Bond Anomaly and Switching - Identifying Cheap or Dear

[Pulit Chhajer]

Could you please help me to distill down the thought process w.r.t below theory as pulled from Acted Material

Yield differences and position relative to a yield curve

In considering possible anomaly switches, yield differences are widely used to identify
individual bonds which seem cheap or dear in relation to other bonds. However, because
high-coupon bonds are likely to have higher gross yields than low coupons, a high gross
yield does not in itself indicate that a bond is cheap.

A problem with the evaluation of individual bonds in relation to a fitted yield curve has been
the stability of the method used to fit the curve.
In other words, small changes in yields on a few stocks can sometimes cause large changes in the
fitted curve. An unstable fitted curve is a poor benchmark to compare individual stocks against.

Price ratios
These can be monitored as well as yield differences. Ideally, a switch under consideration
will look attractive, in relation to both yield and price histories. A practical problem in using
price ratios is that they do not allow for the fact that the two bonds may have different
coupons; they will have different prices but will both be redeemed at 100. So the ratio of the
two prices will display a trend. This history of price ratios may be adjusted by this trend to
produce what are often known as ‘stabilised’ price ratios.

 

[Joe Hook]

Hi, your request was a little vague but I hope the below is ok.

Ok so when we are looking for an anomaly switch we are trying to identify bonds which are mispriced (either too cheap or too expensive). Prices are the inverse of yields so high yields, lower prices (all else being equal). So if you take two identical bonds and one has a higher yield (lower price) you would favour that one. Of course no two bonds are the same and so coupon size will affect things. As it says in the notes:

High-coupon bonds will tend to offer higher gross yields if most investors prefer capital gains to
income, in which case they will bid up the prices of low-coupon bonds. This will be the case if, for
example, the income from bonds is taxed more heavily than the capital gains.

You could compare the yield on a bond to a yield curve (charting the yields on bonds of with different maturities) to determine whether the yield looks high or low. However, given yield differences may be very small, in order to be executing deals on this basis you would need to be confident in the yield curve itself. As this curve is partially fitted to (relatively few) bonds in the market, it will be swayed by individual yield movements.

Another way to look for price anomalies is to track the prices of two bonds over time and look for the prices converging or diverging over time. Because of the difference in bond characteristics e.g coupons a simple snapshot of a price ratio is not enough. For example, a 7% bond of a similar duration to a 5% bond should be more expensive. However, if you see the prices converge overnight ie the price ratio converge towards 1, it may suggest the 7% bond has become cheap and the 5% bond expensive. However, prices will converge naturally over time. As time progresses and there are less future coupons to pay the two prices will converge towards 100. This natural phenomenon can be adjusted for to ensure historical price ratios are relevant.

Joe

 

[Pulit Chhajer]

Could you elaborate "
High-coupon bonds will tend to offer higher gross yields if most investors prefer capital gains to
income, in which case they will bid up the prices of low-coupon bonds. This will be the case if, for
example, the income from bonds is taxed more heavily than the capital gains"

 

[Joe Hook]

If investors prefer capital gains to income then demand for low-coupon bonds will be higher than high-coupon bonds. If demand is low for high-coupon bonds then prices will be low and yields will be high.