15.4.4 Fixed-income Manager Styles

Fixed-Income Manager Styles

Fixed-income managers invest in products such as bonds, mortgage-backed securities, fixed-income mutual funds, exchange-traded funds (ETFs), and preferred shares. Their choices vary based on the product’s term to maturity, credit quality, or expectations regarding interest rates.

Term to Maturity

Short-term managers hold T-bills and short-term bonds with maturities of less than five years. Portfolios with these products are less volatile when interest rates rise because they have investments maturing soon that can be reinvested at the higher rates.

Medium-term managers focus on terms to maturity ranging from five to 10 years. Mortgage funds, which generally invest in high-quality residential mortgages (usually NHA insured) with terms of five years, are typical examples.

Long-term managers hold bonds with maturities greater than 10 years.

Credit Quality

Investment-grade bond quality ranges from Aaa to Baa3 as per Moody’s Long-Term Rating Scale (refer to Table 6.5 in Chapter 6). High-quality issuers include federal and provincial governments and well-capitalized corporations. Typically, lower quality bonds offer higher yields.

Managers balance return potential against the risk of default. Many bond portfolios have pre-set credit quality limits to manage this balance.

High-yield bonds, also called junk bonds, are non-investment grade products. These bonds typically offer higher yields but come with greater credit risks. Managers often favor high-yield bonds that mature in less than three years to mitigate risk.

Corporate issues generally have higher yields than comparable Government of Canada issues due to elevated credit risk. By selecting higher-quality corporate issues, managers can improve yield with minimal additional risk.

Another crucial factor is liquidity. Corporate bonds with lower ratings are less liquid than government bonds, making them difficult to sell in declining markets.

Interest Rate Anticipators

Some managers add value by anticipating interest rate direction and structuring portfolios accordingly. Interest rate anticipators extend the average term on bond investments when they foresee a decrease in interest rates and shorten it when they anticipate an increase.

Duration switching is a form of this strategy. It works best with a normal yield curve, where there’s a wide gap between short-term and long-term rates. In a flat yield curve, it is less beneficial to extend the term maturity.

Did You Know?

Duration is an approximate measure of a bond’s price sensitivity to changes in interest rates. If you anticipate falling rates, you could sell lower duration bonds and replace them with higher duration bonds to lengthen the portfolio’s average duration, increasing its price sensitivity. As rates fall, the heightened price sensitivity should lead to greater capital gains.

Portfolio Manager Styles

Different fund managers employ varying management styles. Understanding a manager’s style is crucial for anticipating how a portfolio will behave under different market conditions. Engage in online learning activities to assess your knowledge of portfolio manager styles.

Case Scenario

Help Sal with his questions about risk through various online learning activities. Test your understanding.

Key Terms & Definitions

Engage in identifying and understanding the key terms from this chapter through participatory online activities.

Key Takeaways

1. Fixed-income managers’ strategies vary by term to maturity, ranging from short-term to long-term.
2. Credit quality significantly affects the risk and return of bond investments.
3. Interest rate anticipation and duration switching are strategies used based on forecasts of interest rates.
4. Understanding different management styles is crucial for predicting portfolio behavior in varied market conditions.

Frequently Asked Questions

What are the types of bonds fixed-income managers might invest in?

Fixed-income managers might invest in government bonds, corporate bonds, mortgage-backed securities, and high-yield bonds.

How does term to maturity affect a portfolio?

Term to maturity affects how sensitive a bond’s price is to changes in interest rates—short-term bonds are less sensitive and hence less volatile compared to long-term bonds.

What is the relevance of credit quality in fixed-income investments?

Credit quality determines the risk of default; investment-grade bonds (higher credit quality) generally have lower risk and yield, while high-yield bonds offer higher returns but come with increased risk.

How do managers anticipate interest rates moving?

Managers analyze economic indicators, inflation rates, and central bank policies to predict interest rate movements, adjusting portfolio durations accordingly.

Glossary

• Bond: A fixed-income instrument that represents a loan made by an investor to a borrower.
• Credit Quality: A measurement of a bond issuer’s ability to repay its debt obligations.
• Duration: A measure of a bond’s sensitivity to interest rate changes.
• Yield Curve: A line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.
• High-Yield Bonds: Also known as junk bonds, these are bonds with a lower credit rating and consequently higher return but greater risk.

Charts and Diagrams

    graph TD;
	  A[Fixed-Income Manager Styles] --> B[Term to Maturity]
	  A --> C[Credit Quality]
	  A --> D[Interest Rate Anticipation]
	  B --> E[Short-term <5 years]
	  B --> F[Medium-term 5-10 years]
	  B --> G[Long-term >10 years]
	  C --> H[Investment-Grade]
	  C --> I[High-Yield/Junk Bonds]
	  D --> J[Duration Analysis]
	  D --> K[Yield Curve Analysis]

Figure: Hierarchical structure of Fixed-Income Manager Styles

Further Reading

1. Introduction to the Portfolio Approach
2. Moody’s Long-Term Rating Scale