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Active bond portfolio management often involves tactical shifts in allocations among different bond sectors or between long and short positions in maturity and credit spreads. In undertaking active strategies, managers are motivated by the belief that they are able to generate excess risk-adjusted returns by correctly timing changes in the level of yields, the slope/curvature of the yield curve, or credit spreads that are not generally anticipated by the market. Given the rich literature linking yield spread patterns to both the business cycle and changes in the level of short-term interest rates (the rate cycle), we motivate and demonstrate the efficacy of spread-trading strategies that trigger reallocations using "turning points" in the cycles.
We investigate allocation strategies stemming from two common approaches: 1) rate anticipation spread trades and 2) intermarket spread trades (see Fabozzi [2004] for an extended treatment). In rate anticipation spread trades, the belief that there will be future (unexpected) increases or decreases in interest rates that will cause the market value of the portfolio to fluctuate motivates managers. A manager increases the duration of the portfolio if she anticipates rate decreases or decreases portfolio duration if she anticipates rate increases. In intermarket spread trades, the belief that there will be a future unexpected narrowing or widening of the yield spread between bonds in two different sectors (e.g., credit) motivates managers. These two strategies are not viewed as mutually exclusive. For example, a manager might trade out of longer-term corporate debt and into short-term Treasury securities if he believes that the overall level of rates is going to increase unexpectedly and that default spreads are going to widen. In light of this blending of strategies, we also examine trades that combine the approaches.
Ample research that documents 1) the well-established empirical relationships between maturity and credit spreads and both the business cycle and changes in the level of short-term interest rates; 2) the usefulness of short-maturity rates and maturity and credit spreads in forecasting stock and bond returns; and 3) the efficacy of patterns in yields and yield spreads in fixed-income strategies motivates this study.1
We investigate the usefulness of ex ante information inherent in the cycles associated with shifts in yield levels, maturity spreads, and default spreads, through which bond portfolio...