM function calculates, from the traded rates, the
forward rates at various dates. For instance a yield of 2,25% for a French bond 5Y
in 1Y (spot rate = 1.73% )

 We use this function to estimate the breakeven on a long position on this 5 year
French bond :
 The 5 year bond will be a 4 year bond in 1 year.
 The 4 year bond in 1 year is trading at a forward rate of 1.99% : this is the breakeven
rate.
 A long 5 year position initiated at 1,73%, held for 1 year, will not loose or make money
(in comparison with holding a 1 Year French bond instead) if the bond is trading at 1.99%
in 1 Year.
 If the bond is trading at a lower yield than 1.99% in 1 year, the long position will have
been more profitable than holding a 1 year French bond, even though the bond has
depreciated, due to its higher carry and roll-down.

• Let’s use again a Carry analysis to illustrate the breakeven analysis.

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 Forward Rates in Duration Strategies (3)
Carry analysis illustrates why the Forward Rate is the breakeven of a position

 Carry analysis sheds some lights on breakeven analysis:

 The French 5 year bond, which is initially trading at 1.73%, earns about 100 bps more than
a 1 year French bond, trading at 0.73%;
 So holding a 5 year bond for 1 year would bring an extra return. This means that the bond
would need to depreciate by a “certain amount” to offset this excess carry received on
the 5 year bond.
 How can we quickly estimate that “certain amount” of depreciation?

• Estimate of the breakeven rate for the 5 year bond in 1 year:

 The 5 year bond earns 100 bp more than a 1 year security (1.73% vs 0.73%).
 After 1 year, the bond has a 4Y maturity
 The excess return earned, per remaining maturity year, is about 25bp: 100 bps/4yr =
25bps.
 This means that the 5 year bond can depreciate by 25bp, to 1.98% (1.73%+0.25%),
without making a loss in comparison to buying the 1 year French bond.
 This is 1 bps away from what Bloomberg FWCM function was giving (impact of the rate
used to discount the cash-flows)

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Duration strategies
Curve Strategies

Monitoring trades and performance

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 Curve Strategies: Concepts (1)

Generalities about Curve Strategies

 Curve strategies are trades based on the investor’s anticipation regarding the evolution
of the shape of a given yield curve. Each curve strategy must then be implemented on
the same yield curve (same asset class and same issuer) and includes at least two bonds.

 Curve strategies including two bonds:

 “flattening” positions;

 “steepening” positions.

 Curve strategies including three bonds:

 “butterfly” positions;

 “barbell” positions.

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Movement on the US Treasury curve between 05/31/2013 and
06/02/2014 (IYC Bloomberg function):
the 2-10 yr sector steepened

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Historical evolution of the 2-10 year US Treasury spread between
06/01/2009 and 06/02/2014 (HS Bloomberg function)

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 Curve Strategies with two bonds (1)

Curve Strategies with two bonds

Principles:

 Curve strategies including two bonds are trades on the evolution of the spread between
the yield to maturity of two bonds from the same yield curve.

 A curve strategy does not include a duration strategy on the evolution of the absolute
levels of all yields (increase or decrease). It must then be immunized to the duration
risk, ie. to a parallel movement (up or down) of the whole yield curve.

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 Curve Strategies with two bonds (2)
Curve Strategies with two bonds

A flattening position anticipates:

 a higher decrease of the long term rate vs. the short term rate = bull flattening (short term and long
term rates increase)
 a higher increase of the short term rate vs. the long term rate = bear flattening (short term and long
term rates increase)
 A long term rate decrease and a short term rate increase

In all cases : the spread between the two rates will tighten (if the yield curve is not
inverted).
A steepening position anticipates:
 a higher decrease of the short term rate vs. the long term rate = bull steepening (short term and long
term rates decrease )
 a higher increase of the long term rate vs. the short term rate = bear steepening; (Ishort term and
long term rates increase: )

 A long term increase and a short term rate decrease

In all cases : the spread between the two rates will widen (if the yield curve is not inverted).

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 Curve Strategies: Concepts

Generalities about Curve Trades

• Implementation of a Curve trade :

 In a portfolio context, a curve trade is duration hedged. This means that the position will
not be affected by the variation in the absolute level of the yields (except for convexity
effect, therefore the investor will need to adjust its hedge from time to time), but only
by the spread between different bonds from the same yield curve (US Treasury, German
government bonds…).

 There are potentially an infinite number of possible curve strategies, for each yield
curve. They will depend on market conditions, trader’s creativity, the ability to mix
different instruments.

Hereafter some of the most common curve strategies and their implications.

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 Curve Strategies implying two bonds: Flatenning/Steepening

Strategy Action Motivation Cash & Carry P&L & Risk

Flatenning Sell short •Rate hikes Increases the cash

/buy long •Decrease in position
inflation outlook
Dur. •Negative growth The carry is positive
Weighted outlook and short when •The position will perform if
rates already DurL/DurSh x YSh >YL the curve flattens /
anchored steepens more than what
is in the fwd rates
•Depending on the bet
(bear or bull flatenning /
steepening), the position
might be adjusted to be
Steepening Sell long •Rate cuts Decreases the cash over/underweighted
/buy short •Increase in position •Convexity adjustement
inflation outlook might be necessary during
Dur. •Positive growth The carry is positive the life of the position
weighted outlook and short when
rates already DurL/DurSh x YSh < YL
anchored

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 Curve Strategies with two bonds: Duration (PV01) Immunization (1)

Curve Strategies with two bonds: Duration (PV01) Immunization

• Principles:

 A position with a total modified duration or PV01 equal to 0 is not exposed to an

immediate parallel move in the yield curve.

 The curve position will then need to be implemented with a total PV01 equal to 0: the
PV01 of one of the two bond wil be compensated by the PV01 of the other bond.

 A curve position is implemented with a long position on a bond and a short position on
another bond, with both legs weighted in a way that the price variation of one bond will
be compensated by the price variation of the other one for parallel moves in the yield
curve (P&L should be the same after a parallel move):

PositionBond1  PV 01Bond1  PositionBond 2  PV 01Bond 2  0

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 Curve Strategies with two bonds: Duration (PV01) Immunization (2)

Curve Strategies with two bonds: Duration (PV01) Immunization

• Principles:

 Immunizing a curve position in duration is not neutral in terms of cash. The total cash
amount needed to finance an immunized curve position correspond to the difference
between the cash amount of the short position (Position Bond 2) and the cash amount
of the long position (Position Bond 1).

æ PV 01Bond 2 ö
TotalCash = PositionBond 2 - PositionBond1 = PositionBond 2 ´ ç1- ÷
è PV 01Bond1 ø

 If the modified duration of the Bond 2 is higher than the one of Bond 1, the total Cash
amount will be negative (and vice versa). For instance, on a 2-10 steepening position,
the Total Cash will be negative (the investor will need to fund this position).

 More generally, a steepening position will need to be funded whereas a flattening

position will generate extra cash to reinvest.

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 Example of a duration (PV01) immunization of a 2-10 yr position:

Bloomberg PDH2 (Position duration Management) :

Is this a flatenning or a steepening position ? What is the result on the cash balance ?

It is a steepening position (I buy 2Y / sell 10Y)

Cash flows : - 9,976,566.92 + 2,145,887.97 = - 7,830,678.95

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 Curve Strategies with two bonds: Analysis

Curve Strategies with two bonds: Analysis

 A curve position can be analyzed as a combination of two separate directional positions

(one long position and one short position).

 For instance, for a 2-10 year steepening position, we will have to:

• Fund the 2Y long position: GC repo rate will be used to estimate the cost of funding
ie 0,30%
• Invest the cash generated by selling the 10Y bond: the 10Y benchmark is trading
special at -0.50%

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Breakeven Spreads for a 2-10 year steepening position
Initial spread : 142 bps bps CCS Bloomberg function:

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 Curve Strategies with two bonds: Immunization Exercise (1)

Curve Strategies with two bonds: Immunization Exercise

The problem:

 Two fixed rate bonds from the same issuer:

 The first one has a 2 year residual maturity with a 5% annual coupon rate and a
DV01 equal to 0.0186;
 The second one has a 3 year residual maturity with a 10% annual coupon rate and a
DV01 equal to 0.0277.

 On the start date, none of them have accrued interest.

 You anticipate that the curve will steepen, what position(s) should you take, with the
constraint that you cannot have a nominal short position exceeding USD 50 Mio?

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 Curve Strategies with two bonds: Immunization Exercise (2)

Curve Strategies with two bonds: Immunization Exercise

Answers

 If you anticipate that the 2-3 year will steepen, you should be long the 2 year bond and
short the 3 year bond. If you do not want to be exposed to directional moves in yields
(parallel shift), nominal amounts on both positions must be adjusted.

 You must take a short position of EUR 50 Mio nominal on the 3 year bond (maximum
short position allowed) and then derived the nominal amount of the 2 year bond that
you will buy. A neutral duration global position is built as follow :
(Nominal on the long 2 year position x DV01 of the 2 year bond)
– (Nominal on the short 3 year position x DV01 of the 3 year bond)
=0
Nominal of the 2Y bond = 50 MEUR x 0,0277 / 0,0186 = 74,462 MEUR

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 Curve Strategies with 3 bonds: Principles
Curve Strategies with three bonds

• Principles:

– Curve strategies including three bonds are trades on the evolution of the spread
between the rate of one bond (referred to as “the body” of the position) vs. the
rates of two other bonds (referred to as “the wings” of the position).

– As for curve strategies with two bonds, curve strategies with three bonds should be
immunized in duration, no to be exposed to parallel shifts in the yield curve.

– Barbell position = Long position on the “wings” and short position on the “body”:
it’s a curve position that anticipates an increase in the level of the “body” ‘s rate vs.
the level of the “wings” ‘ rates.

– Butterfly position = Short position on the “wings” and long position on the “body”:
it’s a curve position that anticipates a decrease in the level of the “body” ‘s rate vs.
the level of the “wings” ‘ rates.

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 Curve Strategy with 3 bonds: Barbell/Butterfly position

Curve strategies implying 3 securities: Barbell/Butterfly

 Relative value trades on the shape of the curve : expectation that the belly will
underperform / outperform the wings
 The carry on such positions depends on the shape of the yield curve
 Barbell (performs when the body underperforms the wings) tends to have a short
duration biais
 Butterfly (performs when the body outperforms the wings) tends to have a long
duration biais

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 Curve Strategy with 3 bonds: Implementation

Main calculations related to a Butterfly/ Barbell

 Calculation of the weight of each part of the trade (risk adjusted):

 Each wing should have the same duration (PV01) weight and the sum of the wings’
duration (PV01) should be equal to the duration (PV01) of the body:

Body PV01 = Wing 1 PV01 + Wing 2 PV01

With Wing 1 PV01 = Wing 2 PV01

 Calculation of the Butterfly’s spread and forward spread:

 The Butterfly’s spread is calculated as:

 Butterfly’s spread = 2 x Body Rate – Wing 1 Rate – Wing 2 Rate

 The Butterfly’s forward spread can calculated in a similar way but with forward rates. It
is possible to calculate it with the Bloomberg FWCV function.

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 Curve Strategies with 3 bonds: Analysis (1)
Curve Strategies with three bonds

• Analysis:

– The analysis of curve strategies with 3 bonds should be done the same way as the
analysis of a directional position or a curve position with 2 bonds.

– Depending on the net carry of the position, we can able to calculate a breakeven
spread between the body’s rate and the wings’ rates. Repo rate (0.30% in the
example next slide) will be used to estimate the funding cost of the long position(s)
and the reverse repo rate (0.10% in the example next slide) will be used to estimate
the remuneration rate of the cash generated by short position(s).

– As for curve strategies with 2 bonds, immunizing in duration a curve position with 3
bonds will be not neutral in terms of cash.

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Breakeven spread calculation for a 2 – 5 – 10 year butterfly
Initial spread : 43.60 bps
3 M breakeven spread = 47.76 bps

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 Curve Strategies with 3 bonds: Analysis (2)
Curve Strategies with three bonds

• Analysis:

 In 3 months, if the 1 year and 9 months – 4 year and 9 months – 9 year and 9
months spread has not widened above the 47.76 bps breakeven spread, the
butterfly trade put in place will generate some positive P&L.

 The objective of this butterfly strategy was indeed a tightening of the spread
between the 5 year rate of the bond bought (body) vs. the 2 year and 10 year rates
of the bonds sold (wings) or a small widening, below 4.16 bps (breakeven spread –
initial spread = 47.76 bps – 43.60 bps).

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Monitoring trades and performance

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 Monitoring trades and performance

Monitoring trades is a full part of the portfolio manager’s responsibility

 Portfolio managers have a natural bias when it comes to monitoring trades: the
gains seem natural, however the losses are surprising. Hence they tend to spend a
lot of time explaining losses but tend to accept gains without analyzing precisely
where the profit is coming from.

 While the precise valuation should be done by the Risk management, it is

important for portfolio managers to have an idea of where the portfolio return
comes from. If the realized return of the portfolio happens to be different from
what was estimated, it might indicate some mispricing or a wrong analysis in the
breakeven of the positions put in place. However, it will often reveal some aspect
of the portfolio that might have been overlooked: a depreciation of a type of asset,
an ineffective hedge, a duration bias which was not seen, some hidden trading
costs, etc.

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 Monitoring trades and performance

Monitoring trades is a full part of the portfolio manager’s responsibility

 Performance should be monitored for the overall portfolio but also by

differentiating the different parts of the curve and the different types of assets.
Traditionally, the elements that can be monitored are:

 Directional exposure (parallel shift of the yield curve);

 Curve exposure/Deformation of the shape of the yield curve: slope for a 2
bonds position, curvature for a 3 bonds position;
 Credit spread: carry and market-to-market;
 Money markets strategies;
 Other strategies, in particular through derivatives, like basis trades (futures vs.
cheapest to deliver).

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