Student Number: 100781798

Candidate Number: 1507817

Course: EC3314 Financial Economics

A critical analysis of GBAs investment strategy, the yield curve kink

decision and the changes in interest rates

Investment strategy:
Greydanus, Boeckh & Associates Inc. (GBA) is an active fund with
$1.7 billion in assets. The fund pursues a conservative investment
strategy by avoiding credit risk of high-yield corporate bonds and
instead focusing entirely on Canadian government bonds. In the
following paragraph I aim to analyse two sides of GBAs strategy.
Eighty per cent of the investment strategy focuses on quantitative
value strategy while the remaining twenty per cent focus on interest
rate anticipation. First, interest rate anticipation is aimed at
maximizing returns by speculating interest rate movements in order
to establish an average rate to maturity. In particular, during a
period of volatile interest rates GBA successfully anticipated the
direction of rate movement and hence decided to put its eggs into
two baskets. With its barbell strategy it split its investments into
long-term bonds but maintained bonds with the target duration
close to benchmark. This way GBA was able to use the interest rate
volatility to its advantage. The long-term bonds protect the portfolio
from losses caused by interest rate decreases. Moreover, by
allowing quick turnovers this strategy poses a sizable advantage.
Short-term bonds are frequently traded to permit profits from
interest rate rises. Second, the core business of the fund is its
quantitative value strategy where investment decisions are based
on valuations models that contrast the selling price of a bond with
the assessment of this bonds intrinsic value. It improves its
accuracy by taking over 50 parameters, including yield to maturity,
coupon rate and time to maturity into account. By trying to identify
cheap bonds it seeks profit. However, based on previous experience
this is a relatively unsuccessful strategy in a high-volatility interest
rate environment.
Performance and Porsche bond:
On the one hand, GBA aimed at taking advantage of the kink it
identified in the government bonds vield curve. The fund was able
to detect cheap bonds and consequently undertook a large position

on the Porsche bond, which was due to mature on the 1st of March
in 2001 with a coupon rate of 9%. Although the bond does have a
comparably long duration, 8.44 years as opposed to the portfolio
duration of 5.65 years and the benchmark duration of 5.47 years,
the fund achieves its goal of remaining within its target duration of
1.5 years within the benchmark duration. By the end of September
1997 yields had dropped and subsequently prices have risen.
Ultimately, GBA enjoyed a fruitful performance.
On the other hand, GBA has not succeeded in attaining its goal of
outperforming the market or the SCM Universe Bond Index by 50
basis points on an annual basis. The fund has attained the goal in
only six out of ten times and out of these six times GBA attained its
main goal, outperforming the market by 0.5%, only three times. This
demonstrates a weak performance.
However, it is crucial to consider that GBA has exhibited consistent
returns with its investment strategy. Most importantly, it has not
incurred substantial losses to its clients and kept attracting new
clients due to its strong track record. Given its conservative
approach to investment it has kept its promise of producing aboveaverage returns with bearing minimum risk.
Economic Outlook, interest rate changes and further
analysis:
Canadian bond markets remained attractive and have substantially
benefitted from weak economic growth in Asia and Europe and US
economic strengthening. Central banks, such as the Federal
Reserve and the Bank of England, have demonstrated their
commitment to tackling excessive growth by constricting spending
in the economy. Keeping inflation low was the main aim of this
monetary action. Similar to the United Kingdom previously, in the
last quarter of 1997 the Canadian central bank increased its rates
and experienced a rise in its bonds market. The rational behind this
is that central banks dictate short-term rates. Market forces, on the
other hand, dictate long-term rates. Given these conditions it seems

reasonable to assume low inflation levels in the long run. This in

turn will manifest itself in the form of short-term risk to bond
holders. The Bank of Canada has pursued constricting monetary
policy in October 1997, which rattled short-term rates.
Consequently, a rise in long run rates will remain a temporary
phenomenon. In addition, appreciating currency levels will decrease
inflationary expectations in at a faster pace than the rise in rates.
This in turn supports keeping long-term rates at a low level.
An interesting analysis is that the interest rate and monetary policy
trends favour the profitability of the Porsche bond. Taking future
investment strategies into considerations GBA should consider
reducing duration. Yet they should not incorporate generating profits
from short-term investment strategies but remain in the long-term
sphere. Finally, It should be considered that the net payoffs for
clients are unclear since further costs such as management fees are
not included in the report.
Yield and bond prices:
The yield to maturity is the annual rate of return a bond is expected
to generate if the bond is held until the end of its lifetime. In order
to infer the YTM value investors must take factors such as coupon
payment, maturity date but also bond price into consideration. In
general prices of bonds are inversely related to their yields. Duration
summarizes the effective average maturity of a portfolio. Moreover,
it is used to approximate the change of bond price as response to a
change in interest rate.
Since duration is a linear relation there will be some price
measurement error when the change of yield is high. Duration is
unable to capture the non-linear relationship of change in bond price
due to a high change in yield. At this point convexity is necessary to
accurately capture this relationship.

Word count: 947

Potential gains of the Porsche Bond are illustrated in the following

table.