Bob Smith, portfolio manager at Sage Advisory Services, says he will shift 10% of the firm's portfolio, or $100 million, from bullet to callable agencies, as he anticipates interest rates will rise early next year. The move is a defensive play: when interest rates rise, negatively convex callable debentures will decline in price less quickly than their bullet counterparts, says Smith. In addition, because interest rates are at an all-time low, selling expensive bullets and buying cheap callables makes sense. Smith will initiate the move immediately to take advantage of this arbitrage.
One example of a trade is the purchase of the five-year Federal Home Loan Bank callable bond, which is non-callable for two-years and which, last Monday, traded at 70 basis points over the curve. Another potential buy is the FHLB seven-year bond, which also has two years of call protection, and which, last Monday, traded at 80-85 basis points over Treasuries. Smith says he will avoid buying Freddie Mac or Fannie Mae debentures and may, on a case-by-case basis, consider selling their bullets. He is concerned that efforts by Congressman Richard Baker (R-La.) to reform Fannie Mae and Freddie Mac may compromise the ability of those issuers to raise money in the market.
Based in Austin, Texas, Smith manages a $1 billion portfolio. He allocates 40% to agencies, 11% to corporate financials, 10% to bonds of industrials companies, 10% to Treasuries, 6% to international corporates, 5% to collateralized mortgage obligations, 5% to asset-backed securities, 5% to agency pass-through, 4% to corporate utilities and 4% to cash. With a 3.30-year duration, the fund is shorter than its benchmark, the Lehman Brothers government/credit intermediate index, which has a 3.64-year duration.
