Some information on the unique management of a bond portfolio has just come to my attention and I could not let this opportunity go. The information has to do with a bond fund, Old Mutual Global Strategic Bond Fund, a $1.5 billion fund managed by Stewart Crowley. The source of the information is the Wall Street Journal article “This Bond Manager Hates Bonds.”
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“Mr. Cowley has gone into hyperdrive with a highly unorthodox strategy: He has taken large negative positions on major government bonds by ‘shorting’ (or betting against) contracts tied to the bonds’ future performance. His duration is minus-four years.”
Mr. Cowley is betting that there will be a substantial rise in interest rates as they pertain to bond yields.
By taking this “negative bet”, Mr. Cowley has positioned himself to that his fund will rise on average 4 percent for every one-percentage-point rise in the average interest rate for the bonds in his fund.”
Frank Fabozzi, in his CFA text “Fixed Income Analysis,” defines duration as “a measure of the approximate price sensitivity of a bond to interest rate changes.” He goes on: “More specifically, it is the approximate percentage change in the price for a 100 basis point change in rates.”
Thus, if there is a 100 basis point rise in interest rates, a bond that has a duration of 4, then the price of that bond will fall by about four percentage points.
In other words it is a measure of the interest rate risk that exists in a bond and is dependent upon expected cash flows that are earned on a bond.
The duration measure was created because most bonds not only have a return of principal when the bond matures, but also receive cash payments during the life-time of the bond associated with timely interest payments.
If the issuer of a bond only makes a payment to the acquirer of the bond when the bond matures, a payment that includes both the return of principal and the payment of interest, then the duration of the bond will be exactly the same as the maturity of the bond.
Since, most bonds make cash payments during the life-time of the bond, the duration of the bond will be less than the maturity date of the bond.
Note, however, that the duration of a bond is usually stated in terms of negative relationship. A rise in interest rates will lower the price of a given bond. And, the duration of the bond is closely related to the potential volatility of the price of that bond in the market. A bond that has a longer duration will experience greater volatility in price that will a bond that has a shorter duration.
But, what has Mr. Crowley done? His positioning has changed the sign to the relationship.
Mr. Crowley has positioned himself so that a rise in interest rates will bring about a rise in the value of the bonds he has in his portfolio.
Many bond strategists have suggested that in the current interest rate environment, managers of bond portfolios should shorter their duration “to mitigate damage from potential rate increases.” I have written about this strategy in my post of October 3.
Mr. Crowley has gone one step further in reversing the sign associated with the duration measure. He has done this by shorting bonds…rather than purchasing them. And, he has not only moved to a slightly positive sign, he has upped his bet by achieving a duration of 4!
Mr. Crowley’s reasoning can be supported in this way. There are times when government policy leads to situations where the outcomes are almost “sure things.” One of the most famous of these was the “bet” that George Soros made against the English government in the early 1990s. Soros believed that it would be impossible for the English government to maintain the value of the pound and therefore sold the pound “short.” He made a lot of money in what looked like a “riskless” bet.
In such a situation, why should an asset manager be prohibited from making such a “sure thing” bet? Mr. Crowley is saying that, sooner or later, interest rates are going to have to rise on US Government debt. Why is the only available strategy the one that just says “buy issues that have a short duration?”
Since the 1980s, investors in bonds have been able to benefit from an extended bull market in bonds. Now when it appears the bond market might become something of a bear market, why shouldn’t investors be able to benefit from market movements in the other direction?
Governments create these kinds of situations from time-to-time. These situations usually occur when governments are faced with policy options, none of which seem to be good ones. An astute investor needs to be on the look out for them. The astute investor needs to be able to invest with managers that can take advantage of them.
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.
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