Editor’s Letter

We begin this issue of The Journal of Fixed Income with two useful articles for managing the risk in mortgage-backed securities (MBS). First, Michael Landrigan and Danny Sun provide a methodology for estimating deltas on mortgage options and the implications for skew and valuation. The most important first order dimension of risk assessment in MBS is effective duration. The assumption of an interest rate distribution in modeling MBS cash flows is crucial to prepayment forecasts and, hence, an effective duration estimate. In the next article, Xu Bai employs a quadratic Gaussian model to provide an alternative to the problems associated with either the normal or lognormal assumptions.

The next three articles concern bond investment strategies that provide significant information concerning investment performance. First, Johan Duyvesteyn and Martin Martens use bond momentum, equity momentum, and term spread as factors to predict the interest rates of emerging government debt issued in local currency. Their investment strategy evidence indicates 1.2% of outperformance a year after transaction costs. In their article, Jon Fulkerson, Susan Jordan, and Timothy Riley find that traditional liquidity measures, along with prior deviations from net asset value (NAV), are significant in explaining bond exchange-traded fund (ETF) premiums and discounts. Furthermore, a long–short portfolio strategy designed to exploit these deviations generates an alpha of 0.96% a month or about 11.5% a year. Next, Hongfei Tang and Xiaoqing Eleanor Xu examine the tracking performance of leveraged and regular fixed-income ETFs with major indexes. They find tracking error is generally large and increases as a function of maturity, credit risk, and leverage.

Finally, Andrei Shynkevich employs a combination of market bond prices and credit default swap spreads to infer and separately identify the term structure of implied default probabilities and the term structure of expected recovery values for corporate debt.

We hope you enjoy this issue of The Journal of Fixed Income. Your continued support of the Journal is greatly appreciated.

TOPICS: Fixed income and structured finance, fixed-income portfolio management, portfolio theory

Stanley J. Kon

Editor

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