Relative value methodologies

[sabiran]

Hello, I was reading this text in CFA text book as they are explaning ‘structure trades’. Can someone please help me understand the sentences in bold?

3. The sharp downward rotation of the U.S. yield curve during the second half of 1997 contributed to poor relative performance by putable structures. The yield investors had sacrificed for protection against higher interest rates instead constrained total return as rates fell.

4. The upward rebound in U.S. interest rates and the f all in interest-rate volatilit y during 1999 contributed to the relative outperformance of callable structures versus bullet structures.

(CFA Institute. Level 3 Volume 4 - Portfolio Management—Study Sessions 9-12, 3rd Edition. Pearson Custom Publishing Page 78).

My question:

1. what is meant with ‘constrained total return’. I read that you should only favor puts if you have a bearish outlook (rise of int rates). I believe total return is coupon (yield) and price apprection. This would mean bondprices would rise, and my put is worthless. But how do I explain the total return.

2. I also read that callables would outperform if volatilty increase as the call option increase in value. But statement 5 seems to contradict?

[sdanalyst]

1. Interest rates were declining making the put structure of the bond useless. The yield investors sacrificed return for the protection of a put in an increasing interest rate environment but instead the rates declined which constrained their return

2. The value of the call option on the bond increases with volatility of rates, but this value is to the issuer not the bondholder. Therefore, the fall in interest rate volatility is beneficial to the holders of callable bonds and why they would see an outperformance in a higher interest rate environment

[S2000magician]

@sabiran

Hello . . .

Howdy.

@sabiran

. . . I was reading this text in CFA text book as they are explaning ‘structure trades’. Can someone please help me understand the sentences in bold?

3. The sharp downward rotation of the U.S. yield curve during the second half of 1997 contributed to poor relative performance by putable structures. The yield investors had sacrificed for protection against higher interest rates instead constrained total return as rates fell.

4. what is meant with ‘constrained total return’. I read that you should only favor puts if you have a bearish outlook (rise of int rates). I believe total return is coupon (yield) and price apprection. This would mean bondprices would rise, and my put is worthless. But how do I explain the total return.

Investors who bought puttable bonds had to pay for the put option - either by paying a higher price for the bond or by accepting a lower coupon - while investors who bought option-free bonds did not; those who bought the puttable bonds had lower returns. “Constrained total return” is finance people’s fancy talk for “lower returns”, because they bought (ultimately worthless) put options.

@sabiran

5. The upward rebound in U.S. interest rates and the f all in interest-rate volatilit y during 1999 contributed to the relative outperformance of callable structures versus bullet structures.

6. I also read that callables would outperform if volatilty increase as the call option increase in value. But statement 5 seems to contradict?

Please recheck where you read that; it’s incorrect.

The investor is short the call option; it’s owned by the issuer (borrower). When volatility rises, the option increases in value, so the callable bond decreases in value, lowering returns. When volatility falls, the option decreases in value, increasing the value of the callable bond, increasing returns.