Active bond portfolio management is a method of managing a fund's portfolio through the use of a single manager, co-managers or a team of managers, to actively manage a bond's portfolio. The active management method relies on tremendous research, analysis, forecasting and the managers own judgment and experience in making the investment decision on what bonds to buy, hold and sell. The investors do not usually follow the efficient market hypothesis, however they believe that it is possible to take advantage of the market through adopting several strategies that help identify underpriced bonds.
Towards this end, many investment companies and fund managers embrace the active management approach to their mutual funds. The main objective with active bond portfolio management is to gain higher returns than those of passively managed index funds. Unfortunately, the vast majority of active managers face great difficulty in beating the market, no matter how smart the portfolio manager is. [1]
The difference between active and passive bond portfolio management
Passive portfolio management is the exact opposite of active bond portfolio management. While active management involves timing the market and finding the niche to make profits, passive management strategies do not time the market.
Passive strategies include buy and hold which means buying the security and holding it till maturity to yield the average return. Bond investors as well as portfolio managers would examine such factors as quality ratings, coupon levels, terms to maturity, call features and sinking funds. [2]
Another passive strategy is called indexing in which the portfolio manager builds a portfolio that will mimic the performance of a selected bond portfolio index such as the Shearson Lehman Hutton Government/Corporate Bond Index and Merrill Lynch Index.
Passive portfolio management does not take advantage of interest rate fluctuations as does the active portfolio management method. [3]
Active bond portfolio management strategies
The Barbell (dumbbell) strategy
The barbell strategy is one of the common active bond portfolio management strategies. The shape that appears when charting the strategy on a timeline looks like a barbell (dumbbell). The reasoning behind this strategy is that it allows one portion of the portfolio to achieve high yields while the other portion minimizes risk [4] . The investor tends to invest in short term bonds and long term bonds, but avoids intermediate maturity bonds. The aim is to increase the convexity of the portfolio, however a key assumption is that the yield curve shifts in a parallel way. [5]
By including two different types of bonds in the portfolio, the investor has quick turnover of the assets in the portfolio at any one time. The portfolio is therefore formed as a spectrum of bonds at two ends. The short term bonds are rolled over to new short term investments and so on as they reach maturity. Therefore, the value of the tolled over investments is increased, leading to an increase in the value of the investment portfolio.
The Bullet strategy
The bullet strategy is the complete opposite of the barbell strategy. The investor tends to build a portfolio of bonds of intermediate durations, but does not invest in long and short duration bonds. [6]
The bullet strategy involves acquiring a number of different types of bonds over a period of time, however, they all have similar maturity dates. The bullet strategy is useful in minimizing the impact of changes in the interest rates, while obtaining good returns on investment.
The bullet strategy is used by investors who require a certain amount of revenue at a certain point in time, for example to make final payments on a property, fund a college education or handle a balloon payment. For instance, if you are 50 years old and you want to save toward a retirement age of 65, in a bullet strategy you would buy a 15-year bond now, a 10 year bond five years from now, and a five-year bond 10 years from now. Staggering the investments this way may help you benefit from different interest rate cycles. [7]
The butterfly strategy
A butterfly is a common active fixed income strategy used by portfolio managers to exploit specific shifts of the yield curve. The strategy is a combination of a barbell and bullet strategies. There are four different types of butterflies, but the one common feature of each type of butterfly is that they always have dollar duration equal to zero. This implies that butterfly trades are insulated from small parallel shifts in the yield curve. The types of butterfly strategies are:
The cash and dollar duration neutral weighted butterfly
This strategy is typically used by pension funds, insurance companies and central banks.
These types of accounts often want to swap out of one bond into two others while maintaining the duration of their portfolios constant. The investors tend to not borrow cash to finance the positions taken.
In order to implement the strategy, the dollar duration of the wings is matched with the dollar duration of the body, the condition for duration neutrality. In order to finance the transaction, the market value of the wings is matched to the market value of the body, the condition for cash neutrality. Using a simple system of equations, we can then compute the appropriate weights required to implement the strategy. [8]
The fifty-fifty weighted regression
This strategy is generally used by market participants who finance all their positions, e.g., dealers and hedge funds.
In this butterfly, the funds are borrowed to take long positions, however the funds are not matched with the lent funds from the short positions. The aim of this butterfly is to neutralize the trade from some small steepening and flattening of the yield curve.
To implement this butterfly, 50% of the duration dollars are placed in each wing. A system of equations can be solved to derive the appropriate weights.. The purpose of the fifty-fifty weighting is to make the trade curve-neutral, or at a minimum, reduce the trade's exposure to curve reshaping. [9]
The regression weighted butterfly
As the yield curve volatility is generally higher at the short duration end than the long duration end, it is expected that the short wing would move farther from the body than the long wing even if both durations are identical. Therefore, regression weighting is used to correct this differential movements. It is worth noting that the weight coefficient is dependent on the frequency of the data used i.e. daily, weekly or monthly changes.
This strategy also corrects for asymmetric butterflies. For example, the wings of a portfolio consisting of 2s/10s/30s might move by the same amount. But, the wings of a portfolio consisting of 2s/3s/30s will most likely move by a different amount.
To implement the strategy, the changes in the spread between the long wing and the short wing on the body are regressed. As mentioned earlier, the short wing tend to have higher volatility, therefore the regression coefficient at the long end should be less than one.
The maturity weighted butterfly
The maturity weighted butterfly is similar to the weighted butterflies, however instead of estimating a historical beta, the weighted coefficients are dependent on the maturities of the three bonds. The trade is dollar neutral but is not cash neutral. [10]
In conclusion, butterfly strategies are structured to exploit shifts in the yield curve. Therefore, there is a risk that the yield curve may not shift as expected and hence the strategy can be severely affected. As a result, after considering all these probable shifts in the yield curve, it is somewhat complex to know under what specific market conditions a given butterfly generates positive payoffs.
Rich/Cheap Analysis
Rich-cheap analysis is one of the most popular models used to fairly value spreads. The analysis is generally based on linear regressions that condition the fair value of the spread against appropriate market variables. The regression residual, which represents the difference between the actual spread and the model spread is used as an indicator of rich-cheap valuation.
When the residual is positive, the spread is considered cheap (too wide) and when the residual is negative, the spread is considered rich (too narrow). The assumption in the regression fitted model is that the spread will eventually return to its model fitted value over some unspecified time period.
Riding the yield curve
Riding the yield curve is an active portfolio management strategy that is based upon the yield curve and is used for interest rate futures. Investors riding the yield curve tend to buy long term bonds, usually longer than the required holding period. The yield curve at the time is upward sloping. The investors use this strategy as they hope to make a profit as the yields fall in the future as the maturity of the bonds decline. [11]
In conclusion, the efficacy of this strategy is difficult to predict because the yield curve cannot be guaranteed to be stable. Therefore, the future profits may be severely reduced and even eliminated if the yield curve flattens or shifts upwards.
Forecasting interest rates
Forecasting interest rates is considered the riskiest strategy because the investor tends to act upon uncertain forecasts of the future interest rates. The main goal of this strategy is to be exposed to minimal capital loss during periods when the interest rates rise and receive the highest possible gains when the interest rates drop.
Investors alter the maturities and duration of their portfolios. Longer maturity and longer duration portfolios will receive higher gains when the interest rates drop and vice versa. Therefore, if the manager forecasts a possible rise in the interest rates, he/she will construct a portfolio with the lowest possible duration.
The risk of mis-estimating the interest rate movement patterns is a major drawback of this strategy. It is extremely difficult to accurately forecast the interest rate movements. [12]
An investor that uses this strategy should be concerned about three things:
The possible direction of the change in interest rates
The magnitude of the change across maturities
The timing of the change.
There are several techniques used to forecast the interest rates as listed below:
Scenario Analysis: what-if analysis, the investor analyses the scenarios and the magnitude of possible gains and losses and the sensitivity of the returns against the changes in the interest rate levels.
Relative Return Value Analysis: the technique involves calculating the returns of each bond under each scenario through given a weight to each scenario. The weight is associated with the probability that each scenario will occur. After that the relationship between the relative returns and the bonds durations are graphed to determine the regression line. The bonds that are above the regression line are considered to perform good.
Strategic Frontier Analysis: We can graph the bonds in our portfolio with the best case scenario - an interest rate decrease - on the vertical axis and the worst case scenario on the horizontal axis. Through this matrix, the investor will be able to identify aggressive bonds, superior bonds, defensive bonds and inferior bonds.
Bond swaps (portfolio rebalancing strategies)
Bond swapping is a strategy in which an investor sells a bond and at the same time purchases a different bond with the proceeds from the sale. There are several reasons behind using a bond swap such as to seek tax benefits, to change investment objectives, to upgrade a portfolio's credit quality or to speculate on the performance of a particular bond. The detailed reasons for using swaps are listed below:
Substitution swap: exchange one bond for another which is similar in terms of coupon, maturity, and credit quality but offers a higher yield
Inter-market spread swap: if an investor believes that spreads between two different types of bonds are not currently at normal levels, he/she can switch into the market expected to perform relatively better
Rate anticipation swap: if an investor believes yields will fall (rise), he/she can switch to bonds of higher (lower) duration.
Pure yield pickup swap: a simple switch to higher yield bonds without regard to any expectations about changes in yields and spreads.
Tax swap: a switch undertaken for tax reasons.
Contingent immunization
This strategy is similar to a "stop-loss" strategy for equities. The investor follows an active strategy, but ensures that the portfolio value never falls below a trigger point which gives the minimum acceptable returns; if the trigger point is reached a contingent immunization strategy is executed. [13]
Valuation Analysis
Valuation analysis strategy involves attempts by the portfolio manager to identify undervalued bonds. The portfolio manager identifies bonds that have a lower expected Yield-To-Maturity(YTM) than the current YTM.
Valuation analysis strategy requires extensive analysis-based trading through continuous evaluations. The portfolio manager bases his/her analysis in buying undervalued bonds and selling over-valued ones.
Valuation analysis also involves the use of multiple factor regression analysis that takes into account other factors that affect the bond yield such as quality rating, coupon effect, sector effect, call provision, and sinking fund attributes. The resultant multiple factor analysis enables the portfolio manager to determine the expected yield of the bond.
However, a major drawback of this strategy is the subjectivity in analyzing the factors affecting the bond yield. For example, the portfolio manager may not anticipate an event risk that may affect the financial stability of the issuing firm, or an upgrade to the bonds market. As a result, the multiple factor valuation analysis is deemed biased and the expected yields would be incorrect. [14]
Yield spread analysis
Yield spread analysis involves monitoring the yield relationships between different types of bonds to identify abnormalities. Once an abnormality is identified to be high, the portfolio manager would trade to take advantage of a return to a normal spread. Therefore, the portfolio manager has to know the "normal" spread and posses the liquidity to trade quickly to take advantage of the temporary abnormalities in the spread.
The yield spread analysis strategy entails monitoring the changes in sectoral relationships. For instance, prices and yields on lower investment grade tend to move together. The changes in the relative yields (spreads) may be related 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 characteristic of the bonds in the sector e.g. zero-coupon feature.
Changes in the supply and demand. [15]
Using the yield spread strategy, the portfolio manager's objective is to invest in the sectors that display the strongest price volatility. Specialized analysis is conducted by brokerage firms as they usually maintain historical data of the yield spreads. The historical data include historical average, maximum and minimum yield spread among sectors.
The main drawback of this strategy is that it requires tremendous amounts of trades and the possibility of poor timing. The abnormal spread tends to be identified very quickly by the market, and corrected almost instantaneously.
Credit Analysis
Credit analysis strategy involves the investor or bond portfolio manager performing an analysis on the issuing firms or entities to determine their ability to meet the debts obligations. The credit analysis strategy aims to identify the appropriate level of default risk associated with investing in that particular firm.
Using this strategy, the portfolio manager can speculate on that change and identify possible opportunities of making profit. For instance, if the portfolio manager received information that the issuing firm debt rating is about to improve i.e lower default risk, he/she might use this information to buy the firms bonds and then sell the bond after the change in the debt rating happens. Therefore, receives a payoff from selling the bonds at a higher price than before. [16]
Conclusion
