Question

Frank Meyers, CFA, is a fixed-income portfolio manager for a large pension fund. A member of the Investment Committee, Fred Spice, is very interested in learning about the management of fixed-income portfolios. Spice has approached Meyers with several questions. Specifically, Spice would like to know how fixed-income managers position portfolios to capitalize on their expectations of future interest rates.

Meyers decides to illustrate fixed-income trading strategies to Spice using a fixed rate bond and note. Both bonds have semi-annual coupon periods. All interest rate (yield curve) changes are parallel unless otherwise stated. The characteristics of these securities are shown in the following table. He also considers a nine-year floating-rate bond (floater) that pays a floating rate semi-annually and is currently yielding 5%.

Spice asks Meyers about how a fixed-income manager would position his portfolio to capitalize on expectations of increasing interest rates. Which of the following would be the most appropriate strategy?

a. Shorten his portfolio duration.

b. Buy fixed-rate bonds.

c. Lengthen his portfolio duration.

Short answer

Answer

a. Shorten his portfolio duration

Step-by-step solution

Step by Step Solution Step 1: Definition

A fixed income portfolio comprises investment securities that give a fixed interest until maturity. The managers of such portfolios are responsible for analyzing, selecting, trading, and monitoring these securities.

Explanation of the choice of strategy

By reducing the duration, the portfolio value becomes sensitive to changes in interest rates. As a result, if there is an increase in interest rate, the portfolio value will also decrease less.