Week 11

Bond portfolio strategies

Presented by
Dr James Cummings
Discipline of Finance

The University of Sydney Page 1

 Learning Objectives

– After studying this topic, you will understand

– the spectrum of portfolio management strategies
– what is meant by a core/satellite strategy
– the different discretionary strategies
– the different types of active bond portfolio strategies: interest-rate
expectations strategies, yield curve strategies, yield spread strategies,
option-adjusted spread-based strategies, and individual security
selection strategies
– bullet, barbell, and ladder yield curve strategies
– the limitations of using duration and convexity to assess the potential
performance of bond portfolio strategies
– why it is necessary to use the dollar duration when implementing a yield
spread strategy

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 Learning Objectives

– After studying this topic, you will understand

– what the cell-based approach to bond portfolio construction is and its
limitations
– the difficulties associated with constructing a bond portfolio when
following a bond indexing strategy
– what is meant by a relative value corporate bond trade and the
assumptions made in such trades
– the different types of relative value corporate bond trades

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 Spectrum of Bond Portfolio Strategies

– The bond portfolio strategy selected by an investor or client depends on the

investment objectives and policy guidelines.
– In general, bond portfolio strategies can be categorised into the following
three groups:
1) bond benchmark-based strategies
2) absolute return strategies
3) liability-driven strategies

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 Spectrum of Bond Portfolio Strategies

– Bond Benchmark-Based Strategies

– There is a wide range of bond portfolio management strategies for an
investor or client who has selected a bond index as a benchmark.
– Traditional bond benchmark-based strategies can be classified as:
1) pure bond index matching
2) enhanced indexing: matching primary risk factors
3) enhanced indexing: minor risk-factor mismatches
4) active management: larger risk-factor mismatches
5) active management: full-blown active
– These strategies range from low-risk strategies at the top to high-risk-
tolerance strategies at the bottom of the list.
– Not only is it important to understand what the risk factors are, but also
how to quantify them.

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 Spectrum of Bond Portfolio Strategies

– Bond Benchmark-Based Strategies

– With the first three strategies, a portfolio manager is not permitted to
deviate from the benchmark’s duration.
– The last two strategies are active bond portfolio management
strategies.
• They differ to the extent that they allow mismatches relative to the
benchmark.
– It is important to note that even if a manager pursues an active strategy,
the manager may still elect to have a duration equal to that of the
benchmark (i.e., pursue a duration-matching strategy).

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 Spectrum of Bond Portfolio Strategies

– Bond Benchmark-Based Strategies

– Portfolio managers often pursue what is referred to as a core/satellite
strategy.
• Basically, this strategy involves building a blended portfolio using an
indexed and active strategy.
• The core component is a low-risk portfolio constructed using one of
the indexing strategies.
• The satellite component is constructed using an active strategy with a
benchmark that is a specialised rather than a broad liquid bond
market index.

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 Spectrum of Bond Portfolio Strategies

– Absolute Return Strategies

– In an absolute return strategy, the portfolio manager seeks to earn a
positive return over some time frame irrespective of market conditions.
– Few restrictions are placed on the exposure to the primary risk factors.
– Absolute return strategies are typically pursued by hedge fund
managers who employ leverage.
– Other absolute return managers set as their target earning a return
from 150 to 400 basis points per year over the return on cash, and
hence such strategies are referred to as cash-based absolute return
strategies.

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 Spectrum of Bond Portfolio Strategies

– Liability-Driven Strategies
– Liability-driven investing (LDI) is concerned with controlling investment risk
where the benchmark for assessing performance is not in terms of an
asset benchmark or a peer group but by reference to a client’s
liabilities.
– These strategies involve managing both assets and liabilities to achieve
some return objective or a series of liabilities that a client faces.
– Life insurance companies use LDI strategies known as immunisation and
cash flow matching for several products that they issue: annuities,
guaranteed investment contracts, and structured contracts that
guarantee a minimum rate.

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 The Primary Risk Factors

– Primary risk factors in bond indexes are those risk factors that a portfolio
manager can match or mismatch when constructing a portfolio.
– A portfolio manager will only intentionally mismatch if the manager has
information that strongly suggests there is a benefit that is expected to result
from mismatching.
– The primary risk factors can be divided into two general types: systematic
risk factors and non-systematic risk factors.
– Systematic risk factors are forces that affect all securities in a certain
category in the benchmark.
– Non-systematic risk factors are the risks that are not attributable to the
systematic risk factors.

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 The Primary Risk Factors

– Systematic risk factors, in turn, are divided into two categories: term
structure risk factors and non-term structure risk factors.
– Term structure risk factors are risks associated with changes in the shape
of the term structure (level and shape changes).
– Non-term-structure risk factors include sector risk, credit risk and
optionality risk.
• Sector risk is the risk associated with exposure to the sectors of the
benchmark.
• Credit risk, also referred to as quality risk, is the risk associated with
exposure to the credit rating of the securities in the benchmark.
• Optionality risk is the risk associated with an adverse impact on the
embedded options of the securities in the benchmark.
– Non-systematic factor risks are classified as the non-systematic risks
associated with a particular issuer, issuer-specific risk, and those associated
with a particular issue, issue-specific risk.

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 Discretionary Active Bond Portfolio Strategies

– Manager Expectations Versus the Market Consensus

– A money manager who pursues an active strategy will position a
portfolio to capitalise on expectations about future interest rates, but
the potential outcome (as measured by total return) must be assessed
before an active strategy is implemented.
• The primary reason for this is that the market (collectively) has
certain expectations for future interest rates, and these expectations
are embodied into the market price of bonds.
• The outcome of a strategy will depend on how a manager’s
expectation differs from that of the market.

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 Discretionary Active Bond Portfolio Strategies

– Interest-Rate Expectations Strategies

– A money manager who believes that he or she can accurately forecast
the future level of interest rates will alter the portfolio’s sensitivity to
interest-rate changes.
– A portfolio’s duration may be altered by swapping (or exchanging)
bonds in the portfolio for new bonds that will achieve the target
portfolio duration.
• Such swaps are commonly referred to as rate anticipation swaps.
– Although a manager may not pursue an active strategy based strictly on
future interest-rate movements, there can be a tendency to make an
interest-rate bet to cover inferior performance relative to a benchmark
index.
– There are other active strategies that rely on forecasts of future interest-
rate levels.

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 Discretionary Active Bond Portfolio Strategies

– Yield Curve Strategies

– The yield curve for Treasury securities shows the relationship between
their maturities and yields.
• The shape of this yield curve changes over time.
– Yield curve strategies involve positioning a portfolio to capitalise on
expected changes in the shape of the Treasury yield curve.

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 Discretionary Active Bond Portfolio Strategies

– Types of Shifts in the Yield Curve and Impact on Historical Returns

– A shift in the yield curve refers to the relative change in the yield for
each Treasury maturity.
– A parallel shift in the yield curve is a shift in which the change in the yield
on all maturities is the same.
– A non-parallel shift in the yield curve indicates that the yields for
different maturities do not change by the same number of basis points.

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 Discretionary Active Bond Portfolio Strategies

– Types of Shifts in the Yield Curve and Impact on Historical Returns

– Historically, two types of non-parallel yield curve shifts have been
observed: a twist in the slope of the yield curve and a change in the
humpedness of the yield curve.
• A flattening of the yield curve indicates that the yield spread
between the yield on a long-term and a short-term Treasury has
decreased; a steepening of the yield curve indicates that the yield
spread between a long-term and a short-term Treasury has
increased.
• The other type of nonparallel shift, a change in the humpedness of
the yield curve, is referred to as a butterfly shift.

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 Discretionary Active Bond Portfolio Strategies

– Types of Shifts in the Yield Curve and Impact on Historical Returns

– Frank Jones analysed the types of yield curve shifts that occurred
between 1979 and 1990.
– He found that the three types of yield curve shifts are not independent,
with the two most common types of yield curve shifts being
1) a downward shift in the yield curve combined with a steepening
of the yield curve
2) an upward shift in the yield curve combined with a flattening of
the yield curve
– These two types of shifts in the yield curve are depicted in the figures
over page.

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 Combinations of Yield Curve Shifts: Upward
Shift/Flattening/Positive Butterfly

Yield

Positive Butterfly

Flattening

Parallel

Maturity
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 Combinations of Yield Curve Shifts: Downward
Shift/Steepening/Negative Butterfly

Yield

Parallel

Steepening

Negative Butterfly

Maturity
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 Discretionary Active Bond Portfolio Strategies

– Different Types of Yield Curve Strategies

– In portfolio strategies that seek to capitalise on expectations based on
short-term movements in yields, the dominant source of return is the
impact on the price of the securities in the portfolio.
– The key point is that for short-term investment horizons, the spacing of
the maturity of bonds in the portfolio will have a significant impact on
the total return.
– In a bullet strategy, the portfolio is constructed so that the maturities of
the securities in the portfolio are highly concentrated at one point on the
yield curve.
– In a barbell strategy, the maturities of the securities in the portfolio are
concentrated at two extreme maturities.
– In a ladder strategy, the portfolio is constructed to have approximately
equal amounts of each maturity.

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 Discretionary Active Bond Portfolio Strategies

– Duration and Yield Curve Shifts

– Duration is a measure of the sensitivity of the price of a bond or the
value of a bond portfolio to changes in market yields.
• A portfolio with a duration of 4 means that if market yields change
by 100 basis points, the portfolio value will change by
approximately 4%.
– If a portfolio of bonds consists of 5-year, 10-year, and 20-year bonds,
the assumption made is that the yield on all maturities will change by the
same number of basis points.
• If the three-bond portfolio has a duration of 4, the statement that
the portfolio’s value will change by 4% for a 100-basis-point
change in yields actually should be stated as follows: The portfolio’s
value will change by 4% if the yield on 5-year, 10-year, and 20-
year bonds all change by 100 basis points.
• That is, it is assumed that there is a parallel yield curve shift.

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 Discretionary Active Bond Portfolio Strategies

– Analysing Expected Yield Curve Strategies

– The proper way to analyse any portfolio strategy is to look at its
potential total return.
– If a manager wants to assess the outcome of a portfolio for any
assumed shift in the Treasury yield curve, this should be done by
calculating the potential total return if that shift actually occurs.
– This can be illustrated by looking at the performance of two
hypothetical portfolios of Treasury securities assuming different shifts in
the Treasury yield curve.
• The three hypothetical Treasury securities shown in the table over
page are considered for inclusion in the two portfolios.
• For the illustration, the Treasury yield curve consists of these three
Treasury securities: a short-term security (A, the five-year security),
an intermediate-term security (C, the 10-year security), and a long-
term security (B, the 20-year security).

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 Three Hypothetical Treasury Securities

Yield to
Coupon Maturity Price Plus Maturity Dollar Dollar
Bond (%) (years) Accrued (%) Duration Convexity
A 8.50 5 100 8.50 4.01 19.82

B 9.50 20 100 9.50 8.88 124.17

C 9.25 10 100 9.25 6.43 55.45

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 Discretionary Active Bond Portfolio Strategies

– Analysing Expected Yield Curve Strategies

– Consider the following two yield curve strategies: a bullet strategy and
a barbell strategy.
– The portfolios created based on these two strategies comprise:
• Bullet portfolio: 100% bond C
• Barbell portfolio: 50.2% bond A and 49.8% bond B
– Dollar duration is a measure of the dollar price sensitivity of a bond or
a portfolio.
• The dollar duration for the bullet portfolio is 6.43.
• For the barbell portfolio, the dollar duration is the weighted
average of the dollar duration of the two bonds. Therefore, dollar
duration of barbell portfolio = 0.502(4.01) + 0.498(8.88) = 6.43.
• The dollar duration of the barbell portfolio is the same as that of
the bullet portfolio.

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 Discretionary Active Bond Portfolio Strategies

– Analysing Expected Yield Curve Strategies

– Duration is just a first approximation of the change in price resulting
from a change in interest rates.
– Dollar convexity has a meaning similar to convexity, in that it provides a
second approximation to the dollar price change.
• The dollar convexity of the bullet portfolio is 55.45.
• The dollar convexity for the barbell portfolio is a weighted average
of the dollar convexity of the two bonds. That is, dollar convexity of
barbell portfolio = 0.502(19.82) + 0.498(124.17) = 71.78.
• The dollar convexity of the barbell portfolio is greater than that of
the bullet portfolio.
– Although both portfolios have the same dollar duration, the yield of the
bullet portfolio is greater than the yield of the barbell portfolio.
• The difference in the two yields is the cost of convexity (i.e., giving
up yield to get better convexity).

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 Discretionary Active Bond Portfolio Strategies

– Analysing Expected Yield Curve Strategies

– Now suppose that a portfolio manager with a 6-month investment
horizon has a choice of investing in the bullet portfolio or the barbell
portfolio.
– Which one should the manager choose? The manager knows that (1) the
two portfolios have the same dollar duration, (2) the yield for the bullet
portfolio is greater than that of the barbell portfolio, and (3) the dollar
convexity of the barbell portfolio is greater than that of the bullet
portfolio.
– Actually, this information is not adequate for making the decision. What
is necessary is to assess the potential total return when the yield curve
shifts.

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 Discretionary Active Bond Portfolio Strategies

– Analysing Expected Yield Curve Strategies

– The table over page provides an analysis of the 6-month total return of
the two portfolios when the yield curve shifts.
– The numbers reported in the table are the difference in the total return
for the two portfolios.
– Specifically, the following is shown:
difference in dollar return = bullet portfolio’s total return − barbell
portfolio’s total return
– A positive value means that the bullet portfolio outperformed the
barbell portfolio, and a negative sign means that the barbell portfolio
outperformed the bullet portfolio.

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 Relative Performance of Bullet Portfolio and Barbell Portfolio
over a 6-Month Investment Horizon*
Yield Parallel Non-parallel Non-parallel
Change Shift Shifta Shiftb
−5.00 −7.19 −10.69 −3.89
−4.00 −4.00 −6.88 −1.27
−3.00 −1.88 −4.26 0.36
−2.00 −0.59 −2.55 1.25
−1.00 0.06 −1.54 1.57
0.00 0.25 −1.06 1.48
1.00 0.09 −0.98 1.09
2.00 −0.31 −1.18 0.49
3.00 −0.88 −1.58 −0.24
4.00 −1.57 −2.12 −1.06
5.00 −2.31 −2.75 −1.92
a Change in yield for bond C. Flattening of yield curve: yield change bond A = yield change bond

C + 25 basis points; yield change bond B = yield change bond C − 25 basis points.
b Change in yield for bond C. Steepening of yield curve: yield change bond A = yield change bond

C − 25 basis points; yield change bond B = yield change bond C + 25 basis points.
* Performance is based on the difference in total return over a 6-month investment horizon.

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 Discretionary Active Bond Portfolio Strategies

– Analysing Expected Yield Curve Strategies

– The second column of the table is labelled ‘Parallel Shift’.
• This is the relative total return of the two portfolios over the 6-month
investment horizon, assuming that the yield curve shifts in a parallel
fashion.
• In this case, parallel movement of the yield curve means that the
yields for the short-term bond (A), the intermediate-term bond (C),
and the long-term bond (B) change by the same number of basis
points, shown in the ‘Yield Change’ column of the table.
– Which portfolio is the better investment alternative if the yield curve
shifts in a parallel fashion and the investment horizon is six months?
• The answer depends on the amount by which yields change.
• Notice that when yields change by less than 100 basis points, the
bullet portfolio outperforms the barbell portfolio.
• The reverse is true if yields change by more than 100 basis points.

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 Discretionary Active Bond Portfolio Strategies

– Analysing Expected Yield Curve Strategies

– This illustration makes two key points.
1) Even if the yield curve shifts in a parallel fashion, two portfolios
with the same dollar duration will not give the same performance.
The reason is that the two portfolios do not have the same dollar
convexity.
2) Although, all other things being equal, it is better to have more
convexity than less, the market charges for convexity in the form
of a higher price or a lower yield. But the benefit of the greater
convexity depends on how much yields change.

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 Discretionary Active Bond Portfolio Strategies

– Analysing Expected Yield Curve Strategies

– The last two columns of the table show the relative performance of the
two portfolios for a non-parallel shift of the yield curve.
• The first non-parallel shift column assumes a flattening of the yield
curve. For this assumed shift, the barbell outperforms the bullet.
• In the last column, the non-parallel shift assumes that the yield curve
has steepened. In this case, the bullet portfolio outperforms the
barbell portfolio, as long as the yield on bond C does not rise by
more than 200 basis points or fall by more than 300 basis points.
– The key point is that looking at measures such as yield, duration or
convexity tells us little about performance over some investment horizon
because performance depends on the magnitude of the change in
yields and how the yield curve shifts.
• Therefore, when a manager wants to position a portfolio based on
expectations as to how she might expect the yield curve to shift, it is
imperative to perform total return analysis.

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 Discretionary Active Bond Portfolio Strategies

– Yield Spread Strategies

– The bond market is classified into sectors in several ways: by type of
issuer (Treasury, agencies, corporates, and mortgage-backed), quality
or credit (risk-free Treasuries, AAA, AA, and so on), coupon (high-
coupon/premium bonds, current-coupon/par bonds, and low-
coupon/discount bonds), and maturity (short, intermediate, or long-term).
– Yield spread strategies involve positioning a portfolio to capitalise on
expected changes in yield spreads between sectors of the bond market.
– Swapping (or exchanging) one bond for another when the manager
believes that the prevailing yield spread between the two bonds in the
market is out of line with their historical yield spread, and that the yield
spread will realign by the end of the investment horizon, are called
intermarket spread swaps.

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 Discretionary Active Bond Portfolio Strategies

– Spreads between Callable and Non-callable Securities

– Spreads that are attributable to differences in callable and non-
callable bonds and differences in coupons of callable bonds will change
as a result of expected changes in (1) the direction of the change in
interest rates, and (2) interest-rate volatility.
– Importance of Dollar Duration Weighting of Yield Spread Strategies
– What is critical in assessing yield spread strategies is to compare
positions that have the same dollar duration.
– Failure to adjust a portfolio repositioning based on some expected
change in yield spread so as to hold the dollar duration the same means
that the outcome of the portfolio will be affected not only by the
expected change in the yield spread but also by a change in the yield
level.
• Thus, a manager would be making a conscious yield spread bet and
possibly an undesired bet on the level of interest rates.

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 Discretionary Active Bond Portfolio Strategies

– Individual Security Selection Strategies

– Money managers can pursue several active strategies to identify
mispriced securities.
– The most common strategy identifies an issue as undervalued because
either
1) its yield is higher than that of comparably rated issues, or
2) its yield is expected to decline (and price, therefore, rise) because
credit analysis indicates that its rating will improve.
– A swap in which a money manager exchanges one bond for another
bond that is similar in terms of coupon, maturity, and credit quality, but
offers a higher yield, is called a substitution swap.

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 Cell-Based Approach to Bond Portfolio Construction

– Under the cell-based approach, the benchmark is divided into cells, each cell
representing a different characteristic of the benchmark.
– Common cells used to break down a benchmark are duration, coupon,
maturity, market sectors, credit quality, and call factors.
– For a portfolio manager pursuing a passive strategy, the objective is to
match the performance of the benchmark.
– Following the cell-based approach, the manager selects from all the
issues in the bond index one or more issues in each cell that can be used
to represent the entire cell.
– The total dollar amount purchased of the issues from each cell will be
based on the percentage of the bond index’s total market value that the
cell represents.
– For a portfolio manager pursuing an active strategy, the manager will
intentionally mismatch the amount allocated to specific cells where a view is
taken.

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 Cell-Based Approach to Bond Portfolio Construction

– The number of cells that the indexer uses will depend on the dollar amount
of the portfolio.
– In practice, when the cell-based approach for bond portfolio construction is
used, once a model portfolio is constructed, the portfolio’s tracking error can
be estimated.
– The cell-based approach ignores how mismatches impact portfolio risk as a
result of cross-correlation associated with the risks of each cell.

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 Cell-Based Approach to Bond Portfolio Construction

– Complications in Bond Indexing

– There are three forms of bond indexing: pure bond index matching,
enhanced indexing matching primary risk factors, and enhanced
indexing allowing for minor risk-factor mismatches.
– It is almost impossible to implement a pure bond indexing strategy, and
it is not simple to do so for the other two bond indexing strategies.

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 Cell-Based Approach to Bond Portfolio Construction

– Complications in Bond Indexing

– In a pure bond indexing strategy, the portfolio manager must purchase
all of the issues in the bond index according to their weight in the
benchmark index.
– Instead of purchasing all issues in the bond index, the manager may
purchase just a sample of issues using the cell-based approach.
• This moves the strategy from being a pure bond indexing strategy
to an enhanced bond indexing strategy with minor mismatches in the
primary risk factors.
• In terms of the cell-based approach, the primary risk factors are the
characteristics or cells.

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 Cell-Based Approach to Bond Portfolio Construction

– Complications in Bond Indexing

– A portfolio manager faces several other logistical problems in seeking
to construct an indexed portfolio.
1) The prices for each issue used by the organisation that publishes
the index may not be execution prices available to the indexer.
2) The prices used by organisations reporting the value of indexes
are based on bid prices. Dealer-ask prices, however, are the ones
that the manager would have to transact at when constructing or
rebalancing the indexed portfolio. Thus, there will be a bias
between the performance of the bond index and the indexed
portfolio that is equal to the bid–ask spread.

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 Cell-Based Approach to Bond Portfolio Construction

– Complications in Bond Indexing

– There are logistical problems unique to certain sectors in the bond
market.
– Consider first the corporate bond market.
• Because of the illiquidity of this sector, not only may the prices used
by the organisation that publishes the index be unreliable, but many
of the issues may not even be available.
– Next, consider the agency mortgage-backed securities market.
• The organisations that publish indexes lump hundreds of thousands
of issues into a few hundred generic issues.
– Finally, recall that the total return depends on the reinvestment rate
available on coupon interest.
• If the organisation publishing the index regularly overestimates the
reinvestment rate, the indexed portfolio could underperform the
bond index by a significant number of basis points a year.

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 Credit Relative Value Strategies

– Valuation methodologies involve the discounting of expected future cash

flows.
– The goal of the valuation is to identify mispriced bonds based on the
portfolio manager’s or analyst’s assumptions regarding the inputs used
in the model.
– The underlying assumption is that the bond market is inefficient in terms
of pricing and therefore there are mispriced bonds that can be
identified with a good valuation model that will allow a portfolio
manager to enhance returns.
– In contrast to identifying mispriced bonds based solely on valuation models,
relative value methodologies seek to rank ‘comparable’ bonds based on
expected return over some specified investment horizon.
– By ‘comparable’ it is meant that the bonds might have the same credit
rating but different structures (i.e., callable versus non-callable or fixed
versus floating coupon rate), with the same maturity and in the same
bond sector.

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 Credit Relative Value Strategies

– There are two underlying assumptions when using relative value

methodologies.
1) In certain sectors of the bond market, it is extremely difficult because
of their complex structure and market mechanics to identify mispriced
bonds using valuation models.
2) For bonds that are comparable, pricing errors can be identified, and
those pricing errors will correct themselves over a specified investment
horizon.

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 Credit Relative Value Strategies

– A good starting point for credit relative value analysis is the decomposition
of historical bond returns.
– In addition, the macroeconomic factors that have caused each source of
return should be analysed.
– The technique of decomposing the historical total return into its different
sources is referred to as return attribution analysis.

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 Credit Relative Value Strategies

– Credit Relative Value Secondary Market Trades

– Portfolio managers are continuously bombarded with macroeconomic
data and industry and company-specific information, causing them to
constantly revise their expectations.
• As expectations change, there is motivation for making trades in the
secondary market.
• There are the following types of trades:
– yield spread pickup trades
– credit-upside trades
– credit-defence trades
– new-issue swap trades
– sector-rotation trades
– curve-adjustment trades
– structure trades

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 Credit Relative Value Strategies

– Yield-Spread Pickup Trades

– Despite the warning about the limitations of yield measures, a major
reason for secondary market trades in credit markets appears to be to
swap one corporate bond for another with a higher credit spread.
– When the trade is undertaken, the portfolio manager must be sure that
it is a dollar-duration-neutral trade, so that the portfolio is not impacted
by changes in the level of Treasury rates.
– The success of such trades is measured by their realised returns, which
will depend on factors other than the magnitude of the current credit
spread for the two corporate bonds that are candidates for a swap.

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 Credit Relative Value Strategies

– Credit-Upside Trades
– Suppose that a credit analyst covering a particular sector within the
corporate bond market believes a particular issuer will have a credit
upgrade and is currently trading at a wider spread than what it would
if the credit rating were upgraded.
– The action that might be taken by the portfolio manager to whom the
credit analyst reports is to acquire the issue that is expected to be
upgraded.
• Such a trade is referred to as a credit-upside trade.

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 Credit Relative Value Strategies

– Credit-Upside Trades
– Credit-upside trades are often done for high-yield corporate bonds
expected to be upgraded to an investment-grade credit rating.
– The benefits of such a trade would be twofold.
1) If the upgrade to investment grade does occur, the expected
return would be better than that of other investment-grade
corporate bonds with the same credit rating because of the
narrowing of its credit spread.
2) Because the issue will be moved from a high-yield corporate bond
index to an investment-grade corporate bond index, its liquidity
would be expected to improve.

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 Credit Relative Value Strategies

– Credit-Defence Trades
– In contrast to a credit-upside trade, a credit-defence trade occurs when
there is uncertainty about the impact of macroeconomic or industry
events that may adversely impact credit spreads.
– The question that is faced by a manager when there is a downgrade is
whether to sell the downgraded issue.
– There are three factors that the portfolio manager must consider.
1) A downgrade to a credit rating below that permitted by the
client’s investment guidelines may require that the downgraded
issue be removed from the portfolio.
2) An analysis of the potential expected return by retaining the issue
versus that of replacing the issue must be performed.
3) In the decision to dispose of a downgraded issue, the portfolio
manager may be slow to remove an issue if a loss must be
realised.

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 Credit Relative Value Strategies

– New-Issue Swap Trades

– Trades from seasoned issues to new issues, referred to as new-issue swap
trades, occur for two reasons.
1) New issues are viewed as having better liquidity than seasoned
issues.
2) A further reason is to gain exposure to a new issuer or to a new
type of corporate bond structure.

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 Credit Relative Value Strategies

– Sector-Rotation Trades
– The three broad sectors within the corporate sector are financials,
industrials, and utilities.
• Within each of these sectors there are further classifications by
industry.
• The purpose of these trades, referred to as sector-rotation trades, is
to overweight the sectors within the corporate market that are
expected to perform better than other sectors, which are then
underweighted.
• Within each sector, the same is done by industry.

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 Credit Relative Value Strategies

– Curve-Adjustment Trades
– Trades are undertaken to adjust a portfolio’s duration relative to that of
the benchmark.
• The portfolio duration can be adjusted to maintain its equality with
the duration of the benchmark, an interest-rate position taken when
the portfolio manager wants to be neutral to the benchmark.
• Adjusting the duration of a portfolio so that it is less than or greater
than that of the benchmark is based on expectations about future
interest-rate movements.
• Trades for the purpose of adjusting portfolio duration are referred
to as curve-adjustment trades.
– Typically, curve-adjustment trades are done in the more liquid Treasury
market (cash or derivatives) rather than in the corporate bond market.

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 Credit Relative Value Strategies

– Structure Trades
– Structure trades involve one of the following:
1) swaps from one structure, such as bullet, callable, or puttable
bonds, to a different structure;
2) swaps into different coupon types (fixed to floating or floating to
fixed); and
3) swaps from less restrictive covenants to more restrictive covenants
or vice versa.
– The decision to do a structure trade is based on expectations about
changes in yields, spreads, and interest-rate volatility.

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 Required reading

– Fabozzi, F.J. and Fabozzi, F.A. (2021), Bond Markets, Analysis, and
Strategies, 10th edition, MIT Press
– Chapters 24 to 26

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 Homework problems

– Fabozzi and Fabozzi (2021)

– Chapter 24
• Questions 10, 12, 14, 17, 19, 20, 21

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