The excerpt that follows is taken from an article titled "Smith Plans to Shorten," which appeared in the January 27, 1992,

Question

issue of BondWeek, p. 6:

"When the economy begins to rebound and interest rates start to move up, Smith Affiliated Capital will swap 30-year Treasuries for 10-year Treasuries and those with average remaining lives of nine years, according to Bob Smith, Executive V.P. The New York firm doesn't expect this to occur until the end of this year or early next, however, and sees the yield on the 30-year Treasury first falling below 7%. Any new cash that comes in now will be put into 30-year Treasuries, Smith added."

What type of portfolio strategy is Smith Affiliated Capital pursuing?

Answer 1

Smith appears to be following an interest-rate expectation strategy. A manager who believes that he or she can accurately forecast the future level of interest rates will alter the portfolio's sensitivity to interest-rate changes. As duration is a measure of interest-rate sensitivity, this involves increasing a portfolio's duration if interest rates are expected to fall and reducing duration if interest rates are expected to rise. For those managers whose benchmark is a bond index, this means increasing the portfolio duration relative to the benchmark index if interest rates are expected to fall and reducing it if interest rates are expected to rise. The degree to which the duration of the managed portfolio is permitted to diverge from that of the benchmark index may be limited by the client.

If we can assume the remaining maturities or the same, it appears that Smith is following a substitution swap strategy. A swap in which a money manager exchanges one bond for another bond that is similar in terms of coupon, maturity, and credit quality, but offers a higher yield, is called a substitution swap. This swap depends on a capital market imperfection. Such situations sometimes exist in the bond market owing to temporary market imbalances and the fragmented nature of the non-Treasury bond market. The risk the money manager faces in making a substitution swap is that the bond purchased may not be truly identical to the bond for which it is exchanged. Moreover, typically, bonds will have similar but not identical maturities and coupon. This could lead to differences in the convexity of the two bonds, and any yield spread may reflect the cost of convexity.