One common goal among fixed-income portfolio managers is to earn high incremental returns on corporate bonds versus government bonds of comparable durations. The approach of some corporate-bond portfolio managers is to find and purchase those corporate bonds having the largest initial spreads over comparable-duration government bonds. John Ames, HFS’s fixed-income manager, believes that a more rigorous approach is required if incremental returns are to be maximized. The following table presents data relating to one set of corporate/government spread relationships (in basis points, bp) present in the market at a given date:
CURRENT AND EXPECTED SPREADS AND DURATIONS
OF HIGH-GRADE CORPORATE BONDS (ONE-YEAR HORIZON)
Bond Ratings | Initial spread over governments | Expected horizon spread | Initial duration | Expected duration one year from now |
Aaa | 31 bp | 31 bp | 4 years | 3.1 Years |
Aa | 40 | 50 | 4 years | 3.1 Years |
a. Recommend purchase of either Aaa or Aa bonds for a one-year investment horizon given a goal of maximizing incremental returns.
b. Ames chooses not to rely solely on initial spread relationships. His analytical framework considers a full range of other key variables likely to impact realized incremental returns, including call provisions and potential changes in interest rates. Describe other variables that Ames should include in his analysis, and explain how each of these could cause realized incremental returns to differ from those indicated by initial spread relationships.
