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Kansas Shop Plays Negative Convexity Bonds

As volatility has increased since Sept.11, Jim Cusser, portfolio manager with Waddell & Reed Investment, has been buying negative convexity bonds, such as callable agencies and pass-through mortgages, on the assumption that volatility will pull back to more normal levels. Cusser says he has been buying $20 million in callable agencies and $30 million in mortgage-backed passthroughs for the past two weeks, representing a 7%, or $49 million, of its portfolio. He says he has done most of his move, although he may add an additional 1.5-2.0%, or $10-20 million more. The move was financed using new cash inflows.

Cusser adds that since Sept. 11, implied volatility has been up 20%, which means that the market shows greater uncertainty as of where interest rates are heading. As a result, callable bonds trade cheaper, he explains. The Overland Park, Kan.-based portfolio manager says he is acting contrary to his typical style--he calls himself "Dr. Put"-- because he thinks volatility is at such high levels right now that it is bound to decrease.

As examples of some recent purchases, Cusser says he bought the Fannie Mae 6.25% of '11, callable in 2006, and the Fannie Mae 5.25% of '06, callable in 2003. His target spread for those bonds is 80 to 90 basis points of Option Adjustment Spread which measures spread compared to the Treasury curve when blending call date and final maturity date. He says the firm will sell the bonds once the OAS tightens to 50-60 basis points. Cusser has also been buying mortgage passthrough from Ginnie Mae with a 30-year average life and a 6.50% coupon at 125 basis points OAS, which the firm expects to sell when the OAS narrows down to 90 basis points.

The firm has a $700 million fund and an asset allocation of 40% corporates, 16% collateralized mortgage obligations, 13% Treasuries, 12% passthroughs, 8% cash, 5% agency debentures, 4% CMBS and 2% ABS. With a 4.72-year duration, the portfolio is slightly long its benchmark, the Salomon Smith Barney bond investment-grade index, which has a duration of 4.21-years.

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