Relative Value

Relative value analysis in fixed income compares yields, spreads, or expected returns across securities to identify which are cheap (high expected return) or rich (low expected return) relative to their peers.

The Salomon Brothers yield curve primer (Part 6) lays out the standard relative value framework:

1. Calculate total expected return for each maturity: carry + roll-down + expected capital gain/loss from rate moves
2. Compare returns across maturities on a duration-adjusted basis
3. Identify mispricings: sectors where expected returns deviate from the norm offer trading opportunities

Common relative value metrics:

• Carry and roll-down: which maturity offers the best income per unit of duration risk
• Fitted curve residuals: how far each bond's yield deviates from the smoothed par curve
• Rich/cheap analysis: comparing individual bonds to their theoretical value on the fitted curve
• Forward rate analysis: comparing implied forward rates to rate forecasts

Relative value trading differs from directional trading in that it takes offsetting positions. A relative value trader might go long a cheap 7-year note and short the rich 10-year note, profiting from convergence regardless of the direction of rates.

This approach is the bread and butter of fixed-income proprietary trading desks and dedicated relative value hedge funds. It requires detailed data across the curve — the kind of analysis the charting tools on this site are built for.