Fixed Income Portfolios: Bonds
Active management looks to earn investment returns by buying and selling in anticipation of price changes. Price changes can be caused by changes in an issuer's credit rating (default risk) or by changes in interest rates (investment risk), but traders concentrate on investment risk. They do this for two reasons:
- Traders tend to trade the highly liquid government bond markets because they need the large size, high volume opportunities these markets provide. Credit ratings are not an issue in this market as most government debt is default-risk free.
- Traders want to be able to execute strategies in which there is only one variable - interest rates - without the complications of having to think about credit issues as well.
Bond prices move inversely to interest rates. And because interest rate risk varies depending on maturity, bonds of different maturities respond differently to changes in interest rates - so changing the shape of the yield curve. Let's look at an example.
If a trader believes that the yield curve is either too steep or too flat, then a profitable trade would be to go short (sell) in bonds of one maturity, and go long (buy) in another maturity.
Here the yield difference between 1 and 3 year bonds is abnormally high and the trader believes the curve will flatten narrowing the yield differential between maturities. So the trader sells the 1year and buys the 3 year.
When the yield curve flattens, the trader closes out the position by selling the 3 year which is now more expensive, and buys back the lower cost 1 year bond, gaining a yield pick-up of 62 basis points which is the difference between the maturity yields on each leg of the trade.
There are many different strategies which bond traders can employ but the underlying aim is always the same in an active strategy. Active traders are looking for short-term profit (so-called yield pick-ups) and an active bond portfolio will hold issues across the most volatile maturity bands in order to get that profit.
As with equities too, an active strategy is a higher risk strategy than a passive strategy.
