In the previous issue, we discussed that coupon income and capital gains together constitute the main returns on financial institutions' investment in bonds. However, with the development of the secondary market, the number of bond investors and the frequency of bond transactions have increased significantly, leading to the development of various bond operation strategies. Below, we will briefly introduce several bond operation modes in conjunction with profit models.

1. Profit Model Aimed at Obtaining Coupons

Bonds are a standardized debt certificate. According to the agreement, upon maturity, the issuer will repay the principal at a face value of 100 yuan per bond, and pay interest at a rate determined at the time of bond issuance on a regular basis (mostly on an annual basis). This profit model is about earning money from the bond issuer, and as long as there is no default, a fixed interest can be obtained. The initial profit model of investing in bonds is to obtain coupons. Under this profit model, a variety of investment strategies have been derived.

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a) Coupon Strategy - Earning Money from the Issuer

The coupon strategy involves investing in bonds to obtain the interest promised by the issuer. In the case of normal performance by the issuer, this is an expected return with high certainty and is the main source of income for many bond strategies. Bonds are also the most important fixed-income assets.

It should be noted that interest rate bonds do not have credit risk, but their yield is relatively lower than that of credit bonds. However, when investing in credit bonds, guarding against the credit risk of the bond issuer is crucial. Before 2014, China's bond market was almost a market with a guarantee of payment. Since the first default of a credit bond on March 5, 2014, the history of defaults in China's credit bond market began. However, coupons remain the main source of profit for bond investment.

b) Leverage Strategy - Earning Money from Risk Mispricing

The leverage strategy involves borrowing money at a cost lower than the bond yield and then investing in bonds to obtain coupons, earning the spread between assets and liabilities.

At present, there are various financial instruments in the bond market for financing. Pledge repurchase is the main means of financing, with a huge transaction volume. For example, the overnight pledge repurchase in the interbank market is measured in trillions of transactions per day. Currently, the leverage strategy is a widely used strategy to enhance returns. Tracing back to the source, some of these leveraged funds come from the central bank. Let's illustrate with an example:A invested 200 yuan in a 10-year government bond with an interest rate of 2.8%. They used 100 yuan worth of this bond as collateral to borrow overnight funds at an interest rate of 1.8%, receiving 97 yuan. They then used this borrowed money to purchase additional 10-year government bonds. The 97 yuan borrowed on the same day could earn an annualized interest rate of 1%, creating a profit from the interest rate differential. The next day, they used the uncollateralized bonds to borrow funds again to repay the previous day's overnight borrowing. The bonds purchased with borrowed money can be collateralized again at a discount of more than 90%, and this leverage can be repeatedly applied multiple times without considering regulatory indicators. Leveraging to amplify profits is also one of the sources of profit for bond funds. As long as the cost of funds is lower than the bond yield, this model is profitable.

It should be noted that while leverage can bring high returns, it also implies high risk. The bond market is a relatively efficient market, and there is no interest rate differential between funds and assets of the same term and risk. Leverage strategies are generally accompanied by maturity mismatch (investing in interest rate bonds is a mainstream model) or credit risk mismatch (investing in credit bonds), and investors must bear the corresponding risks. Once the cost of funds rises, or even exceeds the interest rate on the asset side, leverage can also amplify losses. During periods when the central bank's monetary policy is relatively loose, and the money market interest rates are low, and the funding situation is stable, leverage can be moderately increased.

II. Profit Model Aimed at Gaining Capital Gains

The capital gains of bonds come from the fluctuations in bond yields. For example, if an investor holds a 10-year bond A with an annual yield of 4% and a face value of 100 yuan. After 3 years, the remaining term of the bond is 7 years, and at this time, the newly issued 7-year bond B has a yield of 3%. For the same 7-year term, A earns 1 yuan more in coupon payments than B each year, resulting in a total of 7 yuan more over 7 years. The market price of A would then rise to around 107 yuan. Similarly, if A's yield at the time of purchase was 2%, the price would fall by 7 yuan.

The fluctuation in bond yields is also the main factor in the rise and fall of bond prices. Based on this, investment strategies based on secondary market transactions have been formed.

(1) Duration Extension Strategy - Earning Money from Economic Cycles

When the macroeconomy is in a downturn, due to pessimistic economic expectations, interest rates tend to trend downward. At this time, by appropriately extending the duration, one can earn capital gains from the downward trend in interest rates, which is also the source of the so-called "bond bull market." Representative periods include 2008, 2014-2015, and 2018-2022, among others.

(2) Swing Trading - Earning Money from Trading Opponents

Since bonds can earn capital gains through "buying low and selling high," one can earn price differences through high-frequency swing trading. The key to this profit model is the analysis of interest rate trends, and it is the money of trading opponents that is earned. Swing operations are influenced by many factors, such as trading capabilities, information advantages, and policy sensitivity.

It should be noted that swing trading can be considered a zero-sum game. From the long-term practical experience of the bond market, due to the characteristics of institutional dominance, the money of trading opponents is the most difficult to earn.(III) Riding the Yield Curve Strategy - Earning from Term Spreads

During the holding period of a bond, the remaining term of the bond gradually shortens, and the yield earned by the investor as the bond's yield slides down the yield curve is known as the "riding the yield curve" effect. Correspondingly, the riding the yield curve strategy involves purchasing long-term bonds, and as the remaining term of the bond shortens, the bond's yield decreases and its price increases. By selling the bond before maturity, investors can achieve excess returns. For example, suppose a portfolio has an investment horizon of 1 year, and there are two bond options available: a 1-year bond (yielding 2%) and a 2-year bond (yielding 2.5%). The riding the yield curve strategy refers to an investor buying the 2-year bond and then closing the position after holding it for 1 year; the corresponding strategy is the hold-to-maturity strategy, which is to directly buy the 1-year bond and hold it until maturity.

III. Summary

In addition to the aforementioned strategies, there are various methods to enhance returns, such as credit migration, extending duration, capturing premium on specific bond types, short selling through bond lending, and arbitrage with derivatives. The bond market is a large, institutionally diverse, and specialized market where financial institutions continuously research macroeconomics, policies, interest rate trends, industry development, and creditworthiness of issuers, and are also constantly adjusting and improving their investment strategies.

Qijuan Yun Research

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June 4, 2022