Question:
I am a portfolio manager with equity trading experience and not fixed income derivatives, how can I include inverse floating bonds without destroying my P & L?
Answer:
Poor P & L is as a result of a badly negotiated coupon formula and the lack of an understanding on how to analyze the collateral and the structure.
My goal is to give you a worthwhile explanation of how to value and trade inverse floating bonds in other to avoid heavy loses.
These are some of the variables you should look at when decidind to bid/ask for an inverse floater:
Collateral: WAC, WALA, CPN, SPEED
Coupon Structure:
Bond Type, Lever, CPN, DM, CAP Strike Rate, Rate Reset, Underlying Index, Floor Strike Rate, YLD FWD, and the effective duration.
Hedging:
A portfolio of inverse floating bonds should be hedge with option contract.
In buying option contract you should ask yourself these following questions:
- 1.Which option contract should be used for the hedge?
- 2.Which month?
- 3.Which strike price?
- 4.How many contracts should be used?
The first CMO was created by Credit First Boston in 1983. Some of todays traders were still in elementary school, when the first CMO was structured, so they were not trading CMO during the President Carters double digit inflationary rate or President Regans double digit interest rates. Thus, wont know how inverse floating bonds will react in a double digit inflation or interest rate environment.
Not all inverses are equal. Most are volatile, while some are not. Also consider that you could be looking at PAC Inverse, SEQ inverse, PT inverse, SUP Inverse, Remic Inverse etc.
In a structure of two tranches in comparison to an inverse with five structures, I do not recommend you use recombination in valuing the inverse. In addition, the effective duration signals the change in cash flows due to a change in prepayment speeds and interest rate changes: i.e. for those bonds that are linked to the 1M Libor, COFI or T12. A trader should know how the collateral prepayment speed, inflation, interest swaptions, convexity and forward yield curve when using the YB table.
The inverse bond reset margin is vital. What is driving the index levels, in some cases the currency market, does play a role on most indexes like the Libor. Why? Foreign investors in pursuit of a better return on their investment might buy other currency instead of the dollar; this way, they get a better interest income on their currency, hence forcing the Fed to choose to save the dollar or the housing market.
For a trader who pays 64 cents on a dollar in the primary market, if the index hits the strike it is customary for the inverse floater to trade around 63 cents on a dollar to 65 cents on a dollar. In this case, the option is what the street is looking at and predicting the index will decrease by 25bps. Furthermore, the general idea is that a higher lever is what additional bps points when the inverse floater has hit the strike. However, if the index does not equal the value of your inverse, the outcome could be anyones call.
As someone who has seen the inverse floating universe and the mistakes traders make, it is no surprise that most proprietary trading desk managing directors are having a sleepless night while the hedge fund star traders sleeps like a baby.
Now, with all this talk about option this and option that, dont underestimate the power of the collateral prepayment speed. If a good number of people walk away from their mortgage payment, you can forget the high lever, for you wont have enough cash to meet employee retirements or any other obligations for that matter.
In modeling deals you probably subscribe to INTEX meaning that you have to wait around for INTEX to send you the cash flow. Now, If INTEX has not modeled the deal and you cannot wait, the programmers on your trading desk should know what to do. I recommend you sit down with your C++ developers and I tell them the variables that you need in other to arrive at the bid/ask price for the inverse floater.
In order to trade profitably, an inverse floater bond trader must understand what is vital and whats not vital about the inverse floating bond asset class, such as, margin reset, forward curve, swap, the PSA/CPR at which the mortgage borrower is paying back the loan and the OAS level etc. For example, I pointed a proprietary trader in the right direction see below.
This trader was going to sell 1,000,000 shares of bonds at $75.00 each, and I told him to sell it for $88.50/32 base on my algorithmic calculations. In the end, the trader was paid $88.50/32 for the bond. The major factor here was the CPR speed i.e. the rate at which people are paying back the loans they borrowed to buy their first house in a case of default the investor will be in trouble. The lesson learned here is the need for a trader to have a solid evaluation skill sets like mines for my experience and quant abilities allowed me to value the bond and arrive at a bid/ask price.
The question is: Does your trader know when to buy and when to sell? Some inverse floating bonds are linked to the real estate business cycles. As someone who has seen thousands of inverses and valued them given the interest rate environment, your fortune will take off. The fundamental issue is the structure and cash flow.
The major loss that the fixed income derivative asset class has seen in the past years has to do with traders who did understand that the LIBOR index that the inverse is linked to and the prepayment speed. These traders buy into strength and then turn around to sell weakness. Most of the time, the trader does not have an exit strategy.
As the hedge fund industry becomes a full grown adult, and investment banks are jumping into the game, which means the lack of the required specialist skill sets to look at various Agency CMO asset classes. However, the good news here is the volume of illiquid property that will turn into cash is very huge, hence, creating the opportunity for great wealth creation. While Wall Street is the capital market center of the world and a most innovative one at that, I expect China, Japan, and India to follow suit in the creation of collateral mortgage obligations, hence calling for the demand for a hands-on, seasoned agency CMO specialist. As someone who has seen the whole universe of Agency CMO inverse floaters, I know of and have seen inverse floaters and the struggles hedge fund managers and commercial banks trading desk have in arriving at a bid/ask price due lack of trading experience.
In conclusion, the paramount issue here is been able to submit a bid/ask in the primary or secondary market of inverse floaters. In addition, making sure to have an entry and exit strategy. Your goal as a proprietary managing director is to make sure that your traders submits the right bid/ask price when selling inverse floaters.
