For example, a convertible feature states that the bond can be exchanged at a certain value for the common shares of the corporation issuing the bond. Say XYZ bond has a conversion feature that allows the holder to exchange it for XYZ common shares at $50 per share. If XYZ shares are trading at $60 per share, the value of the bond will be driven more by the performance of the shares than on a change in interest rates.

A retractable feature gives the holder the right to sell the bond back to the issuing company at a specific date. Say the bond has ten years remaining, but you have the right to retract it to the company at its face value in one year. Even though it has a ten year term, it may, because of the retraction feature, act like a one year bond. Point is, every feature of a bond in some way alters how its price changes.

Bond managers understand these pricing properties when managing fixed income portfolios, and generally employ either an active or passive approach to exploit these pricing models.

Passive managers buy and hold securities for the long term, because they believe that a bond’s price generally reflects all available information, and as such, no bond is ever really undervalued or overvalued. If no price discrepancies exist, then trading to exploit discrepancies, becomes a moot point.

By contrast, active managers believe that the market does allow undervalued and overvalued securities to exist. More importantly, they believe that capturing those discrepancies can generate returns that outweigh transaction costs and mistakes.

Not to come down on one side or the other, because both approaches over the long term, work. For individual investors, perhaps the most sensible approach is to have some of your fixed income allocation invested passively and some actively. At least with this approach, you pick up another risk reduction benefit known as diversification by management style.

Passive Approaches

There are three main approaches to passive bond fund management: 1) the dumbbell; 2) the ladder; and 3) the index fund. All use the buy-and-hold approach, but in different ways.

The Dumbbell is a strategy that is heavy on both ends of the portfolio and light in the middle. Suppose, for example, the managers mandate is to concentrate the portfolio in the 10 to 20 year maturity spectrum. The manager may choose to hold say 45% of the portfolio in 10-year bonds and another 45% in 20-year bonds. The 10% residual in invested somewhere in the middle.

Managers generally employ this approach recognizing that it is impossible to know all bonds well. It is easier to familiarize yourself with bonds in the 10 and 20 year range, and then to spot the ones you want to own.

Dumbbell portfolios tend to have higher turnovers, which makes sense if you look down the road one year. At that point, the portfolio would hold mostly 9-year and 19-year bonds, and a few in between. Some 90% of the portfolio would have to be rebalanced to buy new 10- and 20-year bonds, and the same trade would have to be executed every year. The result, higher transaction costs.

The Ladder

One way around high transaction costs is to construct a laddered portfolio. Using the same mandate as above, managers could also invest 10% of the portfolio in 10-year bonds, 10% in 11-year bonds, and so on up to the 20 year mandate. Hence the term ladder.

A year later, the 10-year bonds have become 9-year bonds, just as all the other maturities have declined by one year. The manager can simply sell the 9-year holdings and reinvest the proceeds in new 20-year bonds, putting the ladder back in place for another year. The advantage is less turnover and lower transaction costs, the disadvantage is that the manager can’t specialize as much in knowing a particular maturity.

The Index

A third passive alternative is to buy and hold a universe of bonds. This could include short, mid, and long maturities, high, medium, and low coupons, and a full range of credits. That’s the makeup of an index fund.

A very popular Canadian bond index is the ScotiaCapital Universe Bond Index, which consists of some 900 different bonds. A bond manager may seek to replicate this universe by buying each of the bonds covered by the index in the same proportion as the index. This is the approach taken by iShares Canadian Bond Index Fund (symbol XBB).

Similarly, the iShares Canadian Short Bond Index Fund (XSB) track a short term bond index, and iShares Canadian Real Return Bond Index Fund (XRB) track a real return bond index.

Active Approaches

Active investing involves trading in and out of various positions based on whether the asset is perceived to be undervalued or overvalued. Two common strategies in the search for valuation discrepancies is; Interest Rate Anticipation and Credit Spreading.

The Interest Rate Anticipator

Fixed-income managers know that low coupon, long-term bonds rise the most in price when interest rates fall, and that high-coupon, short-term bonds fall the least when interest rates rise. An active manager can attempt to forecast changes in interest rates and position the portfolio to profit more (from rate drops) and lose less (from rate increases) than a statically held passive portfolio.

In anticipation of an interest rate decrease in the near future, managers can extend the average term of the portfolio. In other words, sell most of the bonds in the short end of the portfolio and use the money to buy long-term bonds and thus the portfolio would benefit from Property three that was discussed last week (archived articles can be found at www.croftgroup.com then click Articles). Similarly, if a rate increase is anticipated, managers can shorten the average term of the portfolio, by selling long bonds and buying more short term bonds.

The Credit Spreader

Property four that was discussed last week noted that each bond is assessed a certain credit rating. We also noted that a rating cut or upgrade on a particular bond can have a significant effect on its price, enough that an active manager who correctly forecasts the change can make a profitable trade.

The typical credit spreader does not try to forecast a rating change for any single bond. This type of manager knows that all bonds of the same rating will have approximately the same yield. For example, all bonds rated BBB will have similar yields as will all bonds rated AA. But yields on AA-rated bonds will be lower than yields on BBB bonds, reflecting the higher risk inherent in BBB bonds.

However, the yield spread between different credits can vary over time. Suppose the typical yield spread between AA and BBB bonds is one percentage point but that this spread also varies over time. If the spread between AA yields and BBB yields narrows to an unusual level, let’s say 0.25 percentage point, an active manager might sell AA bonds and buy BBB bonds in anticipation of that spread returning to more normal levels. If the manager is correct and the spread widens back to one percentage point, the price of BBB bonds will rise relative to AA bonds, and the manager will profit.

In short then, there are many ways one can actively manage a fixed-income portfolio. Term extension or reduction, changes in credit, credit spreading, and substituting coupon for gain and vice versa are just some examples. Opportunities abound, but in the end active managers must spend the time, do the research, incur the transaction costs, and get the magnitude and direction correct more times than they get it wrong in order for active management to provide superior returns to the passive alternative.

Next week, we will look at the role bonds play in your portfolio.