Active Fixed-

Income
Portfolio
Management
▸ Active fixed-income portfolio managers work under the
assumption that investment as well as arbitrage opportunities
exist, which yield on average a higher return than the cost
incurred to implement them.

▸ Two kinds of active strategies:

1) Trading on interest-rate predictions, which is called market
timing.
2) Trading on market inefficiencies, which is called bond
picking

2
“ Market Timing:
Trading on
Interest-Rate
Predictions
3
▸ Active portfolio managers clearly make some bets on
changes in the yield curve or one particular segment of the
yield curve

▸ We distinguish three kinds of bets:

1) Timing bets based on no change in the yield curve.
2) Timing bets based on interest-rate level.
3) Timing bets based on both slope and curvature movements of
the yield curve.

▸ These bets apply to a specific rating class.

4
Timing Bets on No Change in the
Yield Curve or ‘‘Riding the Yield
Curve’’
Analyzing the Strategy

▸ When an investor invests in a fixed-income security with a

maturity different from his desired holding period, he is
exposed to either reinvestment risk or capital risk.

▸ Riding the yield curve is a technique that fixed-income

portfolio managers traditionally use in order to enhance
returns.

▸ When the yield curve is upward sloping and is supposed to

remain unchanged, it enables an investor to earn a higher rate
5
of return.
Timing Bets on Interest-Rate Level
When Rates Are When Rates Are
Expected to Decrease Expected to Increase
▸ If the investor thinks that
▸ If investor thinks that
interest rates will increase in
interest rates will decrease in
level, the investor will
level, the investor will
shorten
lengthen the $duration or
the $duration or modified
modified duration of his
duration of his portfolio by
portfolio by buying bonds or
selling bonds or futures
futures contracts.
Contracts.
. 6
Timing Bets on Specific Changes in
the Yield Curve
Bullet, Barbell and Ladder Strategies

▸ A bullet portfolio is constructed by concentrating

investments on a particular maturity of the yield curve.

▸ A barbell portfolio is constructed by concentrating

investments at the short-term and the long-term ends of the
yield curve.

7
 Examples
A portfolio invested 100% in
the 5-year maturity T-bond is
Timing Bets on an example of a bullet.
Specific Changes in
the Yield Curve A portfolio invested half in the
6-month maturity T-bill and
Bullet, Barbell and Ladder half in the 30-year maturity T-
Strategies bond is an example of a
barbell.
 Timing Bets on Specific Changes
in the Yield Curve
Bullet, Barbell and Ladder Strategies

A Barbell is
More Convex
than a Bullet
with the
Same
Duration
Timing Bets on Specific Changes in
the Yield Curve
Bullet, Barbell and Ladder Strategies

▸ A ladder portfolio is constructed by investing equal amounts

in bonds with different maturity dates.

Example
▸ A portfolio invested for 20% in the 1-year T-bond, 20% in
the 2-year T-bond, 20% in the 3-year T-bond, 20% in the 4-
year T-bond and finally, 20% in the 5-year T-bond is an
example of a ladder.

10
Timing Bets on Specific Changes in
the Yield Curve
Bullet, Barbell and Ladder Strategies

Different ladders depending on the maturity of the bonds.

1) A ladder whose 2) A ladder whose

investments are
concentrated at the
short-term end of the
yield curve or
investments are equally
distributed between short-
term, medium-term and
long-term maturities.

11
Timing Bets on Specific Changes in
the Yield Curve
Butterfly Strategy

▸ A butterfly is one of the most common fixed-income active

strategies used by practitioners. It is the combination of a
barbell (called the wings of the butterfly) and a bullet (called
the body of the butterfly).

▸ The butterfly is usually structured so as to display a positive

convexity, generates a positive gain if large parallel shifts
occur.

12
Timing Bets on Specific Changes in
the Yield Curve
Butterfly Strategy

▸ A Convex Trade

- When only parallel shifts affect the yield curve, the strategy
is structured so as to have a positive convexity.

- An investor is then certain to enjoy a positive payoff if the

yield curve is affected by a positive or a negative parallel
shift.

13
Timing Bets on Specific Changes in
the Yield Curve
Different Kinds of Butterflies

▸ Cash- and $duration-Neutral Weighting

- The idea is to adjust the weights so that the transaction has a

zero $duration, and the initial net cost of the portfolio is also
zero.

14
Timing Bets on Specific Changes in
the Yield Curve
Different Kinds of Butterflies

▸ Regression-Weighting

- The idea is to adjust the weights so that the transaction has a

zero $duration, and the initial net cost of the portfolio is also
zero.

- As short-term rates are much more volatile than long-term

rates, we normally expect the short wing to move more from
the body than the long wing.

15
Timing Bets on Specific Changes in
the Yield Curve
Different Kinds of Butterflies

▸ Maturity-Weighting

- The idea is to adjust the weights so that the transaction has a

zero $duration.

- Maturity-weighting butterflies are structured similarly to

regression-weighting butterflies.

16
Timing Bets on Specific Changes in
the Yield Curve
How to Measure the Performance and the Risk of a
Butterfly?

▸ Total Return Measure

- In an attempt to measure the abnormal performance of a
given strategy with respect to another given strategy for a
specific scenario of yield curve evolution, one needs to
perform a total return analysis.

- The total return in $ from date t to date t + dt is given by:

Total Return in $ = (sell price at date t + dt − buy price at
date t + received coupons from date t to date t + dt + interest
gain from reinvested payments from date t to date t + dt).
17
Timing Bets on Specific Changes in
the Yield Curve
How to Measure the Performance and the Risk of a
Butterfly?

▸ Total Return Measure

▸ When the butterfly generates a nonzero initial cash flow, we

calculate the net total return in $ by subtracting the financing
cost from the total return in $:
Net Total Return in $ = Total Return in $ − Financing Cost
in $

18
Timing Bets on Specific Changes in
the Yield Curve
Spread Measures

▸ Spread measures provide very good estimates of total returns

in dollars. This indicator applies to all kinds of butterfly
except for the cash- and $duration-neutral combination.

▸ A historical analysis of these spreads gives an indication of

the highest or the lowest values, which may be used as
indicators of opportunities to enter a butterfly strategy.

19
Timing Bets on Specific Changes in
the Yield Curve
Level, Slope and Curvature $Duration Risk Measures

▸ One way to measure the sensitivity of a butterfly to interest-

rate risk is to compute the level, slope and curvature
$durations in the Nelson and Siegel (1987) model.

▸ The idea is to compute the level, slope and curvature

durations of the butterfly in this model, and then to construct
semihedged strategies.

20
Timing Bets on Specific Changes in
the Yield Curve
Semi-hedged Strategies

▸ The idea is still to make a particular bet on a movement of

the yield curve while being hedged against all other
movements or some of them by using the level, slope and
curvature $durations of the Nelson and Siegel (1987) model.

21
Scenario Analysis
Scenario analysis is in general performed as a two-step
process:

1) The portfolio manager 2) The portfolio manager

specifies a few yield curve
scenarios for a given
horizon and computes the
total return rate of his
strategy under each
scenario.
assigns subjective
probabilities to the
different scenarios and
computes the probability-
weighted expected total
return rate for his strategy
and its volatility.

22
Scenario Analysis
How to Construct Scenario Analysis?
There are three main steps to deal with:

1) Gather the 2) Make a synthesis 3) Translate these

maximum amount of all this anticipations into a
of information about information and model of the yield
the macroeconomic formulate curve.
context, the anticipations over a
monetary policy of given horizon of
Central Banks, and time..
also econometric
studies.
23
Active Fixed-Income Style
Allocation Decisions
▸ There is now a consensus in empirical finance that expected
asset returns, and also variances and covariances, are, to
some extent, predictable.

▸ The use of predetermined variables to predict asset returns

has produced new insights into asset pricing models, and the
literature on optimal portfolio selection has recognized that
these insights can be exploited to improve on existing
policies based upon unconditional estimates.

24
Active Fixed-Income Style
Allocation Decisions
▸ Practitioners also recognized the potential significance of
return predictability and started to engage in tactical asset
allocation (TAA) strategies as early as the 1970s.

▸ TAA strategies were traditionally concerned with allocating

wealth between two asset classes, typically shifting between
stocks and bonds.

25
Active Fixed-Income Style
Allocation Decisions
Factor Analysis of Bond Index Returns
▸ Investors have an intuitive understanding that different bond
indices have contrasted performance at different points of the
business cycle.

▸ The relatively low correlations between T-Bond and

Investment Grade indices and the high-yield index suggest that
different fixed-income strategies perform better at different
points in time. While unconditional correlations suggest
potential economic value in timing bond indices, conditional
correlations are perhaps more indicative.
26
Active Fixed-Income Style
Allocation Decisions
Factor Analysis of Bond Index Returns
▸ A predictive variable such as a proxy for stock market
volatility can help in the appreciation of the future relative
performance of various bond indices.

▸ Economic conditions are described in terms of the values of a

shortlist of financial and macroeconomic factors. Some of
these factors have been shown to be useful in predicting the
performance of traditional asset classes and/or explaining a
significant fraction of the cross-sectional differences in various
stock and bond index returns.
27
Active Fixed-Income Style
Allocation Decisions
Factor Analysis of Bond Index Returns

▸ The financial factors are ▸ The economic factors are

as follows: as follows:
1) 3-month T-Bill yield. 1) Inflation
2) Dividend yield 2) Money supply
3) Default spread
3) Economic growth
4) term spread
5) Implied volatility
6) Market volume
7) US equity factor

28
Factor Analysis of Bond Index Returns (Example)

29
Factor Analysis of Bond Index Returns (Example-cont.)

30
Active Fixed-Income Style
Allocation Decisions
Factor Analysis of Bond Index Returns
▸ Based on the given table, high-yield bonds tend to
outperform investment grade bonds in the sample on the
previous slides when:

- short-term rates are low and do not change much

- the dividend yield is decreasing or remaining stable;
- the yield curve is very upward sloping;
- implied volatility is decreasing significantly, and the S&P is
increasing;
- Inflation is low and economic growth is high.
31
Active Fixed-Income Style
Allocation Decisions
Selecting the Variables
▸ Rather than trying to screen hundreds of variables through
stepwise regression techniques, which usually leads to high
in-sample R-squared but low out-of-sample R-squared
(robustness problem), it is instead usually better to select a
shortlist of economically meaningful variables.

▸ To select a shortlist of useful variables for each index, one

typically distinguishes between two subperiods:
1) Calibration period:
2) Back-testing period
32
Active Fixed-Income Style
Allocation Decisions
Selecting and Using the Models

▸ The process for ▸ From the selected ▸ Standard

model selection is short list of heteroscedasticity
similar to the one variables for a given tests - designed to
used for variable index, form test whether the
selection. multivariate linear variance of the error
models based on at term changes
most variables. through time or
across a cross
section of data.
33
Active Fixed-Income Style
Allocation Decisions
Selecting and Using the Models

▸ The next step is to ▸ The model forecasting ability can

use the model, or be measured by out-of-sample hit
perform out-of- ratios, which designate the
sample testing of percentage of time the predicted
the models direction is valid, that is, the index
goes up (respectively, down) when
the model predicts it will go up
(respectively, down).

34
Active Fixed-Income Style
Allocation Decisions
Implications for Tactical Style Allocation

▸ Tactical asset allocation (TAA) is a form of conditional asset

allocation, which consists in rebalancing portfolios around
long run asset weights depending on conditional information

35
Trading on
Market
Inefficiencies
▸ Another approach to active bond portfolio management
consists in trying to detect mispriced securities (bond
picking)

The first one which The second one is

takes place within across markets. It
a given market is Two concerns both
called the bond kinds of spread and
relative value trading convergence
analysis. trades.

37
Trading within a Given Market: The
Bond Relative Value Analysis
▸ Bond relative value is a technique that consists in detecting
bonds that are underpriced by the market in order to buy
them and bonds that are overpriced by the market in order to
sell them.

38
Trading within a Given Market: The
Bond Relative Value Analysis
▸ Bond relative value is a technique that consists in detecting
bonds that are underpriced by the market in order to buy
them and bonds that are overpriced by the market in order to
sell them.

39
Trading within a Given Market: The
Bond Relative Value Analysis
Two methods exist that are very different in nature:
▸ The first method consists ▸ The goal of the second
in comparing the prices of method is to detect rich and
two instruments that are cheap securities that
equivalent in terms of historically present
future cash flows. These abnormal yields to
two products are a bond and maturity, taking as
the sum of the strips that reference a theoretical zero-
reconstitute exactly the coupon yield curve fitted
bond. with bond prices. 40
Trading within a Given Market: The
Bond Relative Value Analysis
Using a Theoretical Yield Curve

▸ Bond rich and cheap analysis is a common market practice.

▸ The idea is to obtain a relative value for bonds, which is

based upon a comparison with a homogeneous reference.

41
Trading within a Given Market: The
Bond Relative Value Analysis
Using a Theoretical Yield Curve
▸ To What Kind of Assets It Can Be Applied?

▸ We can develop a rich–cheap analysis for the following:

1) Treasury bonds of a specified country using the Treasury
zero-coupon yield curve of this country as a reference.
2) Treasury bonds of a specified country using the Treasury
zero-coupon yield curve of this country as a reference.
3) Corporate bonds of a specified country or financial unified
zone with the same Corporate bonds of a single firm.
4) ting and economic sector.
42
Active Fixed-Income Style
Allocation Decisions
Using a Theoretical Yield Curve
How It Works?
▸ First, construct an ▸ Then, compute a ▸ Then calculate the
adequate current theoretical price for market yield to
zero-coupon yield each asset as the maturity and
curve using data for sum of its compare it to the
assets with the same discounted cash theoretical yield to
characteristics in flows using zero- maturity.
terms of liquidity coupon rates with
and risk. comparable
maturity.
43
Active Fixed-Income Style
Allocation Decisions
Using a Theoretical Yield Curve

How It Works?
▸ The analysis is then ▸ Short and long positions
improved by means of a are unwound according to
statistical analysis of a criterion that is defined
historical spreads for each a priori..
asset so as to distinguish
actual inefficiencies from
abnormal yields.

44
Trading within a Given Market: The
Bond Relative Value Analysis
Using a Theoretical Yield Curve
▸ When to Unwind the Position?
- The issue lies in the decision timing to reverse the position in
the market. Example, It can be the first time when the
position generates a profit net of transaction costs (in fact the
bid–ask spread).

- These methods seek to benefit from inefficiencies or relative

mispricing detected in the market, considering that the
theoretical yield curves are the good ones and that spreads
will mean-revert around zero level or some other normal
level. 45
Trading across Markets: Spread and
Convergence Trades
Swap-Treasury Spread Trades
▸ This kind of trade consists in detecting the time when swap
spreads are high (which means that credit is cheap in
general) and when they are low (which means that credit is
rich in general)..

▸ The statistical technique used for judging the cheapness or

richness of swap spreads is basically the same as the one
used to perform bond relative value analysis.

46
Trading across Markets: Spread and
Convergence Trades
Swap-Treasury Spread Trades
▸ A swap spread is computed as the difference between the
swap yield and the Treasury bond par fitted yield with the
same maturity.

▸ For example, the 10-year swap spread is equal to the

difference between the 10-year swap yield and the 10-year T-
bond par fitted yield.

47
Trading across Markets: Spread and
Convergence Trades
Corporate-Swap Spread Trades
▸ These trades are based upon the use of relative value tools
like those developed for Treasury bonds.

▸ Corporate bonds are analyzed relatively to a swap curve

rather than to a Treasury curve because of two reasons:
1) , A swap curve is an unambiguously defined reference
2) , The spread between a corporate bond yield and a swap
yield can be considered the specific credit risk premium of
the bond

48
Trading across Markets: Spread and
Convergence Trades
Corporate-Swap Spread Trades
▸ The spread between a corporate bond yield and a Treasury
bond yield represents the total credit risk premium of the
bond (systematic + specific).

▸ Building a reliable relative value tool for corporate bonds is

not an easy task. The use of a joint estimation method so as
to obtain realistic spread curve shapes is a recommended
method to use.

49
Trading across Markets: Spread and
Convergence Trades
Convergence Trades
▸ When a portfolio manager expects a country to join a unified
economic area (unique currency) or a set of countries to
merge into a unified economic area, as was the case for the
Euro area, he can choose to initiate a so-called convergence
trade that enables him to take advantage of the financial
implications of the unification.

50
Trading across Markets: Spread and
Convergence Trades
Convergence Trades
▸ Forward Rate Trades
- Forward rate trades are implemented through the use of
forward rates. The portfolio manager decides to expose his
portfolio to convergence through entering forward swap
transactions.

- Once the term to maturity is chosen and the forward period is

identified, the portfolio manager enters the forward swap
transaction allowing him to profit from the expected
convergence movement.
51
Trading across Markets: Spread and
Convergence Trades
Convergence Trades
▸ forward swap - is a swap with a fixed leg being a forward
swap yield, and a floating leg being made of forward
interbank yields.

- The convergence strategy consists in buying the swap in the

currency for which interest rates are lower and selling the
swap in the currency for which interest rates are higher.

52
Trading across Markets: Spread and
Convergence Trades
Convergence Trades
▸ When a portfolio manager expects a country to join a unified
economic area (unique currency) or a set of countries to
merge into a unified economic area, as was the case for the
Euro area, he can choose to initiate a so-called convergence
trade that enables him to take advantage of the financial
implications of the unification.

53
Trading across Markets: Spread and
Convergence Trades
Convergence Trades
▸ Yield Curve Trades

- Yield curve trades are implemented through yield curve

trading..

- The convergence of the sterling yield curve on the Euro yield

curve implies a “steepening” of the sterling yield curve (at
the time of writing).

54
THANK YOU
