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Transcript of Active Bond Management Strategies
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9/19/2011
SECURITIES ANALYSIS & PORTFOLIO MANAGEMENT
ACTIVE TRADING STRATEGIES
Submitted by:
GROUP I:
Omkar Deshpande
Neeraj Bharti
Shubojita Chakraborthy
Mihir Jha
Ankush Agarwal
Shelly Guha
Anjana Behera
Sanat Kumar
Submitted to:
Dr. KedarNath Mukherjee
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ACTIVE MANAGEMENT STRATEGIES
These strategies require major adjustments to portfolios, trading to take advantage of interest
rate fluctuations, etc. There are the following major active bond portfolio management
strategies:
1. Interest Rate Anticipation/ Yield Curve strategies
2. Bond Swaps
3. Valuation analysis
4. Credit analysis
5. Yield spread analysis
6. Market signals
7. Tax considerations
8. Bond Funds
9. Convergence Trade: On the run Vs. Off the Run
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1. Interest Rate Anticipation/Yield Curve Strategies
This is the riskiest strategy because the investor must act on uncertain forecasts of future interest
rates. The strategy is designed to preserve capital (lose as little as possible) when interest rates
rise (and bond prices drop) and to receive as much capital appreciation as possible when interest
rates drop (and bond prices rise).
These objectives can be obtained by altering the maturity or duration of their portfolios. Longer
maturity, or longer duration, portfolios will benefit the most from an interest rate decrease and
vice versa. Thus, if a manager expects an increase in interest rates, they would structure portfolio
to have the lowest possible duration.
The problem faced with this type of strategy is the risk of mis-estimating interest rate
movements. It is difficult to predict (with accuracy) interest rate movements.
Thus Active strategies of selecting bonds or bond portfolios with specific durations based oninterest rate expectations are referred to as rate anticipation strategies. They can be further
explained as per riding the yield curve strategy and second, barbells, laddered and bullet
strategies in correspondence to various yield curve movements.
A. Riding the yield curve
Certain portfolio managers anticipate to make capital gains in the process of buying and selling
bonds. They resort to `riding the yield curve’. It is a buy-and-hold strategy where the manager
purchases a medium or long-term bond when the yield curve is upward sloping and sells it at a
later date, (before its maturity) so as to make capital gains.
Two major assumptions are necessary if the portfolio manager has to be successful.
• Yield curve should be upward sloping (i.e., long-term securities have high yield) and
remains upward sloping.
• There is no downward shift in the interest rates.
A portfolio manager of a company has the option of investing in a 182-day T-Bill and 364-day T-
Bill. The following data is given to him:
182-day T-Bill: Current selling price = Rs.96.40
Face Value = Rs.100
364-day T-Bill: Selling price = Rs.91.40
Face Value = Rs.100
Therefore the
yield for the 182-day T-Bill = (100-96.40)/96.40*365/182 = 7.49%
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Yield for 364-day T-Bill = (100-91.40)/91.4*365/364= 9.44%
If he buys and holds the 364-day T-Bill and sells the same after 182 days, the expected selling
price will be Rs.96.40 (this is the same as the current price of the 182-day T-Bill because it is
assumed that the yield curve has not changed after 182 days also). Therefore, the expected
return can be calculated as follows:
= (96.40 - 91.40)/91.4*365/182= 10.97%
Therefore, it can be seen that riding the yield curve will give a higher return.
B. Buy-and-hold investors can manage interest rate risk by creating a “laddered” portfolio of
bonds with different maturities, for example: one, three, five and ten years. A laddered
portfolio has principal being returned at defined intervals. When one bond matures, one has
the opportunity to reinvest the proceeds at the longer-term end of the ladder if he wants to
keep it going. If rates are rising, that maturing principal can be invested at higher rates. If theyare falling, the portfolio is still earning higher interest on the longer-term holdings.
With a barbell strategy, an investor can invest only in short-term and long-term bonds, not
intermediates. The long-term holdings should deliver attractive coupon rates. Having some
principal maturing in the near term creates the opportunity to invest the money elsewhere if
the bond market takes a downturn. We have explained the relevant strategies as per
hypothetical numerical examples in reference to various interest anticipations in the excel
sheet.
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2. Bond Swap:
I. Rate Anticipation Swaps
If an investor believes that the overall level of interest rates is likely to change, he may
choose to make a swap designed to benefit or help you protect his holdings.
If he believes that rates are likely to decline, it may be appropriate to extend the
maturity of his holdings. He will be reducing reinvestment risk of principal and
positioning for potential appreciation as interest rates trend down. Conversely, if he
thinks rates may increase, he might decide to reduce the average maturity of holdings in
his portfolio. A swap into shorter-maturity bonds will cause a portfolio to fluctuate less
in value, but may also result in a lower yield.
It should be noted that various types of bonds perform differently as interest rates rise
or fall, and may be selectively swapped to optimize performance. Long-term, zero-
coupon and discount bonds perform best during interest rate declines because their
prices are more sensitive to interest rate changes. Floating-rate, short- andintermediate-term, callable and premium bonds perform best when interest rates are
rising because they limit the downside price volatility involved in a rising yield
environment; their price fluctuates less on a percentage basis than a par or discount
bond.
However, rate-anticipation swaps tend to be somewhat speculative, and depend
entirely on the outcome of the expected rate change. Moreover, shorter- and longer-
term rates do not necessarily move in a parallel fashion. Different economic conditions
can impact various parts of the yield curve differently. To the extent that the anticipated
rate change does not come about, a decline in market value could occur.
II. Swapping for Quality
A quality swap is a type of swap where one is looking to move from a bond with a lower
credit quality rating to one with a higher credit rating or vice versa. The credit rating is
generally a reflection of an issuer’s financial health. It is one of the factors in the
market’s determination of the yield of a particular security. The spread between the
yields of bonds with different credit quality generally narrows when the economy is
improving and widens when the economy weakens. So, for example, if one expects a
recession he might swap from lower-quality into higher-quality bonds with only a
negligible loss of income.
Standard rating agencies classify most issuers’ likelihood of repayment of principal and
payment of interest according to a grading system ranging from, say, triple-A to C (or an
equivalent scale), as a quality guideline for investors.
Also, if a market sector or a particular bond has eroded in quality, it may no longer meet
an investor’s personal risk parameters. He may be willing to sacrifice some current
income and/or yield in exchange for enhanced quality.
III. Swapping to Increase Yield
One can sometimes improve the taxable or tax-exempt returns on his portfolio by
employing a number of different bond-swapping strategies. In general, longer-maturitybonds will typically yield more than those of a shorter maturity will; therefore, extending
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the average maturity of a portfolio’s holdings can boost yield. The relationship between
yields on different types of securities, ranging from three months to 30 years, can be
plotted on a graph known as the yield curve. The curve of that line is constantly
changing, but one can often pick up yield by extending the maturity of the investments,
assuming the yield curve is sloping upward. For example, one could sell a two-year bond
that’s yielding 5.50% and purchase a 15-year bond that is yielding 6.00%. However, heshould be aware that the price of longer-maturity bonds might fluctuate more widely
than that of short-term bonds when interest rates change.
When the difference in yield between two bonds of different credit quality has widened,
a cautious swap to a lower-quality bond could possibly enhance returns. But sometimes
market fluctuations create opportunities by causing temporary price discrepancies
between bonds of equal ratings. For example, the bonds of corporate issuers may retain
the same credit rating even though their business prospects are varying due to transient
factors such as a specific industry decline, a perception of increased risk or deteriorating
credit in the sector or company. So, suppose an investor purchased in the past (at par) a30-year A-rated $50,000 corporate bond with a 6.25% coupon. Assume that comparable
bonds are now being offered with a 6.50% coupon. Assume that he can replace his bond
with another $50,000 A-rated corporate bond having the same maturity with a 6.50%
coupon. By selling the first bond and buying the second bond he will have increased his
annual income by 25 basis points ($125). Discrepancies in yield among issuers with
similar credit ratings often reflect perceived risk in the marketplace. These discrepancies
will change as market conditions and perceptions change.
IV. Swapping for Increased Call Protection
Swaps may achieve other investment objectives, such as building a more diversified
portfolio, or establishing better call protection. Call protection is useful for reducing the
risk of reinvestment at lower rates, which may occur if an issuer retires, calls or pre-
refunds its bonds early. Call protection swaps are particularly advantageous in a
declining interest rate environment. For example, one could sell a bond with a short call,
e.g., five years, and purchase a bond with 10 years of call protection. This will enable
him to lock in his coupon for an additional five years and not worry about losing your
higher-coupon bonds in the near future. He may have to sacrifice yield in exchange for
the stronger call protection
V. Swapping to Lower the Taxes
Tax swapping is the most common of all swaps. Anyone who owns bonds that are sellingbelow their amortized purchase price and who has capital gains or other income that
could be partially, or fully, offset by a tax loss can benefit from tax swapping.
An investor may have realized capital gains from the sale of a profitable capital asset
(e.g., real estate, his business, stocks or other securities). Or he may expect to sell such
an asset at a potential profit in the near future. By swapping those assets that are
currently trading below the purchase price (due to a rise in interest rates, deteriorating
credit situation, etc.) he can reduce or eliminate the capital gains he would otherwise
have paid on his other profitable transactions in the current tax year.
The traditional tax swap involves two steps: (1) selling a bond that is worth less than hepaid for it and (2) simultaneously purchasing a bond with similar, but not identical,
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characteristics. For example, assume a person owns a $50,000, 20-year, triple-A-rated
municipal bond with a 5.00% coupon that he purchased five years ago at par. If interest
rates increase (such that new bonds are now being issued with a 5.50% coupon, the
value of the bond will fall to approximately $47,500. If he sells the bond, he will realize a
$2,500 capital loss, which he can use to offset any capital gains he has realized. If he has
no capital gains, he can use the capital loss to offset ordinary income. He then purchasesin the secondary market a replacement triple-A-rated 5.00% municipal bond (from a
different issuer), maturing in 15 years, at an approximate cost of $47,500. His yield,
maturity and quality of bond will be the same as before, plus he will have realized a loss
that will save money on taxes in the year of the bond sale. Of course, if he holds the new
bond to maturity, he will realize a $2,500 gain in 15 years, taxable as ordinary income at
that time. By swapping, he has converted a “paper” loss into a real loss that can be used
to offset taxable gain.
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3. Valuation Analysis
The portfolio manager looks for undervalued bonds--those bonds that have a computed value
(according to the portfolio manager) higher than the current market price). This also translates to
those bonds whose expected YTM is lower than the current YTM. This strategy requires lots of analysis (continuous evaluations) and lots of trading based on the analysis.
We can examine the term structure of pure discount bonds (zero coupon) and thus determine the
value of Treasuries, thus we can determine the default free characteristics of any other type of
bond. Then we can attempt to determine the other factors that will affect bond yield by using
multiple factor regression analysis (looking at things such as: quality rating, coupon effect, sector
effect, call provision, sinking fund attributes, etc.) Using this factor analysis, we can determine the
expected yield for the security (if the expected yield < current YTM then buy). However, there is
some subjectivity in factor analysis. For instance, if there is some "event risk" (something
affecting the financial stability of firm) missing from the analysis, or if there is any anticipation of
a market upgrade. The valuation analysis is only useful in well developed bond markets for
corporate as well as government bonds, where the impact of different factors are effectively
incorporated in the yields of the bonds.
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4. Credit Analysis
Credit analysis involves examining bond issuers to determine if any changes in the firm's default
risk can be identified. We try to determine if the bond rating agencies are going to change the
firm's rating. Rating changes are prompted by internal changes within the firm as well as external
changes. Various factors examined include financial ratios, GNP, inflation, etc.
It is the assessment of default risk. Default risk has both systematic and unsystematic elements.
First, individual bond issuers may experience difficulty in meeting their debt obligations. This
could be an isolated incident, and can be diversified away (or eliminated by effective credit
analysis). However, if default risk is precipitated by adverse general business conditions, then this
would require more macro-oriented analysis. Many fixed-income investors complement the bond
ratings providing by bond agencies (Fitch's, Moody's, Duff & Phelps, S&P's) with their own credit
analysis, citing reasons such as: more accurate, comprehensive, and timely analyses and
recommendations.
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5. Yield Spread Analysis
A portfolio manager would monitor the yield relationships between various types of bonds and
look for abnormalities. If a spread were thought to be abnormally high, one would trade to take
advantage of a return to a normal spread. Thus, he needs to know what the "normal" spread is,
and he needs the liquidity to make trades quickly to take advantage of temporary spreadabnormalities.
Spread Analysis involves anticipating changes in sectoral relationships. For example, prices and
yields on lower investment grade bonds tend to move together (identifiable classes of securities
are referred to as sectors). Changes in relative yields (or the spread) may occur due to:
altered perceptions of the creditworthiness of a sector of the market's sensitivity to
default risk
changes in the market's valuation of some attribute or characteristic of the securities in
the sector (such as a zero coupon feature); or changes in supply/demand conditions.
The objective is to invest in the sector or sectors that will display the strongest relative price
movements. Brokerage firms maintain historical records of yield spreads and are able to conduct
specialized analyses for clients, such as measurement of the historical average, maximum, and
minimum spread among sectors.
Potential drawbacks of this method include the need to make numerous trades, the possibility of
poor timing (how long will it take for the market to realize the abnormal spread), and the danger
that overall changes in interest rates will dwarf these efforts.
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6. Trading on Market Signals
Note: The following model is relevant for the US markets but the tenets of the model are equally
applicable for the Indian Bond Markets.
Investors translate market signals into successful trades. The Global Fixed Income and ForeignExchange Strategy team at JPMorgan Securities identified seven bond market signals in four
market-driving categories, tested their theories and combined the signals into a composite
bull/bear index on the market known as the Bond Barometer.
Following are the seven signals by category and the trades they were tested on:
Category: Fundamentals
Two fundamental forces drive bond yields: growth and inflation. If you understand that
bond prices are present values of future cash flows, then you know that forecasts of
future growth and inflation are more important than historical data reports on what has
already occurred.
Signal one: Market consensus for year-ahead GDP growth.
Signal two: Market consensus for year-ahead inflation.
Trade: One should buy the 10-year Treasury note when the consensus lowers its
estimate of year-ahead growth and inflation, suggesting interest rates will go down and
bond prices will go up. And sell the 10-year Treasury note when the consensus raises its
estimate of year-ahead growth and inflation, suggesting rates will rise and prices will fall.
It should be held for one month until next consensus figures are released. Roll trade if
consensus moves in same direction; reverse if consensus turns; close if consensus in
unchanged.
Category: Value
Presuming that asset prices fluctuate around a stable, long-term equilibrium, extreme
deviations serve as lead indicators of trend reversals.
Signal three: Real (inflation-adjusted) yields.
Trade: It is suggested that the 10-year Treasury note should be bought when real yields
are more than one standard deviation above the long-term moving average sell when
they are more than one standard deviation below. Hold the position until real yields
cross the opposite threshold.
Signal four: Ratio of the S&P 500 earnings yield to the 30-year Treasury yield.
Trade: The bonds should be bought when the ratio is more than half a standard
deviation below its long-run moving average (bonds are cheap relative to stocks) sell
when it’s more than half a standard deviation above its long-run moving average (stocks
are cheap relative to bonds).
Category: Risk appetite
Risk appetite refers to investors’ relative preference for safe and risky assets, prompted
by business cycle fluctuations, policy developments or exogenous events.
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Signal five: JP Morgan Credit Appetite Index, where zero represents minimum appetite
(widest spreads, positive for government bonds) and 100 represents maximum appetite
(tightest spreads, negative for government bonds).
Trade: One should sell government bonds when credit appetite is high, as signaled by
the CAI being more than one standard deviation above its 50-day moving average, andbuy when it is low, or more than one standard deviation below its 50-day moving
average.
Category: Technicals
Technical indicators trace market patterns in price and volume.
Signal six: Price data.
Trade: One should buy when the short-term moving average of prices crosses the long-
term average from below sell when it crosses from above. In this momentum measure,
the strongest returns were generated when short-term was 10 days and long-term was
20 days.
Signal seven: Flow data, defined as net purchases of U.S. bond market mutual funds, as
an indicator of cash flow into the bond market
Trade: The 10-year Treasury should be bought when the flow indicator is more than one
standard deviation above the long-term moving average sell when it’s more than one
standard deviation below.
JP Morgan’s testing of their Bond Barometer showed that trading rules offer no holy
grail, but they can exploit systematic relationships in the market. In addition,
diversification pays no single indicator works at all times or in all trading environments.In the absence of foresight, a diversified strategy that combines different information
sources (fundamentals, value, risk appetite and technicals), trading strategies
(momentum and contrarian) and holding periods (daily, weekly and monthly) far
outperforms narrower approaches over the longer term.
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7. Tax considerations:
In a taxable investment account, the capital gains and investment income are subject to taxation
in the year they are earned.
Bonds and bond funds can be held in either type of account, taxable or tax deferred account, but
some investors will have a reason to choose one account type over the other. Municipalinvestments, for example, are best held in a taxable account, where they can serve to reduce the
taxable returns. Taxable zero coupon bonds are best held in a tax-deferred account because their
annual interest credits are taxable when earned, even though the investor does not actually
receive them until the bond matures.
If one is in a high tax bracket, he may want to reduce his taxable interest income to keep more of
what he earns.
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8. Bond Funds
A bond fund is a portfolio of fixed-income securities that offers the convenience of professional
selection and portfolio management by an individual manager or an investment team. Its
structure also allows investors to easily and inexpensively diversify risks across a broad range of
bonds. Bond funds can also stabilize the volatility of owning stock funds.Rather than purchasing individual bonds, investors purchase shares in the bond fund. The price of
a share (the "net asset value" or "NAV") is calculated by dividing the fund's total assets by the
number of shares outstanding. Bond funds make money from the interest earned on the
securities they own or by selling those bonds at a profit. Similar to individual bonds, bond funds
provide investors with the opportunity to collect these interest dividends and capital gains or to
reinvest them back into the fund.
Many types of bond funds are available. While the two main categories of funds are those that
provide taxable or tax-exempt income to investors, bond funds also vary based on maturity
(short-term, long-term), type of issuer (municipal, corporate, etc.), strategy, investment objective
and credit quality. There are several ways in which bond funds differ from owning individual
bonds.
Bond funds have no single maturity date.
Investors can sell their shares back to the mutual fund company at any time, at a price
equal to the fund's current net asset value.
A fund's net asset value will move in response to factors such as interest rates, credit
quality and currency values. It may also be affected by overall flows of cash in and out of
bond funds. Because it tracks interest rate fluctuations, the future value of the fund
cannot be known with certainty at any point in time.
Due to the funds' constant maturity, interest rate risk is likely to remain constantthroughout the life of your investment.
Bond funds can be purchased directly from the fund management company or through
brokers and banks, as well as through retirement plans. In addition to open-end mutual
funds, bond portfolios can also be purchased via unit investment trusts, closed-end
funds, exchange-traded funds and money market funds.
Bond funds tend to be highly liquid. However, a fund's liquidity can be affected by
factors such as supply and demand, the attractiveness relative to other investment
sectors and the reputation of the fund management company.
In addition to a sales commission, investors may be required to pay annual managementfees, generally based on a small percentage of the net asset value of the fund, to cover
the costs of active portfolio management. Interest earned is passed on to investors once
management fees have been deducted.
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9. Convergence trade
It is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in
future (going long the asset)—and selling a similar asset forward (going short the asset) for a higher
price, in the expectation that by the time the assets must be delivered, the prices will have become
closer to equal (will have converged), and thus one profits by the amount of convergence. One of
such trade strategy is:
On the run/off the run
On the run bonds (the most recently issued) generally trade at a premium over otherwise similar
bonds, because they are more liquid—there is a liquidity premium. Once a newer bond is issued, this
liquidity premium will generally decrease or disappear.
For example, the 30-year US treasury bond generally trades at a premium relative to the 29½-year
bond, even though these are otherwise quite similar. Once a few months pass (so the 30-year has
aged to a 29½-year and the 29½-year has aged to a 29-year, say), and a new 30-year is issued, theold bonds are now both off-the run and the liquidity premium will in general decrease. Thus, if one
sells the 30-year short, buys the 29½-year, and waits a few months, one profits from the change in
the liquidity premium.