Active bonds portfolio management attempts to take advantage of either superior bond selection or superior market timing. The former requires a bond portfolio manager who is capable of identifying mispriced bonds. The bond portfolio manager can buy underpriced bonds or sell overpriced bonds. The latter strategy requires a bond portfolio manager capable of predicting interest rate changes. Bond portfolio managers use swaps to implement either strategy.
A substitution swap replaces one bond with another bond that has very similar characteristics, such as coupon rate, time to maturity, rating quality, and call and sinking fund features. A bond is purchased if it is overpriced or sold if it is underpriced. The bond that is replaced is properly priced. The bond portfolio profits when the mis-priced bond moves to the proper equilibrium price.
An inter-market spread swap results when the bond portfolio manager shifts from one sector of the bond market to another sector of the bond market. U.S. Treasury bonds, federal agency bonds, corporate bonds, state and municipal bonds, and mortgage-backed bonds each constitute a sector of the bond market. As market risk perceptions change, the risk premium between the U.S. Treasury bond market and the risky bond sector changes. If the bond portfolio manager can determine the direction of the change in the spread, the composition of the bond portfolio can be shifted to the market sector that will increase most in price.
An interest rate anticipation swap depends on the bond portfolio manager's ability to forecast interest rate changes. If the bond portfolio manager anticipates that interest rates will rise (fall) the duration of the bond portfolio is decreased (increased).
A pure yield pickup swap is implemented by moving from bonds with lower coupon payments to bonds with higher coupon payments. This provides a higher current yield and yield to maturity. The added return leads to higher risk, since the high coupon bond is more likely to be called.
SEE ALSO : Bonds
[ Carl B. McGowan Jr. ,
updated by David P. Bianco ]
Bodie, Zvi. Investments. 4th ed. New York: McGraw-Hill, 1998.
Hirt. Geoffrey A. and Stanley B. Block. Fundamentals of Investment Management. 6th ed. Richard D. Irwin, 1998.
Livingston, Miles. Bonds and Bond Derivatives. Blackwell Publishers, 1998.
Moles, Peter, and Nicholas Terry. The Handbook of International Financial Terms. New York: Oxford University Press, 1997.
Comment about this article, ask questions, or add new information about this topic: