Bond Spread Reversion Trading

Bond spread reversion trading is a strategy used by fixed income traders and portfolio managers to capitalize on the mean-reverting behavior of bond spreads.

This trading approach assumes that the spread between yields of different bonds or bond categories will revert to a historical mean over time.

Traders exploit this by buying undervalued bonds and selling overvalued ones, expecting the spreads to normalize.

Key Takeaways – Bond Spread Reversion Trading

• Identifying Spread Divergences
  • Bond spread reversion trading focuses on detecting when the spread between related bonds deviates from historical norms – or what the spread “should” be based on an understanding of the fundamentals or cause-effect mechanics.
• Mean Reversion Principle
  • This strategy is based on the expectation that bond spreads will revert to their historical or fundamental averages over time.
• Interest Rate Sensitivity
  • Traders primarily monitor interest rate movements and economic indicators that influence bond prices and spreads.
• Risk Management
  • Effective risk management involves position sizing, stop-loss orders, use of options, and diversification to reduce potential losses from prolonged spread divergences.

Key Concepts

Bond Spread

A bond spread is the difference in yields between two different bonds, typically of similar maturity but different credit quality or issuers.

The spread reflects the additional risk premium that investors demand for holding a bond with higher perceived risk compared to a safer benchmark bond, like a government bond.

Mean Reversion

Mean reversion is a financial theory suggesting that asset prices and returns eventually move back toward the mean or average level.

In the context of bond spreads, this means that if the spread deviates significantly from its historical average, it’ll likely revert to that average over time.

Mechanics of Bond Spread Reversion Trading

Identifying the Spread

The first step in bond spread reversion trading is identifying the spread between two bonds.

This involves selecting a pair of bonds to compare, such as a corporate bond and a government bond of the same maturity.

The spread is calculated as the yield of the corporate bond minus the yield of the government bond.

Databases like FRED often have this data and can visualize the relationship over time.

When spreads are tight, traders are more likely to short credit spreads (expecting them to widen or as a negative correlation position to risk assets).

When credit spreads are wide, traders are more likely to be long credit spreads and want to own the carry, expecting them to eventually converge.

Analyzing Historical Spread Data

Traders analyze historical spread data to determine the average spread and the typical range of deviations from this average.

Statistical work and historical data are used to establish confidence intervals and to identify when the current spread is significantly above or below the historical average.

Establishing Entry and Exit Points

Based on the historical analysis, traders establish entry and exit points for their trades.

When the current spread is wider than the historical average plus a predefined threshold, it may signal an overvalued situation.

This can prompt a sell on the bond with the higher yield and a buy on the bond with the lower yield. (The trader will have to pay the carry, plus any shorting fees.)

Conversely, a narrower spread than the average minus a threshold may signal an undervalued situation, prompting a buy on the bond with the higher yield and a sell on the bond with the lower yield.

Execution of Trades

Traders execute the trades by taking long positions in undervalued bonds and short positions in overvalued bonds.

The positions are held until the spread reverts to the mean, at which point the trades are closed to realize the gains from the spread normalization.

Risk Management

Spread Risk

The main riss in bond spread reversion trading is that spreads may not revert to the mean as expected.

Various factors, such as changes in growth/inflation, credit ratings, or market sentiment (i.e., flows and positioning), can cause spreads to deviate from historical patterns – or what’s fundamentally warranted – for extended periods.

Interest Rate Risk

Changes in interest rates can affect bond prices and yields, impacting the spread between different bonds.

Effective hedging strategies and monitoring of interest rate movements can be necessary for managing this risk.

Liquidity Risk

Liquidity risk is when there’s not enough market activity to buy or sell bonds without affecting their price.

This can be particularly problematic in less liquid bond markets or during periods of market stress.

It’s also an issue for larger traders who are trying to trade large sums of money.

Let’s look at some trades involving bond spread reversion trading.

These examples show how traders can use bond spread reversion trading by:

• identifying spreads
• analyzing historical data
• understanding fundamental value
• executing trades, and
• managing positions to profit from the mean-reverting behavior of bond spreads

Trade Example 1: Corporate Bond vs. Government Bond

Step 1: Identify the Bonds and Calculate the Spread

• Corporate Bond – ABC Corp 5-year bond with a yield of 5.0%
• Government Bond – 5-year Treasury bond with a yield of 3.0%
• Spread = 5.0% (ABC Corp) – 3.0% (Treasury) = 2.0%

Step 2: Analyze Historical Spread Data

• Historical Average Spread = 1.5%
• Threshold for Overvaluation/Undervaluation = 0.5%

Since the current spread of 2.0% is 0.5% above the historical average when ABC Corp has the corporate credit rating that it has, it indicates a potential overvaluation.

Step 3: Establish Trade Amounts

• Trading Capital = $1,000,000

Step 4: Execute the Trade

Short the Corporate Bond:

• Short $500,000 worth of ABC Corp bonds at a yield of 5.0%.
• Number of bonds = $500,000 / ($1,000 face value per bond) = 500 bonds

Buy the Government Bond:

• Buy $500,000 worth of 5-year Treasury bonds at a yield of 3.0%.
• Number of bonds = $500,000 / ($1,000 face value per bond) = 500 bonds

Step 5: Monitor and Close the Trade

• Target Spread Reversion = Historical average spread of 1.5%
• Exit Strategy = Close the position when the spread reverts to 1.5%.

Trade Example 2: High-Yield Bond vs. Investment-Grade Bond

Step 1: Identify the Bonds and Calculate the Spread

• High-Yield Bond = XYZ Inc. 10-year bond with a yield of 7.0%
• Investment-Grade Bond = BBB-rated corporate 10-year bond with a yield of 4.0%
• Spread = 7.0% (XYZ Inc.) – 4.0% (BBB-rated) = 3.0%

Step 2: Analyze Historical Spread Data

• Historical Average Spread = 2.5%
• Threshold for Overvaluation/Undervaluation = 0.4%

Since the current spread of 3.0% is 0.5% above the historical average, it indicates an overvaluation.

Step 3: Establish Trade Amounts

• Capital = $1,000,000

Step 4: Execute the Trade

Short the High-Yield Bond:

• Short $500,000 worth of XYZ Inc. bonds at a yield of 7.0%
• # of bonds = $500,000 / ($1,000 face value per bond) = 600 bonds

Buy the Investment-Grade Bond:

• Buy $500,000 worth of BBB-rated corporate bonds at a yield of 4.0%.
• # of bonds = $500,000 / ($1,000 face value per bond) = 400 bonds

Step 5: Monitor and Close the Trade

• Target Spread Reversion = Historical average spread of 2.5%
• Exit Strategy = Close the position when the spread reverts to 2.5%

Trade Example 3: Municipal Bond vs. Treasury Bond

Step 1: Identify the Bonds and Calculate the Spread

• Municipal Bond = City of Metropolis 20-year bond with a yield of 4.0%
• Treasury Bond = 20-year Treasury bond with a yield of 2.5%
• Spread = 4.0% (Municipal) – 2.5% (Treasury) = 1.5%

Step 2: Analyze Historical Spread Data

• Historical Average Spread = 1.0%
• Threshold for Overvaluation/Undervaluation = 0.3%

Since the current spread of 1.5% is 0.5% above the historical average, it indicates it may be overvalued.

Step 3: Establish Trade Amounts

• Capital = $1,000,000

Step 4: Execute the Trade

Short the Municipal Bond:

• Short $500,000 worth of City of Metropolis bonds at a yield of 4.0%.
• # of bonds = $500,000 / ($1,000 face value per bond) = 500 bonds

Buy the Treasury Bond:

• Buy $500,000 worth of 20-year Treasury bonds at a yield of 2.5%.
• # of bonds = $500,000 / ($1,000 face value per bond) = 500 bonds

Step 5: Monitor and Close the Trade

• Target Spread Reversion = Historical average spread of 1.0%
• Exit Strategy = Close the position when the spread reverts to 1.0%

Conclusion

Bond spread reversion trading leverages the mean-reverting nature of bond spreads to generate profits.

By:

• understanding and analyzing historical spread data
• establishing clear entry and exit points, and
• managing risks effectively…

…traders can potentially benefit from the normalization of bond spreads.