A fixed income (FI) instrument –more commonly called a bond- is an instrument which provides a consistent/fixed stream of cash flows throughout its life. Unlike shares and other financial instruments -e.g. options etc- where returns are uncertain and unknown, fixed income instruments often provide a stable and already known stream of income for foreseeable future. With greater volatility and uncertainty surrounding the markets, fixed income instruments become lucrative since their returns are known with a greater certainty for foreseeable future. However, the return certainty doesn’t necessarily makes them “risk free” security. In fact, traditionally perceived “risk-free” FI instruments –Treasuries, Tips etc- also entail variety of risks with them. To further elaborate the concept, the bond, return /yield or coupon is a function of: 1 )Maturity 2)liquidity 3)Market returns 4)Ratings 5)Returns of alternative assets 6)Issuer profile etc. Thus what we consider a “risk free return” on a Treasury security is actually a collective compensation for various kinds of risks except credit risk.
Since now we have argued that even so called “risk free” securities are actually a bundle of various risks, there is always value in the market up for grabbing since fluctuations in risk factors keep generating opportunities to generate extra returns. That’s why we see growing active investment mandates for treasuries and other risk free securities since there are always opportunities available given appropriate strategies being used. I will discuss some of them in this article. However, consider this as a primer for active FI management, it is essential to thoroughly understand and predict the future path of interest rate and linkages of financial markets and economy with interest rates to properly position oneself for a winning bet.
First and foremost risk that offers profit opportunity is what we call “price risk”. It means that while face value of FI security coupons and remains same and does not change, its market price does. To understand the dynamics, just consider a bond to be any commodity, say an IPhone. When there is an excessive demand, the holder of IPhone has the incentive to sell IPhone at significantly higher prices. This is exactly what happens when markets are gripped by uncertainty and volatility. Investors seek certainty of returns and thus gravitate towards Treasuries –increasing their demand and thus prices- thus if an investor expects troubled times ahead, it’s just the right time to enter FI market. However, there is a limit to the price appreciation potential since: 1) yield of FI instruments usually don’t fall into negative territory 2) This is a tactical trade –not a buy and hold trade- since price will converge to its par value as the bond matures.
Furthermore, investor can also make decent money out of duration bets. Duration is the % change in the price of security with respect to % change in price. Many analysts and portfolio managers quote duration in terms of years. However, it is incorrect to consider duration as a concept related to maturity or time. Duration is the sensitivity of security with respect to change in interest rate. This sensitivity in turn, is determined by host of factors including the coupon rate, years to maturity, credit ratings etc. To be a bit more elaborative, just consider the Time Value of Money concept. For example if a bond’s coupon and principals as cash flows while the current market rate is the discount factor. The value of bond with higher coupon and longer number of cash flows (maturity) will be more affected by movements in interest rates. This strategy is useful given the longer end of the curve (long term interest rates) remain very volatile to the developments in the market. Since the central banks have a good control over the short term rates (1-3 Years) thus duration bets for the short term rates can be successful if the central bank behavior can be anticipated.
Moreover, the sector allocation can also be used to a good effect in enhancing returns especially investment grade securities and Mortgage Backed securities. MBS securities of federal agencies like Fannie Mae, Ginnie Mae and Freddie Mac can offer a decent yet safe spread (around 20-50 bps) over the traditional treasuries. Furthermore, the maturity of these securities is usually much less than the traditional treasuries (due to prepayment option) making them more acceptable for investors with short term needs. In addition to high quality MBS, a conservative investor seeking yield may also invest in investment grade corporate bonds. This has been especially a very lucrative option since corporate continue to accumulate cash on their balance sheets in the aftermath of great depression. So while high cash on the balance sheet is not favorable for equity investor since it is not an earning asset, it is very favorable for bond investor since even at higher yield than the treasuries, a liquid balance sheet means enhanced credit worthiness. Furthermore, the bond yields also don’t respond as vigorously to bad news (e.g. credit downgrade) as the equity prices. Thus a good yield is on offer to investor if he knows which sectors to are much actually safer than presumed by market.
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