This is the riskiest strategy because the investor must act on uncertain forecasts of future interest rates. For changes in the level of interest rates, interest rate anticipation strategies can be used from an expected level change in interest rates. Duration measures the inverse relationship between a level change in interest rates and a fixed income portfolio’s value. To enhance return, if rates are expected to decline a manager would increase the duration of the portfolio; conversely, if rates are expected to rise, the manager would shorten portfolio duration.
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The strategy is designed to preserve capital 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).
Valuation analysis – In this strategy, the portfolio manager looks for undervalued bonds, those bonds that have a computed value higher than the current market price. This method requires continuous evaluation , lots of analysis and lots trading based on the analysis. Based on the analysis, the investor would buy undervalued bonds and sell overvalued bonds (or ignore them if they are not in the portfolio).
Credit analysis – The issuer is an extremely important feature of bonds. Bond issuers are examined to determine if any changes in the firm’s default risk can be identified. Basically, because issuers differ in default risk, government are normally assumed to be without default risk. Non government bonds are normally classified according to their credit ratings which signal the amount of default risk. Rating changes are prompted by internal changes within the firm as well as external changes. Various factors examined include financial ratios, GNP, inflation, etc.
Yield spread analysis – can be used to earn from an expected change in current bond sector spreads. Yield spread strategies are based on an assumption that current yield spreads between sectors are not consistent with some “normal” yield spread level. In these strategies, often called intermarket spread swaps, a manager sells bonds in one sector and buys bonds in another sector in the hopes of profiting as the yieldspread moves from its current level to its “normal” level. These strategies are generally independent of interest rate anticipation strategies which attempt to capitalize on expectations regarding the level of interest rates.
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An example of this strategy is the decision to purchase callable or noncallable bonds. During periods ofhigh interest rates, the spread between yields on callable and non callable bonds is often greater than during periods of relatively low interest rates. Accordingly , if investors expect rates to decrease in the future, causing the spread between the callable and non callable bonds to narrow, they could capitalize by forming a callable/ non callable bond swap. Interest rate volatility also plays a role in the spread. As volatility increases, the value of the embedded call option rises, causing callable bond prices to fall and the yield spread to widen. Thus, if volatility is expected to increase, the manager would sell callable bonds and purchase non-callable bonds; if volatility is expected to decrease, non-callable bonds would be sold and callable bonds would be purchased.
Substitution swaps – can be used to select one of two bonds that are similar in all aspects except that one that has a higher yield. For example, in a credit quality sector, a bond might be selected if a manager feels that its credit quality should be higher than other similarly rated bonds. If this analysis is confirmed by the market via a rating upgrade, the bond will go up in value. Another example is to compare two mortgage backed securities (MBSs) of similar coupon, maturity, and type, where different prepayment assumptions lead to different prices and yield spreads.
If a manager anticipates a different prepayment assumption than the market, the manager can act on that assumption in the hopes that the market will agree with his prepayment assumption in the future and value that particular MBS. For example, for a particular discount MBS or a PO, if a manager expects faster prepayments than the market, the manager could purchase that security to realize the greater value of receiving principal repayments quicker than the market anticipates. Similarly, for a particular premium MBS or an IO, if the manager expects slower prepayments than the market, the manager would purchase that security because its lower price is compensating to the prepayment risk.
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