One of the most interesting types of reports for fixed income traders and investors are relative value (RV) trade ideas. Talk to any trader and you will know that they look forward to trade ideas. The most common form of trade ideas is switch trades. In switch trades, analysts recommend to buy one credit and sell one credit. If there are two fixed income instruments with similar rating, it implies that their credit risks are similar. If their maturity and duration are also same, then it implies that the interest rate risks are also similar. Applying the basic principle of risk and return, these two securities with identical risks should be priced identically. However, as we are aware, financial markets are not perfect. Information asymmetry exists, which can lead to price variations and differentials. In such a scenario, it makes sense for investors to buy the cheaper security and sell the costlier security. In bonds space, it means that investors should sell bonds which are giving lower yields and buy bonds which are offering higher yields.
Let us consider an example to understand this. Consider two bonds, A and B, which are issued by two companies in the Hong Kong property sector. Let us assume that the companies have same corporate credit ratings and the bonds issued by them also have same ratings of ‘A-‘. Both bonds have similar maturity; bond A matures in August 2015 and bond B matures in September 2015. If A offers 2% and B offer 2.2%, there is an trade opportunity available to sell A and buy B.
Let us slightly modify the example. A matures in August 2015 while B matures in February 2016. A is yielding 2% and B is yielding 2.6%. Here, we notice that B has six months longer maturity, and hence should yield higher. The question here is how much higher the yields should be. By taking a sample of bonds with maturities in 2015 and 2016, the average yield differential between securities with half year maturity difference can be computed. Let us assume that, on an average additional 0.3% yield is offered for half year maturity extension. Then, the yield differential between A and B is higher than the average observed. So, the yield differential should reduce over time. Hence, we can say that investors should sell A and buy B.
In investment grade (IG) rating category, it is relatively easier to come up with RV trade ideas. However, in high yield (HY) space, it is difficult as analysts cannot just go by credit ratings. The credit risks are higher and hence analysts should be more careful to assess all available information and analyze their impact on the credits.