Question

Interest Rate Anticipation is one of widely-used active management strategies for a bond portfolio. Please describe in details how to apply the interest rate anticipation strategy if the interest rate is expected to increase or decline.

Answer 1

A rate anticipation strategy is one that involves selecting bonds that will increase the most in value from an expected drop in interest rates. If a group of bonds are sold so that others can be purchased based on the expected change in interest rates, then it is referred to as a rate anticipation swap. A total return analysis or horizon analysis is conducted to evaluate several strategies using bond portfolios with different durations to see how they would fare under different interest rate changes, based on expected market changes during the investment horizon.

If interest rates are expected to drop, then bonds with longer durations would be purchased, since they would profit most from an interest rate decrease. If rates were expected to increase, then bonds with shorter durations would be purchased, to minimize interest-rate risk. One means of shortening duration is buying cushion bonds, which are callable bonds with a coupon rate that is significantly higher than the current market rate. Cushion bonds generally have a shorter duration because of their call feature and are cheaper to buy, since they generally have a lower market price than a similar bond without the call feature. Rate anticipation strategies generally require a forecast in the yield curve as well since the change in interest rates may not be parallel.

There are a variety of interest rate anticipation strategies. Those which involve moving between long-term government bonds and very short-term treasury bills are based on interest rate forecasts and the way values of securities respond to fluctuations in interest rates.

Basic interest rate anticipation strategy involves moving between long-term government bonds and very short-term treasury bills, based on a forecast of interest rates over a certain time horizon, to provide the maximum increase in price for a portfolio.

Given that long-term bonds change the most in value for a given change in interest rates, a manager would want to hold long-term bonds when rates are falling.

The reverse is true in a rising interest rate environment. Long-term bonds fall the most in price for a given rise in interest rates, so a manager would want to hold treasury bills, which have a very short duration and do not change very much in value. These securities have fixed coupons, which means their price is determined by new issues and relative value in the market.

For example, if a new 10-year government bond is issued with a 6% yield, suddenly an existing 10-year government bond yielding 8% looks quite attractive. Given the new issue’s lower yield, investors will buy the higher yielding bond, pushing up its price, lowering its yield. As a result, demand for the bond will taper out as its price rises.

A more sophisticated interest rate anticipation strategy might involve the use of “zero coupon” or “strip” bonds, which are far more sensitive to interest rate changes than normal bonds. Zero coupon bonds have no coupon payments and therefore have a much longer duration. Their high price volatility makes them especially suitable for speculating on interest rate movements. As the saying goes: “When you are right you are very, very, right and when you are bad you are horrible”.

Mangers looking to implement interest rate anticipation strategies at a lower transactions cost will often look at interest rate derivative securities, such as options and futures.