Trading in the capital markets – just like in any other market – implies three global areas, depending on the risk profile of the investor and the timing of investment: speculative trading, portfolio investment and mixed investment (speculative operations, medium-term ideas and portfolio investment). A professional investor never sticks to just one option, as the market situation is constantly changing. For an ordinary Russian investor, everything can be much simpler, since the capital market on his part, as a rule, is used for portfolio investment, which includes elements of rebalancing, depending on the market situation. In this format, if the investor does not have sufficient knowledge and time, a personal broker can help him. If the investor decides to figure out how to trade bonds, then for starters, you can take courses on the basics of the market and study the following materials: “ Bond: instructions for use ” and “ How not to invest in a bankrupt ”.
Having understood the specifics of bonds, we will touch on the first investment option that does not require daily / weekly control – portfolio investment . This type of investment is suitable for those clients who invest their funds for a long-term period (10 years or more), for example, to save for a pension or for children to study. The easiest way, you might think, is to buy bonds maturing in 10 years (or more) and receive your coupon. Yes, this can be done, but there are nuances.
Educational video about choosing and buying bonds for beginners
If we are talking about the Russian market, then bonds (corporate) with maturity in 10 years or more are not very popular, since we have an economy of a developing country, i.e. political, economic, social components can change much more often, which is directly reflected in the money market and the capital market. For example, during a crisis, money market rates that react to the actions of the Central Bank (changes in the key rate) soar upward in the acute phase, then the regulator begins, depending on the situation, to lower it at different speeds. In such a case, a company that issued a bond maturing in 10 years could embed a put or call option.
These options may have a maturity in 1-2 years, as the company predicts that in 1-2 years the economic situation will improve, the loan rates will drop, which means that the company will be able to borrow capital cheaper. Thus, when investing in the long term, it is necessary to assess the current situation in the economy, in our example, in Russia. Below is a graph of the OFZ PD risk-free yield curve during the crisis in 2014 and at the present time.
As you can see from the chart above, at the peak of the crisis, OFZ-PD yielded significant returns, and corporate bond yields were even higher, depending on the level of risk. Yes, it was possible to buy a ten-year OFZ-PD and already now fix a decent yield on price revaluation. But the market is driven by greed and fear, and during periods of crisis, the latter component prevails among ordinary investors. Thus, not everyone is ready to invest their money in long-term securities, especially if the portfolio was formed in the pre-crisis period. But periods of crisis are the best time to invest, as the crisis is followed by recovery and growth.
In general, when portfolio investing, keep track of economic cycles – this is the main rule. If the peak of the crisis has passed and recovery begins, invest in long-term securities (with a maturity of more than five years) of high-quality issuers (with high investment ratings and those close to them – BB +) and sovereign OFZ-PD. You can also add securities with a speculative composite rating of “BB / BB-” and a maturity of 3-4 years, because. the level of creditworthiness of such companies in such a period does not promise serious problems (bonds of this quality can be bought with a longer period, but it is necessary to assess their financial position before buying, especially since the period of economic recovery may be delayed), plus you can take part in primary placements without paying a price premium.
If the economic cycle is running out, start moving to an average duration of 4-6 years, while investments, first of all, should be in reliable issuers, and it is advisable to reduce bonds with speculative ratings, especially if you see a deterioration in the creditworthiness of an issuer . During periods of crisis, the duration of the portfolio should be in the range of 2-3 years, because Due to the short duration, with the growth of yields, the prices of bonds will not change as significantly as those of long ones. How can the “dirty” price of a bond (in p.p.) change with an increase / decrease in yield by 100 b.p. (1%), can be seen from the chart below on the example of sovereign dollar bonds of the Russian Federation ( Eurobonds):
One of the proxies for the situation in the economy can be the curve of sovereign bonds – the risk-free curve. There are three main forms:
- normal (the economic cycle is on the rise, interest rates are rising – long-term bonds bring higher yields);
- flat (the economic cycle is running out, a period of uncertainty begins, a crisis is approaching – near and far bonds bring almost the same yield);
- inverted (crisis, money market rates at maximum values, expectation of rate cuts, assessment of economic growth is negative – short-term bonds bring higher yields against long-term bonds).
Thus, using information on curves, we can switch from portfolio investment to trading medium-term ideas. All previously presented graphs reflected movements on risk-free curves, but if issuers have enough issues with different durations, then curves can also be made from their bonds.
Speculative ideas and news background
Let me remind you that corporate bonds are traded with a yield premium, and the higher the issuer’s rating and the more stable the company, the lower the premium. I also want to say that we will not consider speculative ideas in detail here, because. all speculation lies in the reaction to the information flow. Especially if we operate on the Russian bond market, which has medium liquidity, minor news may be completely ignored by market participants. And you need to understand that bonds are tied to rates, and corporate news can only affect them if there is a significant positive/negative background. But if you have a burning desire to make a short trade, then first of all it is worth monitoring the financial statements of an issuer – mainly in the context of the loan portfolio and generated cash flows, if significant changes are predicted in one direction or another. It is also worth paying attention to the news background and management statements. For example, if a company is stable from a business standpoint, but is being sued for non-compliance with industry competition rules, then at one point the price of the bond may drop as The market reacts instantly. But then the company’s management will come forward and explain the situation – and it turns out that the claim is insignificant, the company is cooperating with the regulator and the situation is not so critical, which means that in the end the bond may return to its previous levels. You can also follow the assessment of the rating agencies of a particular company – if an increase / decrease in the rating is predicted, the bond may also react with yield in one direction or another. Recall that the change in price depends on the change in yield, and the longer the bond (the longer the duration), the more the change costs. A measure of price change when yield changes by 1 bp. (Basis point value – the cost of a basis point) is expressed in the following formula:
BPV = (Modified Duration (MD) x Dirty Price (GP) of the bond)/10,000 . Accordingly, BPV will be equal to 0.05067 cents. Thus, the “dirty” price will fall to the level of 105.52% if the yield increases by 0.01 percentage points. From here you can calculate the value change of your position (DV01 – dollar value 1 bp), for example, you bought 200 bonds:
DV01 = (Note value/100) x BPV —> (200,000/100) x 0.05067 = 101.34 $.
Medium Term Ideas
Now let’s move on to medium-term ideas. We’ll look at two main strategies, ” parallel shift ” and ” slope “, which involve changing the bond curve. The “rate rise/fall” strategy implies a parallel shift of the curve in all areas up or down, depending on the market situation. The strategy of “changing the slope of the curve”, unlike the previous strategy, insures the investor against a parallel shift and assumes the potential profit from changing the slope of the curve. These strategies can be used during various economic cycles. For example, when the economic cycle is running out and a crisis is approaching, the curve flattens, i.e. the near end begins to rise in yield against the far end.
I want to say right away that the Russian debt market is not as developed, for example, compared to the EU and US markets (average liquidity, insufficient selection of instruments by bond type, weak liquidity of derivatives). In particular, for an ordinary individual investor, as a rule, short sales of bonds (shorts) are not available, which makes the investment strategy one-sided. But 5 years ago OFZ derivatives appeared – futures, which partly make life easier for investors. Using these futures, we can hedge our bond portfolio, increase/decrease the duration of the portfolio, earn on rising/falling rates or changing the shape of the curve. There are five OFZ futures on the Russian derivatives market:
- OFZ2 – includes the most liquid OFZs with maturity in 1-3 years;
- OFZ4 – includes the most liquid OFZs maturing in 3-5 years;
- OFZ6 – includes the most liquid OFZs maturing in 5-7 years;
- OF10 – includes the most liquid OFZs maturing in 7-10 years;
- OF15 – includes the most liquid OFZs maturing in 10-15 years.
Each futures includes, as a rule, 2-4 OFZs. On the settlement date, the buyer gets the cheapest bond for delivery, for ease of understanding, it can also be used to evaluate the modified duration of the futures. Due to the fact that OFZ futures are deliverable, you should not wait for the date of their settlement, but close in advance (if the strategy has been worked out) or roll in the next period (if the strategy is still in effect).
Bond Trading Strategy “Parallel Shift”
Consider the “parallel shift” strategy. This strategy can be used to generate potential profit from rising/falling rates. It can be realized directly through OFZ futures, i.е. open long positions to receive potential profit in anticipation of lower rates or open short positions in anticipation of a rise in rates. Also, using these futures, you can insure your portfolio of OFZs and/or corporate bonds against rising rates or earn extra money from falling rates.
You need to understand right away that fully insuring your portfolio of corporate bondswill not work (from the growth of rates), in contrast to the OFZ portfolio, because the portfolio of corporate bonds has a different DV01 from the corresponding OFZ in the futures. Also, changes in the risk-free curve may not fully affect corporate bonds in one or another period due to a number of factors. For example, in your portfolio there is one OFZ 25083 for ~10 million rubles, the MD of this OFZ is 3.1. You think that rates will fall (there will be a parallel shift) by -50 bp, so your OFZ can bring potential income:
-MD x rev. rates х portfolio value —-> −3.1 х −0.005×10 mln rub. = 155,000 rubles.
Accordingly, a similar calculation will be with an increase in rates. Parallel curve shift +/- 50 bp shown in the chart below:
Bond trading strategy “changing the slope of the curve”
Now let’s move on to the “changing the slope of the curve” strategy. By implementing this strategy, we assume that the curve will change its shape depending on the market situation. Either there will be a flattening (the far end of the yield curve will fall faster than the near one), or a steepening, i.e. reverse situation. We also assume that a parallel shift of the curve will not occur, but at the same time, if it does happen, we will be insured. This strategy can be implemented either through OFZ futures without using the bonds themselves, or, if you have certain bonds in your portfolio, use the futures + bonds hybrid option. Consider the case when the curve is flattened.
In such a situation, it is necessary to sell futures/bonds at the near end and buy futures/bonds at the far end. At the same time, in order to avoid the potential risk of a parallel shift, it is necessary to weigh positions by DV01, and not just 50/50, because. long bonds will have a higher BPV than short ones. In this regard, it will be necessary to sell a larger volume of futures / bonds at the near end and buy a smaller volume – at the far end. Let’s assume that you bought in your portfolio nominal ruble “decades” – OFZ 26212, i.e. bought “length” for ~ 10 million rubles. (body + NKD). To play for a flattening of the curve, you need to sell near-term bonds, for example, nominal “two-year” – OFZ 26210, but, as we said earlier, the broker, as a rule, does not allow you to open a short position on bonds. In this regard, we will use the OFZ2 futures (the cheapest for delivery in June 2018 is OFZ 26210). Next, let’s calculate:
OFZ 26212: MD — 6.732, HC — 102.14
BPV 0.06876 per 1 bp, respectively, for a position of ~10 million rubles. (9,800 bonds) DV01 will be equal to 6,738 rubles.
OFZ 26210: MD — 1.530, HC — 102.96
BPV 0.01575 per 1 bp
To calculate the required amount for a short position, let’s take the following formula:
Amount for a short position = ~10,000,000 rubles. x (BPV “ten years” / BPV “two years”)
–> 10,000,000 rubles. x (0.06867/0.01576) = ~43,657,142 rubles (~42,402 bonds)
Thus, ~42,402 bonds are needed for a short position to eliminate the risk of a parallel shift. But since we are using a futures contract that includes 10 bonds, we need +/- 4,240 futures. Accordingly, now it is necessary to calculate DV01 for OFZ 26210 for 42,402 bonds, it will be:
DV01 OFZ 26210 = (42,402,000/100) x 0.01575 = 6,678 rubles.
It can be seen from the chart above that the 2-year bonds increased in yield by 14 bp, while the 10-year bonds fell by 28 bp. Possible profit may be:
OFZ 26212 = 6,738×28 = 188,664 rubles
OFZ 26210 = – 6,678×14 = – 93,492 rubles
Potential income = 188,664 – 93,492 = 95,172 rubles.
Plus, if we compare DV01 for each position, then they are almost similar, i.e. if there is a parallel shift in the curve, we will not suffer significant losses.
For now, that’s all about bond trading. I hope that the article will help you better understand this issue. If you need advice, please contact Otkritie Broker specialists.