Hedging Callable Bond Inventory
Somewhat new to this. Bear with me. My question revolves around hedging callable bond inventories. For simplicity, lets use Agency FHLB, FFCB, FHLMC, or FNMA as context. Lets say I go to FHLB and print 100mm of a 5% 2Y non-call 1Y 1X bond (so, 2 year bond callable in one year on a specific date, if not called, bullet til maturity, semi-annual payments).
How would one hedge this, and more importantly, how would you peel off your hedge as your balance is sold to the street or internally? I've seen forwards, derivatives, swaps, straddles, euros used, ect.. but what is the best way to exit this hedge without having to move multiple positions every time my inventory balance changes? I guess I'm referring to "slippage" where if my inventory decreases, how do I exit the correct amount of hedge quick enough to where the market wont move too much before I can execute. I'm aware there are multiple ways to hedge a callable inventory but I thought it wouldn't be a bad idea to reach out and ask what other traders prefer. Pointing me in a direction without disclosing details is totally fine of course - just looking for some ideas. Thanks in advance
Very high level- Assuming you purchase the bond and have X yield to worst which would also be your yield to call. You would have an associated duration and DV01 that you can hedge with treasuries, swaps, CDS etc.
All you are doing is hedging your duration. If the bond is called the duration will be shorter and you unwind your shorts. If not called, you may have to put more duration hedges on but you always price to your yield to worst. I prefer swaps/treasuries since very liquid and rarely pay a lot of bid/ask.
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