EBC4058 Fixed Income Management

Deutsche Bank and Cougars Case

School of Business and Economics, Maastricht University

Contents
1. Deutsche Bank: Finding Relative-Value Trades.................................................................2
1.1 Introduction.....................................................................................................................2
1.2 The role of the fixed income research group..................................................................3
1.3 Trading strategies............................................................................................................3
2. COUGARs..........................................................................................................................6
2.1 Introduction.....................................................................................................................6
2.2 COUGARs vs Treasury Bonds.......................................................................................6
2.3 Implied spot yields..........................................................................................................8
2.4 COUGARs’ overall pricing..........................................................................................10
Appendix...................................................................................................................................11
References.................................................................................................................................15

1. Deutsche Bank: Finding Relative-Value Trades

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 1.1 Introduction

In 1870, Deutsche Bank was established to support German companies expanding globally.
They provide financial services to private individuals, companies, governments, institutional
investors and small and medium-sized businesses. These services are divided into the
following four components: European Corporate Bank, Investment Bank, Private Bank, and
asset manager DWS (Deutsche Bank, nd). Within the Deutsche Bank the fixed income
activities are organized around three main pillars: investor coverage, issuer coverage, and
research. Although there are other research groups, in this case the Fixed Income Research
Group will be the main focus. The group consists of around 50 analysts and strategists and is
located in the Deutsche Bank’s London office. Thus far, the group's success rate—which is
determined by the proportion of trade recommendations that result in profitable transactions—
is 75%.

1.2 The role of the fixed income research group

The Fixed Income Research Group is Deutsche Bank’s internal research and development
(R&D) department for fixed income instruments. Their role is to look for untapped value
across bond markets and interest rate derivatives. One way of doing this is to compare the
prices of traded securities against the prices that the group thought the securities should trade
at. To assess the values of traded securities, the majority of banks employ proprietary models
as their foundation. This is also the case for Deutsche Bank, they developed their own
proprietary yield-curve model called three-factor affine model, with the short rate, slope and
long rate as key variables. The predictions from the model are then compared to the actual
zero-coupon yield curve to determine whether any trade ideas became apparent. They then
present their findings to the Deutsche Bank traders, as well as to Deutsche bank clients at the
CEO, CFO and Treasury level. Not only do they provide strategic advice on macro trends and
relative value, they also come up with insightful and informative new ways to look at things.
The activities that the Group performs are centered around three pillars: 1) Investor
coverage includes determining the client's needs, risk tolerance, investment horizon, and
objectives. 2) Issuer coverage intends to monitor the creditworthiness, financial stability,
industry dynamics and regulatory environment. 3) Research on market and macroeconomic

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data, credit ratings and financial statements of issuers so that a strategy to minimize risk can
be implemented.

1.3 Trading strategies

In order to determine the advice Deutsche Bank would provide on the various maturities, first
the yield curve implied from coupon-bonds needed to be created. To do this, the following
formulas have been used to determine the values of the coupon bonds:

Current price
At T=1: P Z
0,1 = coupon rate at T 1
100+( )
2
(1)

coupon rate T
current price− x ∑ values of bonds wit h previousmaturities
2
At T=2 till PZ0,T =
coupon rate at T
100+( )
2
(2)

After that, the formula:

1
( 1
−1),
2x T (3)
Value of bond
T

has been used to determine the yields. The results from both steps can be found in appendix
A.1. The results of the yields have been plotted and are compared to the model predictions,
see figure 1.

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Figure 1 Yields

The yields have been subtracted from each other to show the yield spread, see figure 2.

Figure 2 Yield spread

As can be seen in the figure, the 1-year, the 20-year and the 25-year maturity have a negative
yield spread between market implied yields and Deutsche Bank’s calculated yields. If
Deutsche Bank’s yield calculations are right, as of today, the market pays too low yields for
the 1-year, the 20-years and 25-years maturities, and Deutsche Bank and expects these yields
to increase. As yields are inversely related to prices, an expected increase in yields means that
bond prices are going to decrease, compared to its current levels, and should therefore be sold.

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The Deutsche Bank yields of the 2-year and 10-year maturities are the same as the market
implied yields, since the model was calibrated on those. The buying/selling advise is therefore
neutral for these maturities.

All other maturities have a positive yield spread between market implied yields and Deutsche
Bank’s yields. Again, assuming that Deutsche Bank is good in assessing where yields might
go, this means that the market as of now, pays too high yields for these maturities (for
example 3–9 year maturities). The expected decrease of yields would lead to higher bond
prices, as these are inversely related to yields. Therefore, as of now, these bonds are
undervalued and should be bought.

There are multiple shortcomings to this approach. First of all, there is market volatility. Yield
predictions can be affected by unforeseen market conditions. Second, the model cannot
include every macroeconomic indicator. If there is an over-reliance on the model, other
qualitative factors that are not captured by the model might be overlooked. Third, it will
always be difficult to predict long-term market trends accurately since no one can know for
sure what is going to happen in the future. Lastly, the inputs in the model is a shortcoming.
You can never be certain that the data that you put into the model is correct (for example, data
could be outdated).

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 2. COUGARs
2.1 Introduction
This case study delves into the viability of investing in COUGARs, addressing four key
inquiries. The initial section provides a comprehensive definition of COUGARs and conducts
an analysis of their similarities and distinctions when compared to U.S. Treasury Bonds.
Subsequently, the pros and cons of choosing COUGARs over U.S. Treasury Bonds are
evaluated.

The third segment of the article focuses on the computation of implied spot yields for U.S.
Treasuries across all maturity periods. The methodology for this calculation is shown,
accompanied by illustrative exhibits. The last section of the paper asks the question of
whether the overall issue of COUGARs is deemed overpriced or underpriced, which will also
be accompanied with mathematical calculations.

2.2 COUGARs vs Treasury Bonds

COUGARs, functioning as financial instruments, enable a custodian bank to selectively
convey specific combinations of interest and principal payments derived from an underlying
U.S. Treasury bond to investors. This unique feature facilitates the trading of a 20-year U.S.
Treasury bond, typically characterized by 40 semiannual and one final principal repayment, as
41 distinct securities. Consequently, COUGARs effectively operate as "stripped" U.S.
Treasury bonds, showcasing a tailored cash flow structure that can be customized according
to the preferences of individual investors.

In this specific case, in order to respond to the varied needs of their customers, a number of
investment banks had created vehicles similar to the one created by A.G. Becker Paribas. In
each of these vehicles, investment banks arranged for a custodian bank in this case,
Manufacturers Hanover to pass through the payments of interest and principal from an
underlying U.S. Treasury bond to investors who chose the payments they were interested in
receiving.

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The process of stripping unfolds through a passing-through trust, granting investors the credit
and tax benefits associated with genuine ownership of U.S. Treasuries. To achieve this, these
trusts issue liabilities that align with the payment stream anticipated from the U.S. Treasuries
held as assets. In essence, the expected total cash flows of the bond are disseminated
individually in smaller yet more personalized, and consequently, more intricate partial
payments.

Moreover, in contrast to treasury bonds that provide traders with both principal and interest
payments, COUGAR holders exclusively receive the discrepancy between the purchase price
of the receipt and its face value. This characteristic positions COUGARs as unique financial
instruments, setting them apart from traditional treasury bonds. Also, prices of strips tend to
experience more significant fluctuations compared to regular bonds from the same issuer,
with the same term and credit rating. The main cause of this heightened volatility is the
absence of interest payments for strip bonds before they mature.

The attributes of COUGARs, including their lack of periodic payments and non-redeemable
status before maturity, closely align them with the characteristics typically associated with
zero-coupon bonds. The structure of COUGARs mirrors that of a zero-coupon bond, where
the face amount signifies the ultimate payment to be received.

In situations where an investor, particularly a pension fund or a fund with the capacity to
borrow liabilities, seeks to precisely match their liabilities, opting for COUGARs becomes
advantageous since duration of the assets can be extended. The lack of periodic payments
until maturity in COUGARs, coupled with their discounted nature, allows for effective
liability matching.

Furthermore, certain investors may prefer a substantial one-time payment over multiple
smaller payments, a strategic choice often driven by the desire to streamline financial
considerations and mitigate complexities associated with managing numerous smaller
payments over time. Thus, the appeal of COUGARs extends beyond their discounted values
to encompass considerations of liability matching and efficient management of financial
commitments, especially for investors with specific borrowing capabilities.

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 2.3 Implied spot yields

To derive implied spot yields, one must follow the bootstrapping procedure:
1. The ask quotes given in the case show 32nds and must be converted. Therefore,
100.01 is converted to a decimal price of 100.03 [=100+1/32].

If data for specific maturities were not available, other bonds were used. For these special
cases, also the bond price was recalculated by simply discounting coupons and principal
payment by its yield to maturity (YTM). For example, for May 1994 no single bond data was
available, and the November 1993 bond was therefore used. The bond price for May 1994
was recalculated at $82.69 (present value of its future cash flows) compared to a given bond
price of $82.88 for November 1993 (please see appendix A.2).

Due to its minor extent accrued interest is assumed to have no impact in the case and was not
considered.
2. The Cash Flow Matrix must now be filled. An example of the first four bonds is
shown here:

1. The Inverse of the Cash Flow matrix A-1 is then multiplied by the prices p (calculated
in the first step) to get the Implied zeroes z:

2. Since coupon payments are paid semi-annually, implied spot rates y are calculated as
follows:

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 1
=0,9085
( )
2
y (4)
1+
2

(( ) )
1
1
y= 2
−1 ⋅2=9 , 83 % (5)
0,9085

The implied spot rates can be now compared to the yields of the COUGARs to determine
whether the COUGARs themselves are underpriced or overpriced (see also Appendix A.3).

The implied spot yield, derived through bootstrapping, reflects the market's expectations for
future interest rates. It is essentially the interest rate that equates the present value of future
cash flows from a bond to its current market price. When the difference between implied spot
rates and COUGARs’ YTM is negative the implied yield is lower than the COUGAR’s yield.
Since the COUGAR's implied spot yield is higher than what the implied rates of the bond
markets off, it suggests that the COUGAR is underpriced relative to the market's expectations.
The opposite is true when the difference between implied spot rates and COUGARs’ YTM is
positive (when COUGAR’s yield < market implied spot rates it means that the COUGAR is
overpriced, since yields are inversely related to prices and the COUGAR gives a lower yield).

We can notice that for longer maturities COUGARs are overpriced, and the opposite holds
true for shorter maturities. This can be explained by the longer duration COUGARs offer in
contrast to U.S. Treasury bonds with the same maturity, and since there are not many

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financial instruments with this high duration on the long term the demand for these
COUGARs is high (easy matching with long-term liabilities, no need to reinvest since there
are no coupons). By contrast, the underpricing of short-term COUGARs may be explained by
the less liquidity they offer when compared to U.S. Treasury bonds. Even if COUGARs have
the same issuer, term, and credit rating as regular bonds, they are not as easy to sell.

Underpricing in the bond market could attract investors looking for bargains and present
potential arbitrage opportunities. Investors may seek to capitalize on the discrepancy by
purchasing underpriced securities and potentially benefiting as their prices converge with their
intrinsic values.

2.4 COUGARs’ issue overall pricing

We must compare the present value of the COUGARs to the price of the bond maturing in
November 2003, which featured an annual coupon rate of 11.88% (divided by 2 to get the
semiannual coupon rate) and a market price of $99.88 (in decimals). The present value of the
COUGARs sold is computed as the multiplication of the bond's coupon with each percentage
of the face values at which the strips were sold.

For instance, to calculate the present value of the first two COUGARs, the stripped coupon of
5.94 was multiplied by 95.866% and 90.484%. This process was extended across all
maturities (see Appendix A.3), resulting in a total present value of the COUGARs of $101.37.
Compared to the bond price of $99.88, which was used for stripping, the net income of the
stripping operation can be obtained as $101.37 - $99.88.

The derived result suggests that, excluding taxes or additional fees, the overall issue of
COUGARs may have been overpriced. This outcome aligns with expectations,
acknowledging that the bank selling the COUGARs, seeks to realize a profit from such
operations.

Despite the potential overpricing, demand for COUGARs persists. This can be attributed to
several factors elucidated in paragraph 2.3. Investors may find the appeal of COUGARs
compelling due to the need to mitigate risk on longer terms by investing in strips with
extended durations. COUGARs offer the advantage of having durations that surpass those of
many long-term coupon bonds. Furthermore, the absence of periodic payments eliminates the
need for continuous reinvestment, providing investors with a streamlined and potentially more
efficient investment strategy.

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In essence, while the calculated result points towards potential overpricing, the demand for
COUGARs remains robust (at least for long-term COUGARs), driven by a combination of
market dynamics, risk mitigation strategies, and the unique characteristics of stripped bonds.
Investors are drawn to the extended duration and simplified reinvestment considerations,
despite the slightly higher overall prices when compared to the market.

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Appendix
A.1 – Yields implied from coupon bonds

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A.2 – Data used to imply spot yields

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A.3 – COUGARs’ YTM and implied spot rates + COUGARs’ overall price (101.37)

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References
Deutsche Bank. (n.d.). Who we are. Retrieved from Deutsche Bank:
https://www.db.com/who-we-are/

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