Callable vs Bullets: Performance History
Parth Bhatt – Investment Officer, County of San Bernardino
1 2 Yield Spread Callables out yielded bullets from June 2000 to May 2017 by 48 bps, on average. $10 Million invested in a 1-5 year callable only portfolio in June 2000 turned into $16.084 Million by May 2017. How much did $10 Million invested in an agency bullets only portfolio turn into? Yield to Maturity YieldSpread to Maturity
8 2
7 1.8 1.6 6 1.4 5 1.2 4 1
3 0.8 0.6 2 0.4 1 0.2 0 0 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Oct-00 Feb-01 Oct-01 Feb-02 Oct-02 Feb-03 Oct-03 Feb-04 Oct-04 Feb-05 Oct-05 Feb-06 Oct-06 Feb-07 Oct-07 Feb-08 Oct-08 Feb-09 Oct-09 Feb-10 Oct-10 Feb-11 Oct-11 Feb-12 Oct-12 Feb-13 Oct-13 Feb-14 Oct-14 Feb-15 Oct-15 Feb-16 Oct-16 Feb-17 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Bullets (1 -5 Year) Callables (1-5 Years) Bullet - Callable Spreads Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 3 It’s a Trick Question
1-5 year treasury and agency bullets only portfolio turns into $19.128 Million. Bullets out-performed by $3.44 Million. How much does a 1-5 year treasury only portfolio turn into?
Money Growth $19.12 Million $20,000,000.00
$19,000,000.00
$18,000,000.00
$17,000,000.00
$16,000,000.00
$15,000,000.00 $16.08 Million $14,000,000.00
$13,000,000.00
$12,000,000.00
$11,000,000.00
$10,000,000.00 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Oct-00 Feb-01 Oct-01 Feb-02 Oct-02 Feb-03 Oct-03 Feb-04 Oct-04 Feb-05 Oct-05 Feb-06 Oct-06 Feb-07 Oct-07 Feb-08 Oct-08 Feb-09 Oct-09 Feb-10 Oct-10 Feb-11 Oct-11 Feb-12 Oct-12 Feb-13 Oct-13 Feb-14 Oct-14 Feb-15 Oct-15 Feb-16 Oct-16 Feb-17 Bullets (1 -5 Year) Callables (1-5 Years)
Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 4 Treasuries Only?
1-5 year treasury only portfolio turns into $17.73 Million. Treasuries out-perform callable agencies by $1.64 Million.
$19.12 Million
$17.73 Million
$16.08 Million
Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index, BAML 1-5 Year US Bullet Agency Index & BAML 1-5 Year US Treasury Index 5
Why do callables that out yield bullets significantly underperform bullets with respect to total return? 6 Duration – Callables vs Bullets
Duration Instability 3
2.5
2
1.5
1
0.5
0 Jul-02 Jul-07 Jul-12 Jun-05 Jun-10 Jun-00 Jun-15 Apr-01 Apr-06 Apr-11 Apr-16 Jan-05 Jan-10 Jan-15 Feb-02 Oct-03 Feb-07 Oct-13 Feb-17 Oct-08 Feb-12 Sep-01 Sep-06 Sep-11 Sep-16 Mar-04 Mar-09 Mar-14 Nov-00 Nov-05 Nov-10 Nov-15 Dec-02 Dec-07 Dec-12 Aug-04 Aug-09 Aug-14 May-03 May-08 May-13 Bullets (1 -5 Year) Callables (1-5 Years)
Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 7 Bullet – Duration vs Yield
Duration & Conv exity 3 7
2.5 6
5 2 4 1.5 3 1 2
0.5 1
0 0 Jul-04 Jul-11 Jan-01 Jan-08 Jan-15 Jun-00 Jun-07 Jun-14 Oct-02 Oct-09 Oct-16 Apr-06 Apr-13 Feb -0 5 Sep -0 5 Feb -1 2 Sep -1 2 Dec-03 Dec-10 Aug-01 Aug-08 Aug-15 Nov-06 Nov-13 Mar-02 Mar-09 Mar-16 May-03 May-10 May-17 Bullets (1 -5 Year) Duration 5 Year Treasury Yield
No correlation between yield and duration in the case of bullets.
Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 8 Duration – Negative Convexity
Duration & Negative Conv exity 3 7
6 2.5
5 2
4 1.5 3
1 2
0.5 1
0 0 Jul-02 Jul-07 Jul-12 Jan-05 Jan-10 Jan-15 Jun-00 Jun-05 Jun-10 Jun-15 Oct-08 Oct-03 Oct-13 Apr-01 Apr-06 Apr-11 Apr-16 Sep -0 1 Feb -0 2 Sep -0 6 Feb -0 7 Sep -1 1 Feb -1 2 Sep -1 6 Feb -1 7 Dec-02 Dec-07 Dec-12 Aug-04 Aug-09 Aug-14 Nov-05 Nov-15 Nov-00 Nov-10 Mar-04 Mar-09 Mar-14 May-03 May-08 May-13
Callables (1-5 Years) Duration 5 Year Treasury Yield
High positive correlation between yields and duration. Callable bonds share exactly the opposite relationship with duration than do bullets. As yields rise, bonds become more interest rate sensitive.
Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 9 Price Upside?
Price Upside
109 Average Price $103.20 107
105
103
101
99
97 Average Price $99.88 95 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Oct-00 Feb-01 Oct-01 Feb-02 Oct-02 Feb-03 Oct-03 Feb-04 Oct-04 Feb-05 Oct-05 Feb-06 Oct-06 Feb-07 Oct-07 Feb-08 Oct-08 Feb-09 Oct-09 Feb-10 Oct-10 Feb-11 Oct-11 Feb-12 Oct-12 Feb-13 Oct-13 Feb-14 Oct-14 Feb-15 Oct-15 Feb-16 Oct-16 Feb-17
Bullets (1 -5 Year) Callables (1-5 Years) Par
On average, callable portfolios were carried at a $0.12 loss vs a $3.20 gain, assuming they were issued at par.
Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 10 Total Return Attribution
Breaks down an assets return into individual components (i.e. factors) Done via regression analysis Currency, country, yield curve, spread, etc. Sum up the component return to create total return number In this case, we break down the returns of bullets and callables into two different factors CURVE CARRY – Includes (Accrued Interest + Roll Down) CURVE CHANGE – Returns attributed to parallel shift in the yield curve (up or down) 11 Total Return Attribution
Curve Carry (Accrued + Roll Down) Curve Change Bullets Callable Delta Bullets Callable Delta Mar-13 0.09% 0.07% 0.02% -0.03% -0.04% 0.01% Jun-13 0.09% 0.08% 0.01% -0.86% -0.75% -0.11% Sep-13 0.15% 0.15% 0.00% 0.06% 0.03% 0.03% Dec-13 0.13% 0.12% 0.01% -0.41% -0.40% -0.01% Mar-14 0.14% 0.13% 0.01% -0.15% -0.12% -0.03% Jun-14 0.16% 0.15% 0.01% 0.04% 0.03% 0.01% Sep-14 0.17% 0.17% 0.00% -0.31% -0.37% 0.06% Dec-14 0.17% 0.16% 0.01% -0.11% -0.34% 0.23% Mar-15 0.17% 0.11% 0.06% 0.43% -0.06% 0.49% Jun-15 0.17% 0.11% 0.06% -0.30% -0.14% -0.16% Sep-15 0.19% 0.13% 0.06% 0.16% 0.16% 0.00% Dec-15 0.21% 0.16% 0.05% -0.84% -0.47% -0.37% Mar-16 0.21% 0.17% 0.04% 0.78% 0.37% 0.41% Jun-16 0.19% 0.14% 0.05% 0.44% 0.07% 0.37% Sep-16 0.18% 0.14% 0.04% -0.41% -0.15% -0.26%
Dec-16 0.26% 0.22% 0.04% -1.26% -0.83% -0.43% Sum 2.68% 2.21% 0.47% -2.77% -3.01% 0.24%
Callables offer inferior returns to bullets on both factors.
Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 12 Callables – From Issuer’s Perspective
Bullet Yield Curve Hypothetical Callable
Coupon Bullet Coupon Price Year Bullet Rate Callable Rate Term Structure Coupon Price Cashflow
5.00% $ 500,000.00 $ 100.00 Year 1 1.00% 1.50% 1.50% $ 550,000.00 $ 100.00 5.00% $ 500,000.00 $ 102.80 Year 2 2.00% 2.50% 2.50% $ 450,000.00 $ 100.00 5.00% $ 500,000.00 $ 103.85 Year 3 3.00% 3.50% 3.50% $ 350,000.00 $ 100.00 5.00% $ 500,000.00 $ 102.96 Year 4 4.00% 4.50% 4.50% $ 250,000.00 $ 100.00 5.00% $ 500,000.00 $ 100.00 Year 5 5.00% 5.50% 5.50% $ 150,000.00 $ 100.00 Total $ 2,500,000.00 Total $ 1,750,000.00
Issuing a callable saves a $750,000 in coupon payments over the life of the bond 13 Hypothetical Case (Fixed vs Step-up Callable)
Fixed Coupon Callable
Fixed Coupon Callable Price Bullet Equivalent Coupon Price Delta Rate With Cap Price Cashflow
5.50% $ 100.00 $ 101.79 $ 1.79 $ 550,000.00 5.50% $ 100.00 $ 104.20 $ 4.20 $ 550,000.00 5.50% $ 100.00 $ 104.82 $ 4.82 $ 550,000.00 5.50% $ 100.00 $ 103.45 $ 3.45 $ 550,000.00 5.50% $ 100.00 $ 100.00 $ - $ 550,000.00 Total $ 2,750,000.00
Fixed Coupon Callable Step-up cash flow catches up with Fixed Callable in the final provides higher cash year. If called before – Steps-up will always underperform Fixed flow vs Step-Ups Callable
Step-up Coupon Callable
Step-up Cumulative Cumulative Coupon Bullet Equivalent Fixed Coupon Callable Cash Flow IRR Price Delta Coupon (Fixed Coupon (Step- Cashflow Price Outperformance Coupon Callable) Up callable)
4.50% $ 450,000.00 4.50% $ 98.21 $ (1.79) $ 550,000.00 $ 450,000.00 $ 100,000.00 5.00% $ 500,000.00 4.74% $ 102.08 $ 2.08 $ 1,100,000.00 $ 950,000.00 $ 150,000.00 5.50% $ 550,000.00 4.98% $ 103.82 $ 3.82 $ 1,650,000.00 $ 1,500,000.00 $ 150,000.00 6.00% $ 600,000.00 5.22% $ 103.17 $ 3.17 $ 2,200,000.00 $ 2,100,000.00 $ 100,000.00 6.50% $ 650,000.00 5.45% $ 100.00 $ - $ 2,750,000.00 $ 2,750,000.00 $ - Total $ 2,750,000.00 14 When do callables outperform bullets? Callables outperform bullets when the buyer gets to earn the coupon spread (48 bps – from the first slide) all the way to maturity. When does this happen? When the yield curve is flat -> no roll-down return -> no price appreciation for bullets or callables-> callables unlikely to get called. When yields rise significantly -> prices of both callables and bullets fall below par -> no point calling a bond for par if price is below par -> no point calling a bond to reissue it at higher interest rates -> bonds unlikely to get called. 15 Yield Curve – Flat and Rising
Yield Curve
6
5
4 Flat Yield Curve – December 2006 3
2 Yields are up 100 bps from December 2015
1
0 1M 3M 6M 1Y 2Y 3Y 5Y 7Y 10Y 30Y
Sep-17 Dec-15 Dec-06
Source: Bloomberg 16 Yes: They Do Outperform Occasionally
They outperform when yield curve is flat to Monthly Performance negative for a long period of time. 1.5 3.5
1 3 2.5 0.5 2 0 1.5 -0.5 1
-1 0.5 0 -1.5 -0.5 -2 -1 -2.5 -1.5 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Sep-15 Sep-16 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Net Performance 3 Month T-Bill - 5 Year Treasury (Spread)
Year 2004 2005 2006 2014 2015
Callable 1.74% 1.86% 4.68% 1.37% 1.27%
Bullets 1.71% 1.46% 4.48% 1.28% 0.89%
Delta 0.03% 0.40% 0.18% 0.09% 0.39%
Source: Bloomberg BAML 1-5 Year US Non-Bullet Agency Index & BAML 1-5 Year US Bullet Agency Index 17 Issues with Callables
Duration & cashflow targeting becomes hard Duration volatility gets more extreme as optionality increases (onetime calls -> anytime calls). Cash flow targeting becomes inherently difficult due to extension/contraction risk. As Interest rates rise, duration of the callable increases. . It increases at an increasing rate (i.e. higher interest rates go faster, the duration will rise) Pricing callables is difficult (this deserves its own presentation) Rely on model pricing because YTM and YTC don’t capture important factors. . Input assumptions dictate everything (model selection, input curve, VOL assumption) Relative value comparisons can’t be done – each callable bond is different from another (bullet-to-bullet is easily comparable) Callable bonds are not usually issued in index size, limiting their liquidity. Bid/ask spreads on callables are much wider than bullets, making the bid side liquidity worse. 18 How can these issues be mitigated?
Lower optionality in the bond (onetime calls are better than anytime calls) Lower coupon volatility in the bond (fixed coupon better than step-up coupon) 19
Questions ?