GIOA Workshop :
Effective Agency Strategies
Stephen Manning, CFA
Director – Institutional Branch Services
March 16, 2011
2
Developing Portfolio Strategies Using Agencies
Risk Management Overview
 The Portfolio Process
 A Brief discussion on Duration and Convexity
Agency Alternatives:
 Agency Bullets
 Fixed Coupon Callables
 Step Ups
 Fixed to Float
The Cost of “Waiting”
Useful Bloomberg Tools
3
Risk Management Overview
4
Investment Decision Process
Investment Policy / Guidelines
SAFETY
LIQUIDITY
Interest Rate
Risk
Yield Curve
Risk
Market
Trends
Cash Flow
Risk
Credit
Trends
Credit Risk
Liquidity Risk
Social Screens
Macroeconomic
Trends
Implement
Portfolio Strategy
5
Quantifying Risk
Interest Rate
Risk
Yield Curve
Risk
Cash Flow
Risk
Effective Duration – Expected Change in
Price For every 100bp Shift in Rates
Convexity – How will my duration Change as
yields change.
Partial Durations – Shift a Single Point on the
curve to Determine Where on the curve your
risk exposure is concentrated.
Cash Flow Simulation – Run Cash flows
across multiple horizon rate scenarios to
ensure there are no liquidity gaps
6
Duration
Duration – Expected %Change
in Price For a 100bp Shift in
Rates
Bond Price
Graphically - The Slope of
the Price Yield Function
Duration is the slope of a line drawn tangent to the
price-yield curve and shows the % change in bond
price for a given change in yield.
Yield
7
Duration
Example: the price of a bond
with a duration of 3.0 is
expected to:
 Increase by 3% when rates fall
(rally) 100bp.
However: The price/yield
relationship is rarely linear (a
straight line).
Bond Price
 Fall by 3% when rates rise by
100bp
Out
Performance
Yield
8
Bond Price
Convexity
Convexity – Expected Change
in Duration For a 100bp Shift
in Rates
Negative Convexity – When
rates rally, the bond will
underperform its duration.
Bond A
Bond B
Duration
Bond Price
Positive Convexity - When
rates change, the bond
outperforms the duration.
*P
**P
**P
*Y
**Y
**Y
*Y
Yield
*P
Yield
9
Agency Alternatives
10
Bullets: No Optionality
Key Features:
 Fixed Coupon throughout life
 Certainty of Cash Flow
 Start with HIGHER Duration
than callable.
 LOWER Yield/Coupon than
callable.
 Slight Positive Convexity
 Best Performer when rates
moving lower (Bullish).
 Better Liquidity
Bloomberg: FIT <GO>
Ticker
 Update Market to “Agency” if
not the default.
Spread to TSY
Yield
11
Finding Carry: Callable Agencies
Fixed Coupon Callables
1X Call (Euro):
 Higher Coupons than Bullets,
and initial Step-Up Coupons.
 1x Calls become bullet
alternatives if not called on the
call date.
Berm and Cont. Call:
 Higher Coupon than 1x Call
(Selling more optionality).
 Better Convexity Profile.
 Duration does not extend as
quickly as 1x call, as the “next
call” keeps it shorter.
12
Finding Carry: Defensive Step-Ups
Synthetic Premiums
One time step-up, with above market back end coupon.
Increases the probability the bonds will get called, even
with rates higher.
1X Call, with in-the-money back coupon.
 Give up some income on the front coupon
 Higher probability of call
 Price yield off the Maturity, while synthetically keeping
your duration much shorter.
 5NC2 Example?
Multi-Step Multi Call
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Finding Carry: Defensive Step-Ups
Defensive Multi-Step Structures
Starting coupons significantly higher than short cash
rates to the first call
Coupons set to step up in line with future expectations
in rates, to improve price performance, and keep
durations short in rising rate environment.
14
Defensive Strategies
Fixed To Float
ABOVE Market Initial Coupon – Increase Cash Flow
Below market spread on back end floater, but with
frequent resets, bond remains near par in back up.
Take on “Basis Risk” of spread widening, which should
be much lower than the pure duration risk of a fixed
coupon bond.
15
Discount Callables
Euro Calls (1X)
 Viewed as Bullet Alternatives
 Depending on strike, call date, many already extended in their
durations.
 Look for Yield Pick-Ups to Bullets
Bermuda / Continuous Calls
 Steep Yield Curve / Roll Down means some of the forward call
options are still in the money despite discount price.
 Look for Pick Up to bullets.
 Many trading to the expected call date, as opposed to the
maturity, which can make them look rich optically.
 Look for opportunities to pick up yield to Maturity, with
excellent upside if the market does not back up more, and the
bonds are called early.
16
Cost of “Waiting”
17
Buy and Hold – Carry Still Important
 With the steep yield curve, look for Carry and Roll down.
 Callable agencies such as the one above offer significant pick up
to cash, while taking on moderate duration risk.
 Over a 1 year time period, the Callable Agency outperforms the
theoretical cash pool even in a +100bp rate shift.
 If it takes 2 years to sell off, this Callable outperformed even
through the +200bp scenario.
 Callable Agencies represent a good sector to pick up yield, and
reduce duration vs. similar maturity bullets in the agency and
credit markets.
 Always Keep your Liquidity Needs in mind, and evaluate the full
extension risk of callables.
18
Income Break Even
 Break Even Income Analysis After 1 Year
 The above callable agency generates 840k in interest over 4 yrs
 Starting with a cash rate of 23bp for 1 year (1yr Tsy) you would need to
reinvest at a rate of 2.72% to break even.
 Implies a back up of 94bp in Treasuries to attain that.
 3YR Treasury Rate, 1YR Forward is currently 2.21%, implying just a 100bp
Backup over the next year.
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Useful Bloomberg Tools
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New Issue Monitor: NIM2
 NIM2 <GO>
 Shows all the announced new issue deals, and upsizes in the market.
 Ordered by date, and time, newest to oldest
21
Option Adjusted Spreads (OAS1)
OAS is an Extremely useful pricing tool
 “Spread” to the CURVE after taking out the value of optionality.
 CUSIP Govt OAS1 <GO>
 Spread to Treasury Curve (I111).
 14 Vol is standard for street pricing, but does not reveal value.
22
AOAS Screen – Relative Value
“A”OAS – Spread to the Agency Curve
 CUSIP Govt AOAS <GO>
 Spread to Relevent Agency Benchmark Curve, with Live Volatility
 Spread to Treasury Curve (I111).
 14 Vol is standard for street pricing, but does not reveal value.
23
Forward Rates
FWCM <Go>
Can look at US Treasury and Swap Forward Rates
24
Forward Rates
FWCV <GO>
 Forward curve for agency bullets is projecting higher yields
25
Forward Rates - Series
FWCV <GO> ; 3 <GO>
Useful to see the path of single rate forward in time.
26
Break Even Analysis
GA3 <Go>
27
Looking at the Complete Picture
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Disclaimer
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The author(s) is/are employed by RBC Wealth Management, a division of RBC Capital Markets, LLC, a securities broker-dealer with principal offices located in Minnesota and
New York, USA.
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