Active Bond Portfolio Strategies

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Fixed-Income Analysis

Lectures 8 and 9: Active Bond
Portfolio Strategies
Joëlle Miffre

1

Active Bond Portfolio Strategies
Market Timing: Trading on Interest Rate Predictions
Riding the Yield Curve
Timing Bets Based on Interest-Rates Level
When Rates are Expected to Decrease
When Rates are Expected to Increase: Roll-Over Strategies

Bets on Specific Moves of the Yield Curve
Barbell, Bullet, Ladder, Butterfly
Other Semi-Hedged Strategies: Ladder Hedged against Slope Movement

Active Fixed-Income Style Allocation Decisions

Bond Picking: Trading on Market Inefficiencies
Pure arbitrage opportunities
Speculative arbitrage opportunities

2

1

Active Strategies
Investors who do not accept the EMH pursue active investment strategies
Pursuit of an active strategy assumes that investors possess some advantage relative to other market participants
Superior information
Superior analytical or judgment skills
Ability or willingness to do what other investors are unable to do

Two types of active strategies
Market timing (trading on interest rates predictions)
Bond picking (trading on market inefficiencies)

3

Market Timing
Portfolio managers are making bets on changes in the Treasury yield curve
Bets based on no change in the yield curve (riding the yield curve) Bets on changes in interest rate level (e.g., roll-over strategies) Bets based both on level, slope and curvature moves of the yield curve (butterflies)

Managers need scenario analysis tools to estimate the return and the risk of implemented strategies
Evaluation of break-even point from which the strategy will start making or losing money
Assessment of the risk that the expectations are not realized

4

2

Timing Bets on No Change in the Yield Curve
or “Riding the Yield Curve”
Riding the yield curve is a technique that fixed-income portfolio managers traditionally use in order to enhance returns
When the yield curve is upward sloping
and is supposed to remain unchanged

Enables an investor to earn a higher rate of return by
Purchasing fixed-income securities with maturities longer than the desired holding periods and
Selling them to profit from falling bond yields as maturities decrease with the passage of time

5

Riding the Yield Curve – An Example
Consider at date t = 0 the following zero-coupon curve and five bonds with the same $100 nominal value and 6% annual coupon
rate
Prices of these bonds are given at date t = 0 and one year later at date t = 1 assuming that the zero-coupon yield curve has remained unchanged
Maturity
(Years)
1
2
3
4
5

Zero Coupon Bond Price at Bond Price at
t =0
t =1
Rate
3.90%
$102.021
$102.021
4.50%
$102.842
$102.842
4.90%
$103.098
$103.098
5.25%
$102.848
$102.848
5.60%
$102.077
6

3

An Example
A portfolio manager who has money to invest with a 1-year horizon Option 1: Invest in 1-year maturity bond
Option 2: Ride the yield curve
Option 2.1: Buy the 2-year bond and sell it back in 1 year
Option 2.2: Buy the 3-year bond and sell it back in 1 year
Option 2.3: Buy the 4-year bond and sell it back in 1 year
Option 2.4: Buy the 5-year bond and sell it back in 1 year

Total return TR for option 1
Buy at $102.021
Hold until maturity
⎛ 106 − 102.021 ⎞
Total return ⎜
⎟ = 3. 9%
⎝ 102.021 ⎠
7

An Example
Option 2.1
Buys at $102.842 at t = 0
Receives a $6 coupon payment at t = 1
Sells the bond with 1-year residual maturity at $102.021

⎛ 6 + 102.021 − 102.842 ⎞
⎟ = 5.036%
102.842



Total return ⎜

Profit from riding the YC: 5.036% - 3.9% = 2.733%

Option 2.2

⎛ 6 + 102.842 − 103.098 ⎞

⎟ = 5.571%
103.098



Option 2.3

⎛ 6 + 103.098 − 102.848 ⎞
⎟ = 6.077%

102.848



Option 2.4

⎛ 6 + 102.848 − 102.077 ⎞
⎟ = 6.633%

102.077



8

4

An Example
Options “riding the curve” are better than option 1
Best option is 2.4: The longer the maturity of the bond bought at the outset, the...