This case is from Textbook 2 Page 267 Example 6. I have questions for the solution.
Arturo manages a mutual fund that is benchmarked to the Global Aggregate Bond Index. He currently has a bullish view of the global economy and believes corporate bond spreads are attractive. He is bearish on US Treasury interest rates given his economic growth forecast and expects rates to increase. The fund’s US corporate bond holdings have a duration of seven years. He believes the best opportunities are in emerging market securities, and in particular, he is bullish on Brazilian rates, expecting them to decrease. The fund has experienced strong inflows recently and is fully invested. Arturo is evaluating tools to potentially increase the fund’s total return by creating leveraged fixed-income
exposures. Given Arturo’s plan to leverage exposures in his fund, discuss how he would achieve his objectives and identify the strategy risks.
Solution:
The mutual fund is fully invested and, therefore, Arturo needs to use leverage to potentially increase his returns. His bearish view on US Treasury interest rates would require that he reduce the fund’s seven-year duration contributed by the US corporate bond holdings. He can sell the number of futures contracts on US Treasuries whose notional value and associated duration would offset the duration of the corporate bonds to his new target duration. Doing so would allow him to retain exposure (spread duration) to the corporate bonds whose spreads may contract as the economy grows while shedding the interest rate exposure, since he believes rates will rise, adversely affecting bond prices. Arturo’s bullish view on Brazilian rates can be expressed by entering into a receive fixed-rate, pay floating-rate swap on Brazilian rates. The fund will effectively have the equivalent of a fixed-rate bond that will appreciate in price if his view materializes and Brazilian interest rates fall.
Both the short US Treasury futures and long Brazilian interest rate swap positions are leveraged since the only capital used is the collateral required by the counterparties. The risk to the leveraged strategy is that if Arturo’s view on either position turns out to be incorrect, losses are magnified. This may also require positions to be closed and assets sold to cover the losses, which may occur at an inopportune time if the markets have sold off.
Here’s my question:
“His bearish view on US Treasury interest rates would require that he reduce the fund’s seven-year duration contributed by the US corporate bond holdings.”
- How to deduct reduce duration from bearish view? Please give me a hint. Thank you.