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spread swap
sectors of the bond market is temporarily out of line.
Switching from one
For example, if the yield spread between 10-year Treasury bonds and 10-year Baa-
segment of the bond
rated corporate bonds is now 3%, and the historical spread has been only 2%, an investor
market to another.
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.
rate anticipation
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
A switch made in
bonds of longer duration. For example, the investor might sell a five-year maturity
response to forecasts
Treasury bond, replacing it with a 25-year maturity Treasury bond. The new bond has the
of interest rate
same lack of credit 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 longer
pure yield pickup
duration 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. The
Moving to higher yield
investor is willing to bear the interest rate risk this strategy entails.
bonds, usually with
A yield pickup swap can be illustrated using the Treasury bond listings in Figure 9.1
longer maturities.
from the last chapter. You can see from that table that a Treasury note maturing in
October 2006 yields 4.35%, while one maturing in February 2031 yields 5.36%. The
investor who swaps the shorter term bond for the longer one will earn a higher rate of
Bodie’Kane’Marcus: III. Debt Securities 10. Managing Bond © The McGraw’Hill
Essentials of Investments, Portfolios Companies, 2003
Fifth Edition

10 Managing Bond Portfolios

return as long as the yield curve does not shift upward during the holding period. Of
course, if it does, the longer duration bond will suffer a greater capital loss.
We can add a fifth swap, called a tax swap to this list. This simply refers to a swap to ex- tax swap
ploit some tax advantage. For example, an investor may swap from one bond that has de- Swapping two similar
creased in price to another similar bond if realization of capital losses is advantageous for tax bonds to receive a
purposes. tax benefit.

Horizon Analysis
One form of interest rate forecasting is called horizon analysis. The analyst selects a particu- horizon analysis
lar investment period and predicts bond yields at the end of that period. Given the predicted Forecast of bond
yield to maturity at the end of the investment period, the bond price can be calculated. The returns based largely
coupon income earned over the period is then added to the predicted capital gain or loss to on a prediction of the
yield curve at the end
obtain a forecast of the total return on the bond over the holding period.
of the investment

A 20-year maturity bond with a 10% coupon rate (paid annually) currently sells at a yield to ma-
turity of 9%. A portfolio manager with a two-year horizon needs to forecast the total return on
the bond over the coming two years. In two years, the bond will have an 18-year maturity. The
analyst forecasts that two years from now, 18-year bonds will sell at yields to maturity of 8%, Horizon Analysis
and that coupon payments can be reinvested in short-term securities over the coming two years
at a rate of 7%.
To calculate the two-year return on the bond, the analyst would perform the following
1. Current price $100 Annuity factor(9%, 20 years) $1,000 PV factor(9%, 20 years)
2. Forecast price $100 Annuity factor(8%, 18 years) $1,000 PV factor(8%, 18 years)
3. The future value of reinvested coupons will be ($100 1.07) $100 $207
$207 ($1,187.44 $1,091.29)
4. The two-year return is 0.278, or 27.8%
The annualized rate of return over the two-year period would then be (1.278)1/2 1 0.13,
or 13%.


Bond Swapping Strategies
Go to http://www.investinginbonds.com. This site has several publications that are
designed for the individual investor.
After you have read the short pamphlet on swapping strategies, answer the following
1. What potential benefits may be found from swapping?
2. What strategy would you employ if you believed that interest rates were going
to fall?
3. What is a wash sale, and how can you avoid wash sales?
Bodie’Kane’Marcus: III. Debt Securities 10. Managing Bond © The McGraw’Hill
Essentials of Investments, Portfolios Companies, 2003
Fifth Edition

364 Part THREE Debt Securities

7. What will be the rate of return in the example above if the manager forecasts that
in two years the yield to maturity on 18-year maturity bonds will be 10% and that
CHECK the reinvestment rate for coupons will be 8%?

Contingent Immunization
Some investment styles fall within the spectrum of active versus passive strategies. An exam-
contingent ple is a technique called contingent immunization, first suggested by Liebowitz and Wein-
immunization berger (1982). The idea is to allow the fixed-income manager to manage the portfolio actively
unless and until poor performance endangers the prospect of achieving a minimum acceptable
A strategy that
portfolio return. At that point, the portfolio is immunized, providing a guaranteed rate of re-
immunizes a portfolio
turn over the remaining portion of the investment period.
if necessary to
guarantee a minimum To illustrate, suppose a manager with a two-year horizon is responsible for a $10 million
acceptable return
portfolio. The manager wishes to provide a two-year cumulative return of at least 10%, that is,
but otherwise allows
the minimum acceptable final value of the portfolio is $11 million. If the interest rate currently
active management.
is 10%, only $9.09 million would be necessary to guarantee a terminal value of $11 million,
because $9.09 million invested in an immunized portfolio would grow after two years to
$9.09 $11 million. Since the manager starts with $10 million, she can afford
to risk some losses at the outset and might therefore start out with an active strategy rather
than immediately immunizing.
How much can the manager risk losing? If the interest rate at any time is r, and T is the time
left until the horizon date, the amount needed to achieve a terminal value of $11 million is
simply the present value of $11 million, or $11 million/(1 r)T. A portfolio of this size, if im-
munized, will grow risk-free to $11 million by the horizon date. This value becomes a trigger
point: If and when the actual portfolio value dips to the trigger point, active management will
cease. Contingent upon reaching the trigger point, an immunization strategy is initiated.
Figure 10.8 illustrates two possible outcomes in a contingent immunization strategy. In
Figure 10.8A, the portfolio falls in value and hits the trigger at time t*. At that point, immu-
nization is pursued, and the portfolio rises smoothly to the $11 million value. In Figure 10.8B,
the portfolio does well, never reaches the trigger point, and is worth more than $11 million at
the horizon date.

8. What is the trigger point if the manager has a three-year horizon, the interest rate
is 8%, and the minimum acceptable terminal value is $10 million?

An Example of a Fixed-Income Investment Strategy
To demonstrate a reasonable, active fixed-income portfolio strategy, we discuss here the poli-
cies of Sanford Bernstein & Co., as explained in a speech by its manager of fixed-income in-
vestments, Francis Trainer. The company believes big bets on general marketwide interest
movements are unwise. Instead, it concentrates on exploiting numerous instances of perceived
relative minor pricing misalignments within the fixed-income sector. The firm takes as a risk
benchmark the Lehman [Aggregate] Bond Index, which includes the vast majority of publicly
traded bonds with maturities greater than one year. Any deviation from this passive or neutral
position must be justified by active analysis. Bernstein considers a neutral portfolio duration
to be equal to that of the index.
The firm is willing to make only limited bets on interest rate movements. As Francis
Trainer puts it in his speech:
If we set duration of our portfolios at a level equal to the index and never allow them to vary, this
would imply that we are perpetually neutral on the direction of interest rates. However, we believe
Bodie’Kane’Marcus: III. Debt Securities 10. Managing Bond © The McGraw’Hill
Essentials of Investments, Portfolios Companies, 2003
Fifth Edition

10 Managing Bond Portfolios

F I G U R E 10.8
$ millions

Portfolio value

t* Horizon

$ millions

Portfolio value



the utilization of these forecasts will add value and, therefore, we incorporate our economic fore-
cast into the bond management process by altering the durations of our portfolios.
However, in order to prevent fixed-income performance from being dominated by the ac-
curacy of just a single aspect of our research effort, we limit the degree to which we are willing
to alter our interest rate exposure. Under the vast majority of circumstances, we will not permit
the duration of our portfolios to differ from that of the [Lehman Brothers] Index by more than
one year.

The company expends most of its effort in exploiting numerous but minor inefficiencies in
bond prices that result from lack of attention by its competitors. Its analysts follow about
1,000 securities, attempting to “identify specific securities that are attractive or unattractive as
well as identify trends in the richness or cheapness of industries and sectors.” These two ac-
tivities would be characterized as substitution swaps and intermarket spread swaps in the
Homer“Leibowitz scheme.
Sanford Bernstein & Co. realizes that market opportunities will arise, if at all, only in sec-
tors of the bond market that present the least competition from other analysts. For this reason,
Bodie’Kane’Marcus: III. Debt Securities 10. Managing Bond © The McGraw’Hill
Essentials of Investments, Portfolios Companies, 2003
Fifth Edition

366 Part THREE Debt Securities

it tends to focus on relatively more complicated bond issues in the belief that extensive re-
search efforts give the firm a comparative advantage in that sector. Finally, the company does
not take unnecessary risks. If there do not appear to be enough seemingly attractive bonds,
funds are placed in Treasury securities as a “neutral” parking space until new opportunities are
To summarize the key features of this sort of strategy, we can make the following
1. A firm like Bernstein has a respect for market prices. It believes that only minor
mispricing usually can be detected. It works toward meaningful abnormal returns by
combining numerous small profit opportunities, not by hoping for the success of
one big bet.
2. To have value, information cannot be reflected already in market prices. A large research
staff must focus on market niches that appear to be neglected by others.
3. Interest rate movements are extremely hard to predict, and attempts to time the market
can wipe out all the profits of intramarket analysis.


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