WU066-Henderson-FM WU066-Henderson September 2, 2003 18:30 Char Count= 0 Fixed Income Strategy The Practitioner’s Guide to Riding the Curve Tamara Mast Henderson iii WU066-Henderson-FM WU066-Henderson September 2, 2003 18:30 Char Count= 0 Copyright C 2003 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone (+44) 1243 779777 Email (for orders and customer service enquiries): [email protected] Visit our Home Page on www.wileyeurope.com or www.wiley.com 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. 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British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 0-470-85063-9 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. iv WU066-Henderson-FM WU066-Henderson September 2, 2003 18:30 Char Count= 0 To Callum v WU066-Henderson-FM WU066-Henderson September 2, 2003 18:30 Char Count= 0 Contents Acknowledgments xi Biography xiii Introduction xv PART I BASIC TOOLS FOR ESTABLISHING A FIXED INCOME STRATEGY 1 1 Fixed income basics 3 1.1 Pricing a bond 3 1.2 Market risk: The price–yield relationship 5 1.3 Yield curve risk: The yield–maturity relationship 9 1.4 Beyond theoretical value: Other sources of risk 13 1.5 Sources of return 15 1.6 Summary 16 Notes 16 Recommended reading 17 2 Fixed Income Securities: Beyond the Basics 19 2.1 Spread risk: Evaluating bonds of different quality 19 2.2 Volatility risk: Evaluating bonds with embedded options 21 2.3 Interest rate derivatives 27 2.3.1 Futures 27 2.3.2 Options 29 2.3.3 Swaps 32 Notes 36 Recommended reading 37 3 Economic Fundamentals 39 3.1 The building blocks of economic analysis 39 3.2 Interest rate theories: Forecasting market direction 44 3.3 Yield curve models: Forecasting movements in the yield curve 50 3.4 Spread theories: Anticipating changes in the risk premium 54 vii WU066-Henderson-FM WU066-Henderson September 2, 2003 18:30 Char Count= 0 viii Contents 3.5 Volatility models: Anticipating changes in volatility 57 3.6 The efficient markets hypothesis 58 3.7 Chaos theory 59 3.8 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 65 4.1 The political economy perspective 65 4.1.1 Political business cycles 65 4.1.2 Budget deficits and monetary policy 67 4.1.3 Central bank independence 68 4.1.4 Policy objectives 68 4.1.5 The monetary policy mechanism 69 4.2 Anticipating changes in monetary policy 69 4.2.1 Fed watching 69 4.2.2 ECB watching 71 4.3 Implications for fixed income investors 73 Notes 74 Recommended reading 75 5 Human Factors 77 5.1 Group behavior: A demographic approach 77 5.2 The inherently human nature of markets: A psychological approach 83 5.2.1 Information processing 84 5.2.2 Attitude and mood: The effect on risk tolerance and judgment 88 5.2.3 Social psychology: The herding phenomenon 91 5.2.4 Implications for fixed income investors 94 5.2.5 Limitations of the psychological approach 96 Notes 96 Recommended reading 97 Appendix: Summary of psychological phenomena 98 6 Technical Analysis: Applied Social Psychology 99 6.1 Fundamentalists versus technicians 99 6.2 The basic tools of technical analysis 100 6.3 The contrarian approach 109 6.4 The “smart money” approach 111 6.5 Implications for fixed income investors 112 6.6 The limitations of technical analysis 113 Notes 113 Recommended reading 114 7 Other Techniques for Short-Term Analysis 115 7.1 Flow analysis 115 WU066-Henderson-FM WU066-Henderson September 2, 2003 18:30 Char Count= 0 Contents ix 7.2 Supply and demand analysis 118 7.3 Seasonal analysis 120 7.4 Quantitative analysis 121 7.5 The limitations of statistical methods 125 Notes 126 8 An Integrated Approach to Bond Strategy 127 8.1 An interdisciplinary model 127 8.2 The appropriate use of tools 130 8.3 Resolving mixed signals 132 8.4 Evaluating downside risk 133 8.5 System checks 133 8.6 A template for constructing a view on which to trade 135 8.7 Limitations of the interdisciplinary approach 137 Notes 137 Recommended reading 138 PART III IMPLEMENTING YOUR VIEW 139 9 Fixed Income Instruments, Investors and Portfolio Management Styles 141 9.1 The fixed income universe 141 9.1.1 Government securities 142 9.1.2 Corporate securities 144 9.1.3 Structured securities 145 9.1.4 Fixed income derivatives 146 9.1.5 Structured products 147 9.1.6 Country and currency considerations 148 9.2 Investor types 149 9.3 Portfolio management 153 9.3.1 Passive portfolio management 154 9.3.2 Structured portfolio management (asset–liability management or ALM) 155 9.3.3 Active portfolio management 156 Notes 160 Recommended reading 161 10 Fixed Income Trading 163 10.1 Market directional bets 163 10.2 Yield curve bets: Steepeners and flatteners 165 10.3 Yield curve bets: Rising and falling curvature 167 10.4 Spread bets 169 10.5 Volatility bets 171 10.6 Summary 172 Notes 174 Appendix: Bullets, barbells, and butterflies 175 WU066-Henderson-FM WU066-Henderson September 2, 2003 18:30 Char Count= 0 x Contents 11 Odds and Ends 177 11.1 Asset allocation 177 11.2 Individual bond selection 179 11.3 Leverage 180 11.4 Risk management 180 11.5 Strategy management 182 Notes 183 Recommended reading 183 12 Survival Principles for the Financial Battlefield 185 12.1 Six pearls of wisdom 185 12.2 Concluding remarks 187 Bibliography 189 Index 195 WU066-Henderson-FM WU066-Henderson September 2, 2003 18:30 Char Count= 0 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.