One of the most interesting types of reports for fixed income traders and investors are relative value (RV) trade ideas. Talk to any trader and you’ll know they’re eager to brainstorm ideas. The most common form of trading ideas is trading change. In Forex trading, analysts recommend buying a credit and selling a credit. If there are two similarly rated fixed income instruments, it implies that their credit risks are similar. If their maturity and duration are also the same, it implies that the interest rate risks are also similar. Applying the basic principle of risk and return, these two securities with identical risks should have an identical price. However, as we know, financial markets are not perfect. There is information asymmetry, which can lead to variations and price differentials. In such a scenario, it makes sense for investors to buy the cheapest security and sell the most expensive security. In the bond space, it means that investors should sell bonds that offer lower yields and buy bonds that offer higher yields.

Let us consider an example to understand this. Consider two bonds, A and B, issued by two companies in the Hong Kong real estate sector. Suppose the companies have the same corporate credit ratings and the bonds issued by them also have the same ‘A-‘ ratings. Both bonds have a similar maturity; bond A is due in August 2015 and bond B is due in September 2015. If A offers 2% and B offers 2.2%, there is a trading opportunity available to sell A and buy B.

Let’s modify the example a bit. A is due in August 2015 while B is due in February 2016. A yields 2% and B yields 2.6%. Here, we note that B has six more months to maturity and therefore should yield more. The question here is how much higher the returns should be. By taking a sample of bonds maturing in 2015 and 2016, the average yield spread between securities with a half-year maturity difference can be calculated. Assume that, on average, an additional yield of 0.3% is offered for the half-year maturity extension. So the yield differential between A and B is greater than the observed average. Therefore, the performance differential should be reduced over time. Therefore, we can say that investors should sell A and buy B.

In the investment grade (IG) rating category, it is relatively easier to generate VR business ideas. However, in the high yield (HY) space, it is difficult as analysts cannot simply rely on credit ratings. Credit risks are greater and therefore analysts need to be more careful in evaluating all available information and analyzing its impact on credits.

Relative value trade ideas offer attractive investment opportunities for fixed income investors. However, given the complexities involved, we recommend that investors seek the advice of financial advisers.