All benchmarks presumably have some convention that is used to reinvest
proceeds generated by the index. For example, coupons and prepayments
are paid at various times intramonth, yet most major indices simply take
these cash flows and buy more of the respective index at the end of the
month‚Ä”generally, the last business day. In short, they miss an opportunity
to reinvest cash flows intramonth. Accordingly, portfolio managers who put
those intramonth flows to work with reverse repos or money market prod-
ucts, or anything else, may add incremental returns. All else being equal, as
a defensive market strategy portfolio managers might overweight holdings
of higher coupon issues that pay their coupons early in the month.
Various forms of leveraging a portfolio also may help enhance total returns.
For example, in the repo market, it is possible to loan out Treasuries as well
as spread products and earn incremental return. Of course, this is most
appropriate for portfolio managers who are more inclined to buy and hold.
The securities that tend to benefit the most from such opportunities are on-
the-run Treasuries. The comparable trade in the MBS market is the dollar
166 FINANCIAL ENGINEERING, RISK MANAGEMENT, AND MARKET ENVIRONMENT
roll1. Although most commonly used as a lower-cost financing alternative
for depository institutions, total return accounts can treat the ‚Äúdrop‚ÄĚ of a
reverse repo or dollar roll as fee income.
Each index has its own rules for determining cut-off points on credit rank-
ings. Many indexes use more than one rating agency like Moody‚Ä™s and
Standard & Poor‚Ä™s to assist with delineating whether an issuer is ‚Äúinvest-
ment grade‚ÄĚ or ‚Äúhigh yield,‚ÄĚ but many times the rating agencies do not agree
on what the appropriate rating should be for a given issue. This becomes
especially important for ‚Äúcrossover‚ÄĚ credits. ‚ÄúCrossover‚ÄĚ means the cusp
between a credit being ‚Äúinvestment grade‚ÄĚ or ‚Äúnoninvestment grade.‚ÄĚ
Sometimes Moody‚Ä™s will have a credit rating in the investment grade cate-
gory while S&P considers it noninvestment grade, and vice versa. For cases
where there is a discrepancy, the general index rule is to defer to the rating
decision of one agency to determine just what the ‚Äútrue‚ÄĚ rating will be.
Generally, a crossover credit will trade at a yield that is higher than a
credit that carries a pair of investment-grade ratings at the lowest rung of
the investment-grade scales. Thus, if a credit is excluded from an index
because it is a crossover, adding the issue to the portfolio might enhance the
portfolio returns with its wider spread and return performance. For this to
happen, the portfolio cannot use the same crossover decision rule as the
benchmark, and obviously it helps if portfolio managers have a favorable
outlook on the credit. Finally, the credit rating agency that is deferred to for
crossovers within the investment-grade index (or portfolio) may not always
be the credit rating agency that is deferred to for crossovers within the high-
yield index (or portfolio).
Intramonth Credit Dynamics
Related to the last point is the matter of what might be done for an issue
that is investment grade at the start of a month but is downgraded to non-
A dollar roll might be defined as a reverse repo transaction with a few twists. For
example, a reverse repo trade is generally regarded as a lending/borrowing
transaction, whereas a dollar roll is regarded as an actual sale/repurchase of
securities. Further, when a Treasury is lent with a reverse repo, the same security is
returned when the trade is unwound. With a dollar roll, all that is required is that a
‚Äúsubstantially identical‚ÄĚ pass-through be returned. Finally, while a reverse repo
may be as short as an overnight or as long as mutually agreed on, a dollar roll is
generally executed on a month-over-month basis. The drop on a reverse repo or
dollar is the difference between the sale and repurchase price.
investment grade or to crossover intramonth. If portfolio managers own the
issue, they may choose to sell immediately if they believe that the issue‚Ä™s per-
formance will only get worse in ensuing days2. If this is indeed what hap-
pens, the total return for those portfolio managers will be better than the
total return as recorded in the index. The reason is that the index returns
are typically calculated as month over month, and the index takes the pre-
downgrade price at the start of the month and the devalued postdowngrade
price at the end of the month.
If the portfolio managers do not own the downgraded issue, they may
have the opportunity to buy at its distressed levels. Obviously, such a pur-
chase is warranted only if the managers believe that the evolving credit story
will be stable to improving and if the new credit rating is consistent with
their investment parameters. This scenario might be especially interesting
when there is a downgrade situation involving a preexisting pair of invest-
ment-grade ratings that changes into a crossover story.
As an opposite scenario, consider the instance of a credit that is upgraded
from noninvestment grade at the start of the month to investment grade or
crossover intramonth. Portfolio managers who own the issue and perceive
the initial spread narrowing as ‚Äúoverdone‚ÄĚ can sell and realize a greater total
return relative to the index calculation, which will reference the issue‚Ä™s price
only at month-end. And if the managers believe that the price of the upgraded
issue will only improve to the end of the month, they may want to add it to
their investment-grade portfolio before its inclusion in the index. Moreover,
since many major indices make any adjustments at month-end, the upgraded
issue will not be moved into the investment-grade index until the end of the
month; beginning price at that time will be the already-appreciated price.
All indexes use some sort of convention when their daily marks are posted.
It might be 3:00 P.M. New York time when the futures market closes for the
day session, or it may be 5:00 P.M. New York time when the cash market
closes for the day session. Any gaps in these windows generate an option
for incremental return trading. Of course, regardless of marking convention,
all marks eventually ‚Äúcatch up‚ÄĚ as a previous day‚Ä™s close rolls into the next
business day‚Ä™s subsequent open.
Portfolio managers generally have some time‚Ä”perhaps up to one quarter‚Ä”to
unload a security that has turned from investment grade to noninvestment grade.
However, a number of indexed portfolio managers rebalance portfolios at each
month-end; thus there may be opportunities to purchase distressed securities at that
168 FINANCIAL ENGINEERING, RISK MANAGEMENT, AND MARKET ENVIRONMENT
With nonbullet securities, measuring duration is less of a science and more
of an art. There are as many different potential measures for option-adjusted
duration as there are option methodologies to calculate them. In this respect,
concepts such as duration buckets and linking duration risk to market return
become rather important. While these differences would presumably be con-
sistent‚Ä”a model that has a tendency to skew the duration of a particular
structure would be expected to skew that duration in the same way most of
the time‚Ä”this may nonetheless present a wedge between index and portfo-
Selling (writing) call options against the underlying cash portfolio may pro-
vide the opportunity to outperform with a combination of factors. Neither
listed nor over-the-counter (OTC) options are included in any of the stan-
dard fixed income indexes today. Although short call positions are embed-
ded in callables and MBS pass-thrus making these de facto buy/write
positions, the use of listed or OTC products allows an investor to tailor-make
a buy/write program ideally suited to a portfolio manager‚Ä™s outlook on rates
and volatility. And, of course, the usual expirations for the listed and OTC
structures are typically much shorter than those embedded in debentures and
pass-thrus. This is of importance if only because of the role of time decay
with a short option position; a good rule of thumb is that time decay erodes
at the rate of the square root of an option‚Ä™s remaining life. For example, one-
half of an option‚Ä™s remaining time decay will erode in the last one-quarter
of the option‚Ä™s life. For an investor who is short an option, speedy time decay
is generally a favorable event. Because there are appreciable risks to the use
of options with strategy building, investors should consider all the implica-
tions before delving into such a program.
Maturity and Size Restrictions
Many indexes have rules related to a minimum maturity (generally one year)
and a minimum size of initial offerings. Being cognizant of these rules may
help to identify opportunities to buy unwanted issues (typically at a month-
end) or selectively add security types that may not precisely conform to index
specifications. As related to the minimum maturity consideration, one strat-
egy might be to barbell into a two-year duration with a combination of a
six-month money market product (or Treasury bill) and a three-year issue.
This one trade may step outside of an index in two ways: (1) It invests in a
product not in the index (less than one year to maturity), and (2) it creates
a curve exposure not in the index (via the barbell).
An MBS portfolio may very well be duration-matched to an index and
matched on a cash flow and curve basis, but mismatched on convexity. That
is, the portfolio may carry more or less convexity relative to the benchmark,
and in this way the portfolio may be better positioned for a market move.
Trades at the Front of the Curve
Finally, there may be opportunities to construct strategies around selective
additions to particular asset classes and especially at the front of the yield
curve. A very large portion of the investment-grade portion of bond indices
is comprised of low-credit-risk securities with short maturities (of less than
five years). Accordingly, by investing in moderate-credit-risk securities with
short maturities, extra yield and return may be generated.
Table A4.1 summarizes return-enhancing strategies for relative return
portfolios broken out by product types. Again, the table is intended to be
more conceptual than a carved-in-stone overview of what strategies can be
implemented with the indicated product(s).
An index is simply one enemy among several for portfolio managers. For
example, any and every debt issuer can be a potential enemy that can be
analyzed and scrutinized for the purpose of trying to identify and capture
TABLE A4.1 Fund Strategies in Relation to Product Types
Strategy Bonds Equities Currencies
Cash flow reinvestment
‚Č¤ Cash flows
Securities going in/out
Index price marks vs.
the market‚Ä™s prices
‚ąö ‚ąö ‚ąö
170 FINANCIAL ENGINEERING, RISK MANAGEMENT, AND MARKET ENVIRONMENT
something that others do not or cannot see. In the U.S. Treasury market,
an investor‚Ä™s edge may come from correctly anticipating and benefiting from
a fundamental shift in the Treasury‚Ä™s debt program away from issuing
longer-dated securities in favor of shorter-dated securities. In the credit mar-
kets, an investor‚Ä™s edge may consist of picking up on a key change in a com-
pany‚Ä™s fundamentals before the rating agencies do and carefully anticipating
an upgrade in a security‚Ä™s credit status. In fact, there are research efforts
today where the objective is to correctly anticipate when a rating agency
may react favorably or unfavorably to a particular credit rating and to assist
with being favorably positioned prior to any actual announcement being
made. But make no mistake about it. Correctly anticipating and benefiting
from an issuer (the Treasury example) and/or an arbiter of issuers (the credit
rating agency example) can be challenging indeed.