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CHAPTER 10. Bond Strategies

Bond investment strategies usually are described as being either passive or active. However, I prefer the dichotomy to be “passive” or “aggressive” to focus attention on managerial intent rather than frequency of trading. Some passive strategies – for instance, tracking the performance of some published bond index or targeting a preset rate of return over a known investment horizon – require active trading to rebalance the portfolio. Trades in a passively managed bond fund are about “needs” and not “wants.”

In contrast, an aggressively managed bond portfolio seeks to maximize the rate of return, typically over a given time period. For example, a fixed- income mutual fund manager focuses on changes in net asset value, subject to constraints on overall credit quality and maturity. When credit risk is a factor, the portfolio manager might overweight (or underweight) companies and industries expected to outperform (or underperform) market expectations. This draws more on equity analysis tools and not so much on bond math. Therefore, I focus on aggressive strategies having to do with an anticipated shift in the shape and level of the benchmark yield curve. The question is whether average portfolio duration and convexity are useful summary statistics for the strategy.

Some bond investment strategies can be described as passive-aggressive, borrowing loosely the term from psychology. In fact, I suspect that many bond portfolio managers in practice tread this middle ground, sometimes content to follow the market passively and at other times intentionally staking out some position that is hoped to achieve superior performance. For example, fixed- income portfolios often are judged relative to a published index. The fund manager might just track the index, holding positions very similar to the bonds that compose the benchmark, and wait for opportunities to be aggressive.

Before starting, let's try one more quiz – no tricks this time; there is no wrong or right answer. Suppose that some government trying to deal with its enormous debt decides to run a national lottery to raise needed funds – Big Bond Lotto, it's called. The payoff each week is a fixed-rate, long-term government bond. This is a pari-mutuel lottery in that the grand prize depends on the number of winning tickets. You pick your numbers strategically and are lucky enough to be the sole winner of Big Bond Lotto, fortunately after several months have gone by without a winner, thereby building up a huge payout. Now that you're a very rich fixed-income investor, what is your hope for benchmark interest rates? Are you hoping that government bond yields go down, go up, or are you indifferent?

If you are like most people to whom I've posed this scenario, you hope that yields go down so that the bond price goes up. You have revealed your investment horizon – you plan to sell the government bond soon to diversify into other, more fun, assets. Not only are you rich, you want capital gains, too! Occasionally, someone hopes that yields go up so that coupons can be reinvested at the higher rates. This is a revealed hold-to-maturity investor whose total return is a function of coupon reinvestment risk. The hope is that the real rate goes up, not inflation.

Suppose that some clever person, after checking a financial function on Excel or Bloomberg, or maybe digging out a bond math formula and using a financial calculator, announces that he or she is indifferent to yields going up or down. Granted, that indifference is subject to how and when yields change but still this person claims, “I'm good, I'm immunized from interest rate risk because it just so happens that the Macaulay duration of this government bond matches my investment horizon.” Okay, this has never happened, but in theory it could.

Immunization strategy is a great way to conclude a study of bond math. The key point is that the difference between the duration of the fixed-income portfolio and the investment horizon measures interest rate risk. When those are matched, risk is minimized and the investor is immunized to a large extent from rate volatility. An implication is that two investors holding the same bond portfolio can have diametrically opposed risk profiles. One investor gains if yields rise; the other gains if yields fall. One hedges risk by entering a receive-fixed interest swap; the other hedges by entering a pay-fixed swap.

In sum, fixed-income strategy ultimately depends on the time horizon for the investment portfolio. That raises the specter of what I call horizon risk, which is the risk that a strategy is set assuming a particular holding period, only to find that the bonds need to be liquidated prematurely or unexpectedly rolled over.

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