The Tools of Relative Value Analysis
There are two basic approaches to the valuation of fixed income products. The discounted cash flow method seeks to a value of a bond given assumptions about cash flows, reference yield curves, risk premiums, and so on. These methods are covered in Chapters 4 and 5. The other method, relative valuation, is less ambitious and hence more popular. Tools of relative value analysis, when properly interpreted, give the user some clues about how similar bonds are currently priced in the market on a relative basis. Simply put, these tools allow us to make conjectures such as “Bond X is cheaper than Bond Y.” Some of these tools we discussed in Chapter 5 on yield measures. Another method of measuring a risky bond’s relative value is to compute its yield spread relative to a designated benchmark. Discerning relative value is then simply a matter of comparing the yield spreads of two or more otherwise the same bonds. The bond with the largest yield spread is viewed as the cheapest and is considered the best relative value. In this chapter, we will introduce yield spread measures utilizing instruments from both cash and derivatives markets. We begin by discussing how portfolio managers add value when managing a fixed income portfolio. This section will place the quest for tools of relative value in context.
HOW PORTFOLIO MANAGERS ADD VALUE
The performance of an actively managed fixed income portfolio is measured against a designated benchmark ...