While bonds are often purchased to be held to maturity many a times they are not. Henry Kaufman, a renowned bond expert argues that ‘bonds are bought for their price appreciation potential and not for income protection. Many bond investors subscribe to this view and pursue active strategies. They seek to profit by (1) forecasting interest rate changes and/or (2) exploiting relative mispricings among bonds.
Forecasting Interest Rate Changes:
Bond prices and interest rates are inversely related. Hence, if an investor expects interest to fall, he should buy bonds, preferably bonds with longer maturity (more precisely longer duration) for price appreciation. On the other hand, if an investor expects interest rates to rise, he should shun bonds, particularly bonds with longer maturity. While this approach may appear tempting, it must be borne in mind that interest rate forecasting is a difficult and uncertain task. Hence betting on interest rate movements is a risky proposition.
Exploiting Mispricings among Securities:
Bond portfolio managers regularly monitor the bond market to identity temporary relative mispricings. They try to exploit such opportunities by engaging in bond swaps – purchase and sale of a bond – to improve the rate of the return. The most popular bond swaps are described below.
Substitution Swap: A substitution swap involves bonds that are very similar in terms of credit rating, coupon payments, maturity, call provisions and liquidity. The only difference between them, at a particular time, is that they sell at different prices and hence different yields. The swap is made from the lower yield bond to the higher yield bond. If the yield on the latter declines to that of the former the bond holder enjoys capital appreciation.
Pure Yield Pickup Swap: A pure yield swap involves a switch from a lower yield bond t a higher yield bond of almost identical quality d maturity. Unlike a substitution swap, this swap is not based on expectations about price changes. It is motivated strictly by a desire to earn a higher yield.
Inter-market Spread Swap: An inter-market spread swap seeks to benefit from the expected changes in the yield differences between various sectors of the bond market. For examples a bond investor may believe that the yields of utility bonds and Treasury bonds are misaligned. If the difference between the yields is perceived to be too wide, the bond investor would switch from Treasury bonds, Utility bonds in the hope that the difference will become narrow in future.
Tax Swap: A Tax swap involves selling an existing bond at a capital loss, using the capital loss to offset capital gains in other securities, and purchasing another bond with similar features.
Need for Active Management:
An eminent investment expert argues in favor of active management of bonds. Although, buy-and-hold is a realistic option for investors who buy equities, it is an act of wanton imprudence for investors in debt securities. Ultimately of course a debt security reverts to cash, and therefore earns nothing for its owner. Well before the maturity date, however, its entire pattern behavior changes with the passage of time. This means that active management of fixed income securities is an inescapable responsibility.
Interest Rate Forecasting Models:
A wide range of models are used for interest rate forecasting. Some models are based on forecasting the expected inflation rate, the key determinants of interest rates. The advantages of these models are: (1) There is a solid link between expected inflation and interest rates (2) They are relatively simple. The disadvantages of such models are: (a) They may not be very helpful in short term forecasting (b) It is not easy to predict expected inflation.
Then there are models that forecast interest rates based on past interest rate changes. These models emphasize the time series behavior of interest rates and predict further interest rates using distributed lags of past interest rates. These models are simple to implement as they rely on available information. However, shifts in fundamental factors may alter the distributed lag relationship.
Some other models assume that interest rates move in a normal range, thanks to the mean reversion tendency. If the normal range is known it is simple to build such models. However, the normal range may shift over time if fundamental variables change.
Finally, there are comprehensive multi-sector models of the economy that attempt to predict interest rates. These models look at the supply and demand of funds in the economy from all sources and their impact on interest rate changes. While these models are comprehensive in their nature, they require numerous inputs which may be difficult accurately.