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:
Calculate total expected return for each maturity: carry + roll-down + expected capital gain/loss from rate moves
Compare returns across maturities on a duration-adjusted basis
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
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.
Curve Trade— A position designed to profit from changes in the yield curve's shape rather than the overall level of rates.
Carry— The income earned from holding a bond, equal to the coupon income minus the cost of financing the position.
Roll Down— The yield pickup a bond earns as it ages along an upward-sloping yield curve, holding the curve constant. A core component of fixed-income carry trades.
Forward Rate— The implied future interest rate derived from the current yield curve using no-arbitrage pricing.