Fixed Income Analytics: Bonds in High and Low Interest Rate Environments

213 Pages·2017·8.19 MB·English

by  Wolfgang Marty (auth.)

Wolfgang Marty
Fixed
Income
Analytics
Bonds in High and Low Interest Rate
Environments
Fixed Income Analytics
Wolfgang Marty
Fixed Income Analytics
Bonds in High and Low Interest Rate
Environments
WolfgangMarty
AgaNolaAG
Pfaeffikon
Switzerland
ISBN978-3-319-48540-9 ISBN978-3-319-48541-6 (eBook)
DOI10.1007/978-3-319-48541-6
LibraryofCongressControlNumber:2017952064
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Foreword
In light of an investment environment characterized by low yields and new regu-
latory capital regimes, it has become increasingly demanding for investors to
achieve sustainable returns. Particularly, fixed income investments are called into
question.Thereisasolution.
Since the foundation of AgaNola a decade ago, we have put our interest into
convertibles,andatthispointwewanttothankourclientsforhavingsupportedus
alsoinchallengingtimes—particularlywhenconvertiblebondswereconsideredat
mostanicheinvestment.Unjustly!
For being a hybrid, convertible bonds offer the “best of both worlds,” the
benefitsofanequitywiththeadvantagesofacorporate bond.AgaNolaisconsid-
eredaleadingproviderinthisassetclass,andtodateconvertiblebondsremainthe
corecompetenceofusasaspecializedassetmanager.
As we consider increasingly popular convertible bonds a living and dynamic
universe,weareplacingagreatimportanceonresearchandtheexplorationofthe
natureofthisassetclass.Asaninternationallyrenownedexpertinthefixedincome
and bond field, Dr. Wolfgang Marty has contributed valuable insights to our
work—making the bridge from theory to portfolio management. AgaNola is
committedtocontinuetosupporthisfundamentalresearch.
WewishWolfgangMartylotsofsuccesswithhislatestbook.
ChairmanandFounderAgaNolaAG StefanHiestand
v
Foreword
Comparedtootherassetclasses,fixedincomeinvestmentsareroutinelyconsidered
as a relatively well-understood, transparent, and (above all) safe investment. The
notionsofyield,duration,andconvexityarereferredtoconfidentlyandresolutely
inthecontextofsinglebondsaswellasbondportfolios,andtheeffectsofinterest
ratesaregenerallybelievedtobewell-understood.
Atthesametime,weliveinaworldwheretheamountofprivate,corporate,and
sovereigndebtissteadilyincreasingandwherepostcrisisstimulicontinuetoaffect
and distort investor behavior and markets in an unprecedented way. And that is
even before we start contemplating the enormous uncertainties introduced by
negativeinterestrates.
In his book, Dr. Wolfgang Marty covers and expands on classic fixed income
theoryandterminologywithaclarityandtransparencythatisraretobefoundina
world where computerization of accepted facts often is the norm. Wolfgang
highlights obvious but commonly unknown conflicts that can be observed, for
example,whenapplyingstandardtheoryoutsideitsdefaultsettingorwhenmigrat-
ingfromsingletomultiplebondportfolios.Healsoincludestheeffectsofnegative
interestratesintostandardtheory.
Wolfgang’sbookmakeshighlyinformativereadingforanyoneexposedtofixed
income concepts, be it as a portfolio manager or as an investor, and it shows that
often we understand less than we think when studying bond or bond portfolio
holdings purely based on their commonly accepted key metrics; Wolfgang
encourages to ask questions. Anyone building automated software would benefit
from familiarity with the model discrepancies highlighted as it is to everyone’s
disadvantage if we find these too deeply rooted in commonly and widely applied
tools.
In summary, Wolfgang’s book makes interesting reading for the fixed income
noviceaswellastheseasonedpractitioner.
HeadofQuantitativeResearch Dr.JanHendrikWitte
RecordCurrencyManagement
vii
Preface
Computershavebecomemoreandmorepowerfulandoftenareaninvaluableaid.
Butthereisaconsiderabledisadvantage:often,theoutputofacomputerprogramis
difficult to understand, and the end user may be swamped by data. In addition,
computerssolveproblemsinmanydimensions,and,ashumanbeings,westruggle
thinking in more than a few dimensions. To provide a sound background of
understanding toanyone working infixedincome, we intend toillustrate here the
essentialbasiccalculations,followedbyeasytounderstandexamples.
The reporting of return and risk figure is paramount in the asset management
industry,andtheportfoliomanagerisoftenrewardedonperformancefigures.The
firstmotivationfortheherepresentedmaterialwerethefindingsofaworkinggroup
of the Swiss Bond Commission (OKS), where we compared the yield for a fixed
income benchmark portfolio calculated by different software providers: we found
different yields for the same portfolio and the same underlying time periods. The
following questions are obvious: How can a regulating body accept ambiguous
figures?Shouldtherenotbeastandard?
An additional complication is linearization, often the first step in analyzing a
bond portfolio. The yield of the bonds in a bond portfolio is routinely added to
report theyieldofthetotalbondportfolio,anddifferentdurationsofbondsinthe
portfolio are simply added to indicate the duration of a bond portfolio. We found
thatlinearizationworkswellforaflatyieldcurve,butthemoretheyielddeviates
fromaflatcurve,themoretheresultingfiguresbecomequestionable.
Also, historically, interest rates have been positive. In the present market
conditions, however, interest rates are close to zero or even slightly negative. We
find ourselves confronted with several questions: Does the notion of duration still
make sense in this new environment? And which formulae can be applied for
interest rates equalorvery close tozero? Howdodiscountfactorsbehave?Inthe
following, we attempt to include negative interest in our considerations. For
instance, in the world of convertibles, yield to maturities can easily be negative
andisnotproblematic.
ix
x Preface
Wedescribetheherepresentedmaterialinthreeways.Firstly,weusewordsand
sentences,inordertogiveanintroductionintointhenotions,definitions,ideas,and
concepts.Secondly,weintroduceequations.Thirdly,wealsousetablesandfigures
inordertomaketheoutputsofournumericalcalculationsaccessible.
PfaeffikonSZ,Switzerland WolfgangMarty
July18,2017
Acknowledgments
Thisbookisbasedonseveralpresentations,courses,andseminarsheldinEurope
andtheMiddleEast.Theherepresentedmaterialisbasedonacompilationofnotes
andpresentations.PresentingfixedincomeisauniqueexperimentandIamgrateful
forthemanyfeedbacksfromtheaudience.Theinitialmotivationforthebookwasa
seminar held at the education center of the SIX Swiss Exchange. I became aware
thatmanyissuesinfixedincomeneedtoberestudiedandrevised;moreover,Idid
not find satisfying answers to my questions in the pertinent literature. The SIX
Swiss Exchange Bond Advisory Group was an excellent platform for analyzing
openissues.
Furthermore,theworkinggroup“PortfolioAnalytics”oftheSwissBondCom-
mission was instrumentalforthe researchactivities.Inparticular mythanksgoto
Geraldine Haldi, Dominik Studer, and Jan Witte. They revised part of the manu-
scriptandprovidedhelpfulcomments.
TheEuropeanBondCommission(EBC)wasveryimportantformyprofessional
development. The members of the EBC Executive Committee Chris Golden and
Christian Schelling gave me continuing support for my activities, and the EBC
sessionsthroughoutEuropeyieldedimportantideasforthebook.
AtthemomentIamfocusingonconvertibles.MythanksgotoMarcoTurinello
and Lukas Buxtorf for introducing me into the analytics of convertibles. The last
chapterofthebookisdedicatedtoconvertibles.
The book was written over several years, and I am grateful to my present
employerAgaNolafortheopportunitytocompletethisbook.
xi
Conventions
Thisbookconsistsofeightchapters.Thechaptersaredividedintosections.(1.2.3)
denotesformula(3)inSect.1.2.Ifwerefertoformula(2)inSect.1.2,weonlywrite
(2); otherwise we use the full reference (1.2.2). Within the chapters, definitions,
assumptions,theorems,andexamplesarenumeratedcontinually,e.g.,Theorem2.1
referstoTheorem1inChapter2.
Squarebrackets[]containreferences.Thedetailsofthereferencesaregivenat
theendofeachchapter.
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