Over the last few years, credit-default swaps have helped transform credit investment from a long-only game to a global market in which wholesale credit risk can be transferred, managed and assumed pro-actively. For all its merits, the default swap is not hugely adaptable for tailoring returns around specific views or return requirements.
Non-linear corporate bond option payoffs, however, provide the tools to construct more sophisticated risk-return profiles when used in conjunction with bonds, default swaps or other options. In particular, we would highlight the following investment characteristics of corporate bond options:
* The non-linear payoffs generated by options allow strategies to be constructed that go beyond simple directional views about whether the credit is rich or cheap at current levels.
* Bond options can be used in conjunction with underlying bonds to either reduce risk or enhance yield in return for capping upside. Furthermore, the ability to vary the strike price gives considerable flexibility in tailoring the desired pay-off.
* Bond options can be used to create short-term synthetic longs (or shorts) which reference a long-duration underlying bond. This can offer a more powerful means of expressing an immediate directional view than default swaps.
* Bond options provide the means for taking positive or negative views on volatility.
* As the underlying is an unhedged corporate bond, option strategies can make greater intuitive sense to institutional portfolio managers who don't necessarily focus on asset swap spreads as valuation metrics.
Bond Option Basics
The option strike price is typically quoted in terms of the underlying bond price rather than the yield. The strike price can be essentially any bond price but it is quite common to trade either the current clean spot price or the clean at-the-money (ATM) forward price of the bond. Most are European style options.
The relatively young market in OTC options references a variety of benchmark bond issues from across the U.S., Europe and Asia.
Options are liquid for maturities up to two years. However, liquidity is highest for three-month and six-month options.
Writing Covered Calls
A covered call position is a combination of a long underlying bond position and a short call option on the same bond. Chart 1 highlights the payoff of a covered call strategy at expiration.
Writing covered calls results in an immediate one-time upfront cash inflow from the sale of the call option which translates into an effective yield enhancement throughout the life of the bond. This strategy also limits the upside of the underlying bond at the strike price and reflects the fact that covered calls are significantly less risky than naked call positions.
A covered call does not benefit from high or rising volatility. If the bond price rises too much, the investor gives up an increasing amount of upside. If the bond price falls below the breakeven price, the investors would make a loss on the covered call position (however, they are still better off than if they hadn't sold the option).
The key risk for a covered call investor is the potential opportunity cost on the upside, i.e. the investor would not participate on any bond price increase above the strike price at expiration. Bonds that trade at relatively tight spreads and where investors have a neutral credit view would make attractive covered call candidates.
Buying Protective Puts
Investors can hedge a long bond position against downside risk by buying at-the-money or out-of-the-money (OTM) puts. The investor retains the upside of the bond position while hedging all or part of the downside. The net position is similar to a long call position. An ATM put provides greater downside protection but costs more than an OTM put.
The strategy of buying a deep out-of-the-money put is similar to buying a credit-default swap. There is, however, a key difference between the two payoffs. An investor who is long protection would receive a payoff only if there is a credit event (unless the default swap is unwound before expiry). On the other hand, a buyer of a bond put option will receive a large payoff if bond prices deteriorate significantly even though there is no credit event.
Writing Puts
Investors can make targeted purchases as well as enhance yield by writing puts. Writing puts makes sense in an environment where the investor is bullish, is probably long the credit, and is willing to buy more bonds if the price falls below the strike price. Thus investors can write puts to make bond purchases at target prices equal to the strike price.
Asset Allocation Strategy
Bond investors who maintain a disciplined approach to asset allocation or those who are benchmark-oriented can use bond options to implement effective asset allocation strategies. For example, investors who expect an overweight position to have a limited absolute upside, the investor can write a covered call on the overweighted portion (relative to the neutral weight) of that bond. If the bond price rises above the strike price, the overweighted position of the bond would be called at the strike price and the weight of the bond would move to neutral. The investors would lose any upside above the strike price. However, they get a premium for locking-in a strategy to which they were already committed.
Similarly if an investor expects an underweight position to have a limited absolute downside, the investor can sell puts on the underweighted position. If the bond price falls below the strike, the investor will be sold the bond thereby increasing the weighting of the position toward neutral. The risk is that the bond will fall substantially below the strike price. However, once again the investor would be paid a premium for locking-in to a committed strategy.
Synthetic Long/Short Positions
Investors can use bond calls and puts to create synthetic forward long or short bond positions in the following manner (assuming the same strike price):
* Buy Call + Sell Put = Synthetic Long
* Buy Put + Sell Call = Synthetic Short
Investors who wish to express a leveraged long position in a credit can buy a longer-duration bond The downside of this strategy is the funding cost of the long holding. Investors could sell protection instead (unfunded) but the most liquid maturity is the five year default swap. Investors can use bond options as an unfunded alternative for establishing a short-term long (or short) view in longer duration bonds.
Expressing Volatility Views
Investors who have a strong view on volatility can set up straddles (or strangles) to capitalise on any significant changes in bond price or yield volatility.
A long straddle is composed of a long call and a long put at the same strike and reflects an expectation of significant increase in price or yield volatility. On the other hand, investors who believe that volatility will collapse in the future could take on a leveraged view of this position by setting up a short straddle which is a combination of a short call and short put at the same strike.
Alternatively, investors can use calls and puts of different strike prices to generate strangles. A long strangle would be a cheaper method of expressing a similar view of increasing volatility relative to the long straddle. Similarly a short strangle would generate a lower yield compared to the short straddle and would also benefit from a reduction in volatility.
Bond Option Spreads
Investors can use bond option spread strategies to make targeted purchase and sale decisions. For example, investors can set up long call spreads (buy a call and sell a call at a higher strike price) to capture the upside from a targeted purchase and sale strategy. The lower strike price would represent the target purchase price while the higher strike price would represent the target sale price.
Similarly an investor who buys a put on a bond could partially finance this purchase by selling a put option at a lower strike price (long put spread). The investor would give up any upside below the lower strike.
Investors can also set up short call spreads (sell a lower strike call and buy a higher strike call) and short put spreads (sell a higher strike put and buy a lower strike put). Both strategies limit the downside associated with a short call or short put position.
Hedging for Corporate Issuers
Corporate issuers can use bond options to provide protection against increasing yields demanded by the market or as part of a delevergaing strategy. In particular, a typical company may want to do the following:
(1) Issue debt if yields are less than the current yields: Investors can sell a call at the target yield strike. If the yield falls below this level, the company will issue bonds at the strike yield and miss out on any upside.
(2) Be protected in the event of an increase in yields: The company can buy puts struck at the target yield. If the yield increase above this level, the company can then issue bonds at the target yield.
(3) Buy back bonds at cheaper prices: An issuer that wants to buy back its bond at prices lower than the current market price can sell OTM puts at strike prices equal to one or more target bond purchase prices. This strategy lowers the net purchase price even further due to the upfront premium received by the corporate issuer.
This week's Product Focus was written by Atish Kakodkar, v.p. in credit derivatives research, and Chris Francis, managing director and head of international credit research at Merrill Lynchin London.
Hedging A Long Position Using Long ATM Put
Hedging A Long Position Using Long OTM PutS
Source: Merrill Lynch
