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  A new way of looking at relative value in fixed income 

A new way of looking at relative value in fixed income

By Dr Philip Bayley, Australia Ratings

When market practitioners talk about relative value in fixed income markets, they are talking about price or yield comparisons between bonds with common characteristics.

Yield is a function of price. The more investors are willing to pay for a bond, the lower the yield that the bond will return. When making relative value comparisons in the wholesale market, all single ‘A’ rated property trust issues may be assessed as a group. Or it could be all ‘BBB’ rated utility companies.

To determine relative value, bond yields or credit spreads over swap or the bank bill rate, will be measured against the term to maturity or duration of the bond. Those bonds offering higher yields for a given term to maturity are considered cheap, while those offering lower yields are considered expensive. This simple analysis does not however, mean that you should buy the cheap bonds or sell the expensive ones. Much more investigation is required before making such decisions.

Whilst in the examples given, differences in the credit quality and the industry sectors of bond issuers have been been controlled for, there are other differences in the bonds themselves that should be taken into consideration. These differences can also determine the yield or price of a bond.

Is the issue size large or small?
Large bond issues tend to be more liquid in the secondary market and will therefore attract higher prices. Secondary market liquidity will also be determined by the number of buyers and sellers in the market at any time. This can be measured by the bid/ask spread for the bond.

Is the coupon paid on the bond relatively high or low?
This will be determined by the point in the interest rate cycle that the bond was issued – when rates were high or low. High coupon bonds tend to be favoured, as investors will see their funds returned to them at a faster rate. The same applies for bonds that pay quarterly coupons over those that only pay semi-annually. Secured bonds are less risky than unsecured bonds and therefore will offer lower yields. The same applies to senior ranking bonds over those that are subordinated.

These are all quantifiable determinants of bond prices or yields that should also be taken into account in any determination of relative value. There are also qualitative factors that should be considered which go beyond the scope of this article.

When it comes to considering relative value among the debt securities listed on the ASX, the same quantitative and qualitative considerations apply but the starting point for such an analysis is much more obscure. There is a lack of commonality among the issuers.

The most common issues are the Additional Tier 1 capital hybrid securities that have been issued by the major banks. But then similar hybrids have also been issued by regional banks and insurance companies. There are also subordinated bonds that have been issued by banks. Some of these are Basel III compliant and therefore contain non-viability clauses, some do not.

There are also a few subordinated note issues from non-financial companies such as, Crown Resorts, AGL Energy, Tabcorp etc. The credit quality among these issuers varies, as does the credit quality among the very few companies that have issued plain vanilla senior ranking bonds. Indeed, the credit quality of these issuers was unknown to retail investors until Australia Ratings assigned credit ratings to the issues. At the same time, Australia Ratings used its Product Complexity Indicator (PCI) to distinguish between simple senior ranking bonds (GREEN) and the most complex hybrid notes (RED) and all those in between (BLUE, YELLOW and ORANGE).

It is much harder to group these disparate issues to provide a starting point for any relative value analysis among ASX listed debt securities. To illustrate this point the chart below presents issues plotted by yield to term to call. Australia Rating’s PCI colour coding has been used to distinguish the different levels of complexity among the instruments.

From the chart there appears to be very little differentiation the yields for term to call for securities with a RED PCI but quite a lot of variation among those with an ORANGE PCI. The yield curve for YELLOW PCI securities appears very steep but there is virtually no differentiation among those that are BLUE.
And GREEN designated senior ranking bonds show significant variation in yields relative to the term to call.

Remember, however, this is just the starting point for undertaking a relative value analysis. None of the other quantifiable features mentioned above have yet been taken into account, let alone qualitative considerations. Using a specially constructed empirical model it is possible to take into account all of the quantifiable variables that are of concern. The model uses data from across the listed market as a whole and measures the contribution of each variable to the yield (in this case) of the debt security and in so doing, determines a fair market value for every debt security considered.

With a fair market value determined for each security it is easy to then assess fair market value. Securities with yields above the fair market value line are cheap, and those below the line are expensive (subject  to any qualitative factors that may impact this judgement.).

The chart below shows the output from the empirical model.

The results are presented by security from the lowest on the fair market value line to the highest. The model explicitly takes into account term to call and the Australia Ratings credit ratings assigned, along with all the other variables.

Relative value is now easy to see across the whole market, and the ranking of securities with ORANGE and RED PCIs is intuitively appealing. The ranking of those with GREEN, BLUE and YELLOW PCIs seems more anomalous but can be explained by the differing credit ratings of the issuers.

The BLUE securities are old-style non-Basel III compliant subordinated debt issues from the major banks, the YELLOW securities are mostly subordinated debt issues from large non-financial companies, and the GREEN securities are senior ranking bonds issued by smaller companies. The line that runs between all of the securities is the fair market value line calculated by the model.

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