Sources of Potential Profit
Broadly speaking, there are two sources of potential value in active bond management. The first is interest rate forecasting, that is, anticipating movements across the entire spectrum of the fixed-income market. If interest rate declines are forecast, managers will increase portfolio duration; if increases seem likely, they will shorten duration. The second source of potential profit is identification of relative mispricing within the fixed-income market. An analyst might believe, for example, that the default premium on one bond is unnecessarily large and the bond is underpriced.
These techniques will generate abnormal returns only if the analyst’s information or insight is superior to that of the market. You can’t profit from knowledge that rates are about to fall if everyone else in the market is onto this. In that case, the anticipated lower future rates will be built into bond prices in the sense that long-duration bonds already sell at higher prices, reflecting the anticipated fall in future short rates. If you do not have information before the market does, you will be too late to act prices will have already responded to the news. You know this from our discussion of market efficiency.
Broadly speaking, there are two sources of potential value in active bond management. The first is interest rate forecasting, that is, anticipating movements across the entire spectrum of the fixed-income market. If interest rate declines are forecast, managers will increase portfolio duration; if increases seem likely, they will shorten duration. The second source of potential profit is identification of relative mispricing within the fixed-income market. An analyst might believe, for example, that the default premium on one bond is unnecessarily large and the bond is underpriced.
These techniques will generate abnormal returns only if the analyst’s information or insight is superior to that of the market. You can’t profit from knowledge that rates are about to fall if everyone else in the market is onto this. In that case, the anticipated lower future rates will be built into bond prices in the sense that long-duration bonds already sell at higher prices, reflecting the anticipated fall in future short rates. If you do not have information before the market does, you will be too late to act prices will have already responded to the news. You know this from our discussion of market efficiency.
For now we simply repeat that valuable information is differential information. And it is worth noting that interest rate forecasters have a notoriously poor track record. Homer and Leibowitz (1972) have developed a popular taxonomy of active bond portfolio strategies. They characterize portfolio rebalancing activities as one of four types of bond swaps. In the first two swaps, the investor typically believes the yield relationship between bonds or sectors is only temporarily out of alignment. Until the aberration is eliminated, gains can be realized on the underpriced bond during a period of realignment called the workout period.
1. The substitution swap is an exchange of one bond for a nearly identical substitute. The substituted bonds should be of essentially equal coupon, maturity, quality, call features, sinking fund provisions, and so on. A substitution swap would be motivated by a belief that the market has temporarily mispriced the two bonds, with a discrepancy representinga profit opportunity.
1. The substitution swap is an exchange of one bond for a nearly identical substitute. The substituted bonds should be of essentially equal coupon, maturity, quality, call features, sinking fund provisions, and so on. A substitution swap would be motivated by a belief that the market has temporarily mispriced the two bonds, with a discrepancy representinga profit opportunity.
An example of a substitution swap would be a sale of a 20-year maturity, 8% coupon Toyota bond that is priced to provide a yield to maturity of 8.05% coupled with a purchase of an 8% coupon Honda bond with the same time to maturity that yields 8.15%. If the bonds have about the same credit risk, there is no apparent reason for the Honda bonds to provide a higher yield. Therefore, the higher yield actually available in the market makes the Honda bond seem relatively attractive. Of course, the equality of credit risk is an important condition. If the Honda bond is in fact riskier, then its higher promised yield does not represent a bargain.
2. The intermarket spread swap is an exchange of two bonds from different sectors of the bond market. It is pursued when an investor believes the yield spread between two sectors of the bond market is temporarily out of line. For example, if the yield spread between 10-year Treasury bonds and 10-year Baarated corporate bonds is now 3%, and the historical spread has been only 2%, an investor might consider selling holdings of Treasury bonds and replacing them with corporates. If the yield spread eventually narrows, the Baa-rated corporate bonds will outperform the Treasury bonds. Of course, the investor must consider carefully whether there is a good reason that the yield spread seems out of alignment. For example, the default premium on corporate bonds might have increased because the market is expecting a severe recession. In this case, the wider spread would not represent attractive pricing of corporates relative to Treasuries but would simply be an adjustment for a perceived increase in credit risk.
3. The rate anticipation swap is an exchange of bonds with different maturities. It is pegged to interest rate forecasting. Investors who believe rates will fall will swap into bonds of longer duration. For example, the investor might sell a five-year maturity Treasury bond, replacing it with a 25-year maturity Treasury bond. The new bond has the same lack ofcredit risk as the old one, but it has longer duration.
4. The pure yield pickup swap is an exchange of a shorter-duration bond for a longerduration bond. This swap is pursued not in response to perceived mispricing but as a means of increasing return by holding higher-yielding, longer-maturity bonds. Theinvestor is willing to bear the interest rate risk this strategy entails.
2. The intermarket spread swap is an exchange of two bonds from different sectors of the bond market. It is pursued when an investor believes the yield spread between two sectors of the bond market is temporarily out of line. For example, if the yield spread between 10-year Treasury bonds and 10-year Baarated corporate bonds is now 3%, and the historical spread has been only 2%, an investor might consider selling holdings of Treasury bonds and replacing them with corporates. If the yield spread eventually narrows, the Baa-rated corporate bonds will outperform the Treasury bonds. Of course, the investor must consider carefully whether there is a good reason that the yield spread seems out of alignment. For example, the default premium on corporate bonds might have increased because the market is expecting a severe recession. In this case, the wider spread would not represent attractive pricing of corporates relative to Treasuries but would simply be an adjustment for a perceived increase in credit risk.
3. The rate anticipation swap is an exchange of bonds with different maturities. It is pegged to interest rate forecasting. Investors who believe rates will fall will swap into bonds of longer duration. For example, the investor might sell a five-year maturity Treasury bond, replacing it with a 25-year maturity Treasury bond. The new bond has the same lack ofcredit risk as the old one, but it has longer duration.
4. The pure yield pickup swap is an exchange of a shorter-duration bond for a longerduration bond. This swap is pursued not in response to perceived mispricing but as a means of increasing return by holding higher-yielding, longer-maturity bonds. Theinvestor is willing to bear the interest rate risk this strategy entails.
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