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Active Bond Management

Active bond management strategies rely on expectations of interest rate movements or changes in yield-spread relationships. Active bond management contrasts with passive bond management strategies which make no attempt to enhance performance by capitalizing on these expectations. Rather, the objective of passive strategies is to design a portfolio that will achieve the performance of a predetermined benchmark. The benchmark might either be to achieve the return on a specified index or it might be to accumulate sufficient dollars to satisfy a future liability stream.


Active bond managers attempt to exploit the four general factors that affect a fixed income portfolio’s return:

Changes in the level of interest rates

For changes in the level of interest rates, interest rate anticipation strategies can be used from an expected level change in interest rates. A level change in interest rates is defined as a parallel shift in the yield curve. Duration measures the inverse relationship between a level change in interest rates and a fixed income portfolio’s value. To enhance return, if rates are expected to decline a manager would increase the duration of the portfolio; conversely, if rates are expected to rise, the manager would shorten portfolio duration.

Changes in the shape of the yield curve

Because duration only measures the effect of a parallel shift in interest rates, durational neutral strategies can be used to profit from an expected change in the shape of the yield curve. The yield curve can shift in various ways, but the two most common are 1) a downward shift combined with a steepening and 2) an upward shift combined with a flattening. Two portfolios can have similar durations, but if their bond maturities are different they will react differently to changes in the shape of the yield curve.

One method to measure the effects of a change in the shape of the yield curve is to construct a bullet portfolio and a barbell portfolio, each with an equivalent duration. A bullet portfolio is one where maturities are centered at a single point on the yield curve. A barbell portfolio is one where maturities are concentrated at two extreme points on the yield curve, with one maturity shorter and the other longer than the bullet portfolio’s maturity. In general, the bullet will outperform if the yield curve steepens with long rates rising relative to short rates, because of the capital loss on the longer term bonds in the barbell portfolio. Conversely, if the yield curve flattens with long rates falling relative to short rates, the barbell will almost certainly outperform because of the positive effect of capital gains on long term bonds. Even if the yield curve shifts in a parallel fashion, the relative performance of bullets and barbells may be different, even if their duration is the same. The reason is that the bullet often has a higher yield, but the barbell has greater convexity. Thus, if the yield curve rises by a small amount, the bullet may outperform because of its yield advantage. However, for large yield curve increases, the barbell may outperform because its convexity advantage will keep it from falling as much in price as the bullet.

Partial duration can also be used to measure a portfolio’s sensitivity to yield curve shape changes. Partial duration measures the change in a bond’s value due to a shift in one point in the yield curve while all other yield curve points remain the same. Using this method, a manager can hold portfolio duration constant and select bonds that provide superior performance for an expected change in one point on the yield curve.

Changes in yield spreads across/between sectors

Yield spread strategies can be used to profit from an expected change in current bond sector spreads. The bond market can be segregated into different sectors such as type (corporate, treasury, or mortgage backed), quality (treasury, government agency, AAA, AA, A, BBB, below investment grade), or call feature (callable or non-callable).

Yield spread strategies are based on an assumption that current yield spreads between sectors are not consistent with some “normal” yield spread level. In these strategies, often called intermarket spread swaps, a manager sells bonds in one sector and buys bonds in another sector in the hopes of profiting as the yield spread moves from its current level to its “normal” level. These strategies are generally independent of interest rate anticipation strategies which attempt to capitalize on expectations regarding the level of interest rates. There are many instances when yield spread strategies can be used, with two examples being given below.

During periods of economic expansion, corporate yield spreads (the spread between treasury issues and non-treasury issues) generally narrow, reflecting corporate bonds decreased credit risk. Conversely, during recessions, corporate yield spreads generally widen, reflecting the increased credit risk due to a weakening economy. Thus, if an expansion is forecast, a manager would purchase corporates and sell treasuries in anticipation of greater price appreciation or less price erosion due to the spread narrowing. On the other hand, if the economy is expected to weaken the manager would sell corporates and buy treasuries to reduce the price loss due to the spread widening.

Another example is the decision to purchase callable or noncallable bonds. If interest rates are expected to decline, callable yields generally widen because the call option is becoming more valuable. Callable bonds are short a call option which increases in value as interest rates drop, and buyers of callable bonds will demand more compensation in yield spread to offset the call risk as interest rates decline. If interest rates are expected to fall, a manager would sell callable bonds and purchase non-callable bonds to avoid the depreciation in price of callable bonds due to spread widening (negative convexity at work). Conversely, if interest rates are expected to rise and callable bond spreads to narrow, the manager would sell non-callable bonds and purchase callable bonds. Interest rate volatility also plays a role in the spread. As volatility increases, the value of the embedded call option rises, causing callable bond prices to fall and the yield spread to widen. Thus, if volatility is expected to increase, the manager would sell callable bonds and purchase non-callable bonds; if volatility is expected to decrease, non-callable bonds would be sold and callable bonds would be purchased.

Changes in yield spreads for a particular instrument

Individual security yield spread strategies, often called substitution swaps, can be used to select one of two bonds that are similar in all aspects except that one has a higher yield. For example, in a given credit quality sector, a bond might be selected if a manager feels that its credit quality should be higher than other similarly rated bonds. If this analysis is confirmed by the market via a rating upgrade, the bond will go up in value.

Another example is to compare two mortgage backed securities (MBSs) of similar coupon, maturity, and type, where different prepayment assumptions lead to different prices and yield spreads. If a manager expects a different prepayment assumption than the market, the manager can act on that assumption in the hopes that the market will agree with his prepayment assumption in the future and “correctly” value that particular MBS. For example, for a particular discount MBS or a PO, if a manager expects faster prepayments than the market, the manager could purchase that security to realize the greater value of receiving principal repayments quicker than the market anticipates. Similarly, for a particular premium MBS or an IO, if the manager expects slower prepayments than the market, the manager would purchase that security because its lower price is overly compensating for the prepayment risk.

J. Wade Luther E-mail, CFA, ASA, MAAA
April 1999

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