I have received an eMail with some questions of sufficient generality that I thought I would publish it – suitably redacted, of course!<\/p>\n
\u00a0<\/p>\n
I now understand YTW and the concept of pseudo convexity, but not the application of pseudo convexity e.g. in your current recommendations, which is more \u201cbond like\u201d, a negative 12.00 (###.##.##) or a positive 6.00 (###.##.#)?\u00a0 Given my interest rate view, I should stay away from more bond like.<\/p><\/blockquote>\n
A “normal bond”, by which I mean a fixed-income instrument with no embedded options, will always have a positive convexity, which will vary (roughly speaking) as the square of the duration.<\/p>\n
[One implication of this relationship is that one may use convexity as a measure of the “barbelledness” of a bond portfolio; for instance, an extremely barbelled portfolio comprised of 3-month treasury bills and 30-year bonds will have a greater convexity than an extremely bulletted portfolio comprised solely of 10-year bonds even though both portfolios have exactly the same weighted average duration<\/em>.<\/p>\n
Classical fixed-income mathematics states that a more convex portfolio will always outperform a less convex portfolio that has the same yield, regardless of the direction of a change in interest rates; this is because classical fixed income mathematics assumes that all changes to the yield curve will be parallel. In fact, (given equal durations, different convexities) convexity (= barbelledness) helps when the curve is flattening, hurts when it is steepening. When it is humping (by which I mean the middle is increasing in yield by more than the average of the two endpoints – what did you think I meant?) convexity helps; when de-humping (I will admit that I’ve never used this term before, although I have used “humpedness”) convexity hurts.<\/p>\n
However, classical fixed income mathematics has led to one of the more truly dumb slogans ever used in portfolio management: the benter the better<\/a>. This phrase picks up from looking at plots of duration vs. price; since (in classical fixed-income mathematics with perfectly normal bonds) the curvature of this plot works in the holder’s favour so some believe that more bending = more value.<\/p>\n
End of rant, back to the main question.]<\/p>\n
Convexity is of very little value in quantitative\u00a0fixed income analysis, but has some use as a qualitative measure (as long as you don’t take it too seriously). Pseudo-Convexity<\/a>, used in HIMIPref\u2122, results from a mathematical calculation that seeks to accomplish the same thing while accounting for embedded options. It is a Good Thing for pseudoConvexity to be positive (all else being equal, which is never the case) because<\/p>\n
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- Pseudo-Convexity may be interpreted as a measure of how “bond-like” the instrument is; bonds have positive convexity (and pseudo-convexity, of course)<\/li>\n
- It is good for preferred shares to be bond-like, because the only ways in which they differ from regular bonds are bad for the holder<\/li>\n<\/ul>\n
When confronted by the choice between two instruments that differ in pseudo-convexity, you should ensure that you are being paid (higher expected total return) for the risks you are incurring by taking a lower convexity [to the extent that this lower convexity is due to embedded options, not simply lower duration. Virtually all differences in pseudoConvexity will be due to embedded options].<\/p>\n
I understand the different types of pref share, but I am not clear as to how to think about that i.e. advantages\/disadvantages of different types per se.<\/p><\/blockquote>\n
This is a big, big question. All I can really do is point you to the various articles I have written, specifically those referenced on the PrefLetter page introducing these types<\/a>.<\/p>\n
After that I am trying to turn your recommendations into practical action e.g. one of your current recommendations is ###.##.#; I own that, it is down 5.2% since I purchased (which is likely one of the reasons you are recommending it!), but, should I add to that position at this price?\u00a0 I suppose that specific question resolves itself into the more general one of buy, sell, hold-at given purchase price ranges.\u00a0 So, I know how to buy from your letter, but not how to sell.\u00a0 I imagine your answer may be to buy your managed fund, which I may well consider, but couldn\u2019t you turn your letter into a model portfolio, or is that the purpose of your fund?\u00a0 Maybe I should be buying that as opposed to the newsletter!\u00a0 My portfolio of prefs has actually done well over the couple of years I have held it but has started to head South over the last Qtr in response to inflation\/interest.\u00a0 I believe in prefs as a sensible part of a yield portfolio, but the prudent management is beginning to seem complex.\u00a0 I own 14 different prefs of which 5 are positive, 9 are now negative by generally small amounts, and I\u2019m fumbling as I am pretty sure further rate increases are ahead. ( I understand your view on interest rate forecasting!)<\/p><\/blockquote>\n