How Managers Add Value to a Bond Portfolio

The performance of an actively managed fixed-income portfolio is measured against a designated benchmark (e.g., an index or liability structure). Portfolio managers employ five basic strategies to add value relative to the benchmark. First, bond portfolio managers may seek to outperform by extending duration before a rally and shortening duration before a sell off. That is, they can take a directional view on the interst rates. Unfortunately, portfolio managers who possess the skill need to successfully employ this strategy on a consistent basis are scarce. Consequently, guidelines for most managed funds impose fairly tight duration targets on portfolio managers.

A second strategy to outperform is to take views on the future slope of the yield curve as opposed to the future level of interest rates. Managers would put on steepening trades before the yield curve steepens and flattening trades before the yield curve flattens. Barbells and bullets are among the most commonly used vehicles. Specifically, a flattening yield curve tends to favor barbells while a steepening yield curve tends to favor bullets. Most portfolio managers have more latitude to express curve-shaping views than directional views but they are still constrained. Perhaps they are merely reluctant to do so.

The third strategy that can be employed is one when there is a mismatch between a manager’s view on expected volatility and the implied volatility of bonds with embedded options, This strategy involves buying or selling convexity before realized volatility increases or decreases can enhance return. The convexity and volatility trades can be implemented through bullets and barbells, through bonds with embedded options like structured products or through the interest rate derivatives markets.

Sector selection is the fourth strategy. Fixed-income markets are comprised of various sectors which include Treasuries, agencies. corporates, structured products, etc. Since the returns across sectors are imperfectly correlated, managers can add value by overweighting sectors expected to outperform and underweighting expected to underperform.

The fifth strategy, and probably the most common one, portfolio managers attempt to outperform benchmarks through security selection. When pursuing a security selection strategy, managers attempt to overweight cheap issues and underweight rich issues to enhance total rate of return relative to their benchmark. For this to occur, one or more of the bond’s risks must be mispriced.