Bond Question

Quote from bestfriend:

I have some corporates due in 7-30 yrs and I want to hedge out the risk on a good portion using the futures as a proxy. Which should I seel and how much? Say I have $500k in 30 yr aa corpproates and $1 mill in 7-15 yr corporates. I have an IB acct. I want to avoid selling them as they are pretty illiquid.
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optioncoach and f-tdr have the right idea, but I would only use this for a short term hedge, ie 1 week or less if you are worried about a short term spike in rates. Over time you will have credit spread, change in deliverables (which will change the duration of the futures contracts, and other issues to worry about.) Also, bond yields have gone up nearly 50bps in the past 3 months, so you might be a little late.

As an example, without knowing the coupon and maturity of your bonds, I could estimate and say the dollar value of 1bp on $1mm 30 year bond is $1404. So your $500k bond would be worth approximately $702 / bp. The $value of the Sept bond futures contract is $106.40 ($val of cheapest to deliver, 7.625 11/2022 = $1232 divided by conversion factor 1.1593 = 106.27) So, you could short 6 or 7 bond futures contracts to hedge your $500k 30yr bond.

As for $1mm of 7 - 15 yr corporates, again a wild ass guess without knowing the coupons or maturities would be an 11yr average worth around $1007/ bp. The 10yr futures contract has a $value of $61.92 per bp. You would probably want to use a combination of 10yr and bond futures, because the 10yr future actually tracks a 5/2014 issue (only 7yr maturity). Anyway, you would short about 16 TYU7 (10yr futures contracts) to hedge your 1mm in corporates. $1007 divided by $61.92.

There are a lot of risks - the most obvious being some type of panic that widens out credit spreads, ie a flight to quality in treasuries, where your corporate bonds could go down while the treasury futures go up, compounding your loss instead of hedging it.

Goldman would probably design you a nice hedge program for 5% of your principal :D
 
Quote from bestfriend:

I have some corporates due in 7-30 yrs and I want to hedge out the risk on a good portion using the futures as a proxy. Which should I seel and how much? Say I have $500k in 30 yr aa corpproates and $1 mill in 7-15 yr corporates. I have an IB acct. I want to avoid selling them as they are pretty illiquid.
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the real question is why you have bonds when you can't calculate even something as elementary as duration. And you want to trade credit... :eek:
Sell them now and have a good sleep.
 
Jaxon hit on what most people look at for short term hedges -- dollar value of a basis point, or DV01. DV01 measures absolute change whereas duration measures percentage change.

As far as change in deliverables (i.e. basis optionality), that will not be a problem until rates rise substantially. To around 6% to be (somewhat) precise.

If you want to get cute, you can throw in a swap or CDS to hedge your credit risk. By the time you pay all the bid ask spreads on that though, you might be better off paying the spread in the illiquid market.
 
Thanks for all the great advice. It took a day or so for it all to filter in--insults included---but I am not offended. It wasn't that I didn't understand what duration is, but rather how it related to the futures contract in an effort to hedge.

The idea of credit spreads widening and making this a bad idea is well taken. I realize that the treasury / corporate spread has narowed quite dramatically in the past few years.

The longest stuff is mostly tax-frees which really don't seem to move as much as the 30 yr and are mightly illiquid since virtually all munis are held to maturity.And, of course, future tax rate changes may make the TEY of these more attractive relative to corporates.

FYI I have been short some of the 30 and 10 futures for a few months. I just took a look the other day and I had lost a lot more on the bonds that I made on the futures. All the stuff was acquired over the past 8 or 9 years from trading profits, so most is still in a cap gains position.
Also, I have been able to find insured share certificates through credit unions over the past 2-3 years that yielded as much as 2.25% over comparable treasuries. Most have been perhaps 1-1.5% over treasuries.So, the point is that at least 55% of my total portfolio is 1-5 years.Maybe another 15-20% is in cash, with the balance long-term.

I've been building the portfolio to generate a nice monthly income and I've acheived that. It's just that I'm very susceptible to inflation as I haven't really done a good job of diversification into assets other than financials. I have a really hard time buying anything without a yield as a long-term investment. I'm not at all goos at global macro trends.
 
Speaking of credit spreads widening, 2 yr swaps are out 9 bps, 5yrs 18.6 bps, 10 yrs 21.2 bps, and 30 yrs 20 bps. Today would have been a bad day to be short credit spreads. ;-)
 
Quote from DynamicReplic8r:

Speaking of credit spreads widening, 2 yr swaps are out 9 bps, 5yrs 18.6 bps, 10 yrs 21.2 bps, and 30 yrs 20 bps. Today would have been a bad day to be short credit spreads. ;-)
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it is not called credit spreads but rather spreads or swap spreads...
that said credit spreads obviously widened too....
 
Quote from DynamicReplic8r:

Swaps are generally a good proxy. If swap spreads widen there is a very low chance that credit spreads on average did not.
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concur - correlation is high but not perfect...
 
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