Huggins Doug - Fixed income relative value analysis : a practitioners guide to the theory, tools, and trades

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Library of Congress Cataloging-in-Publication Data

Huggins, Doug, 1965

Fixed income relative value analysis : a practitioners guide to the theory, tools, and trades / Doug Huggins and Christian Schaller.

1 online resource.

Includes bibliographical references and index.

Description based on print version record and CIP data provided by publisher; resource not viewed.

ISBN 978-1-118-47720-5 (hbk) ISBN 978-1-118-47721-2 (ebk)

ISBN 978-1-118-47722-9 (ebk) ISBN 978-1-118-47719-9 (ebk)

1. Fixed-income securities. 2. SecuritiesValuation. I. Schaller, Christian, 1971 II. Title.

HG4650

332.632044dc23

2013009914

A catalogue record for this book is available from the British Library.

ISBN 978-1-118-47719-9 (hbk) ISBN 978-1-118-47720-5 (ebk) ISBN 978-1-118-74197-9 (ebk)

ISBN 978-1-118-47722-9 (ebk) ISBN 978-1-118-47721-2 (ebk)

Relative Value: a Practitioners Guide

I remember very clearly the beginnings of the Relative Value Group at Deutsche Bank. The year was 1995. I was one of a small group of Research and Sales professionals who had recently arrived at Deutsche Bank. We became convinced that significant opportunities existed to apply relative value concepts to fixed income instruments in a way that was highly interesting for sophisticated clients. We realized that by analyzing separately the opportunities and risks of certain fixed income products, we could help our clients achieve the performance they aimed for while mitigating credit, market and liquidity risk. Our goal was simple: to help our clients achieve the best possible riskreward equation.

We soon realized that we could apply these principles more widely across our client base in fixed income. For example, some of our clients held clear beliefs on areas of value in the market, but were seeking new ways to invest which reflected those beliefs. These were clients who provided important liquidity to the markets in which they operated, and this provided us with another important insight: as relative value addressed irrational differences between the prices of related instruments, we saw markets become more transparent, more liquid, and more efficient. Unquestionably, the science of relative value, and the transparency it brings to relationships between the prices of different instruments, has contributed to the growth of derivatives and other financial products which reduce market risk.

These were years in which Deutsche Bank was building up a world-leading markets platform, and as a comparable new entrant in many areas, we needed to innovate to prosper. Relative value disciplines formed a core part of our intellectual capital. Relative value provided us with a way to reduce risk and spot opportunities between different instruments, both within and across asset classes, and thus to help our clients perform better for their investors. Relative value gave us a systematic way to address the fundamental question: whats expensive and whats cheap? That discipline contributed greatly as we advised clients on asset allocation in their portfolios, and gave us valuable insights about how to deploy our own resources: capital, technology and people. Already, relative value at Deutsche Bank had evolved far beyond its origins as a method of identifying pricing inefficiencies in fixed income instruments. It gave us a framework for a much wider range of portfolio and business decisions.

The financial crisis of 2008 and early 2009 was a defining period in the development of relative value analysis. Under conditions of extreme market stress and acute shortages of liquidity, we saw the conventional relationships between the prices of related securities break down. Put simply: the normal rules ceased to apply. The risk of sovereign default, suddenly much more apparent, profoundly impacted the prices of government debt and the derivatives related to it. This posed a major challenge for our clients and for the sound functioning of financial markets on which the global economy depends. But this extremely difficult period also brought us fundamental insights. Our experience with Long-Term Capital Management, and the Russian and Asian crises, warned us that at times of significant market stress, the conventional rules governing relationships between assets cease to function and for us, this was a clear signal to reduce our balance sheet and risk exposures. Perhaps most significantly of all: as market conditions stabilized and liquidity returned, well-funded investors were able to invest in good-quality assets at very favorable prices. Relative value analysis was able to guide us toward many opportunities for us to create value for our clients.