Lee Thomas guides investors through the enormous opportunities the US fixed interest markets present

Fannie Maes, Strips, munis, pass throughs - new investors in the US bond market often find its choice of instruments, not to mention its jargon, a little bewildering. The US fixed income market is the most diverse in the world. Understanding this is key to performance. A good US bond manager will usually exploit the extraordinary breadth of the $9trn market by taking positions in many sectors. A good manager also makes sure that no single risk dominates his portfolio.

As well as US Treasury securities and futures contracts on them, investors can choose among corporate bonds, mortgage backed securities and municipal bonds as well as a large and liquid market in debt securities backed by other assets, such as credit card receivables.

No other country boasts all these markets. Asian markets are very sparse by contrast, though a modest corporate bond market exists. Europe's fixed interest markets look more like the US model, and are expected to resemble it even more following European monetary union in 1999. But at present, Europe's corporate bond and asset-backed securities markets are small compared to the US, and mortgage-backed securities markets don't really exist outside Denmark. (Germany's Pfandbriefe are not like US or Danish mortgage backed instruments because they trade without the prepayment complexities.)

From a bond manager's perspective, of course, a big choice of market segments means a plethora of ways to add value (see Figure 1). So different US bond managers follow a wide array of different strategies.

Some are mainly top down managers, some bottom up, some take big duration bets against the benchmark; others add value by rigorous credit analysis, or by specialising in specific credit sectors such as mortgages.

The basic tool for adding value in any US fixed income portfolio is good macroeconomic analysis, just as it is in Europe's bond markets. A successful manager must be able to judge the likely direction of US rates, forecast whether short or long rates are likely to move more, and also predict how volatile interest rates will be.

However, by contrast with Europe, rotating among sectors is a key source of additional return for bond managers in the US. Managers make relative value comparisons among the many US fixed interest sectors, then overweight cheap sectors and underweight expensive ones. Watching developments in each sector is a full time job for experienced professionals, so US managers should appoint dedicated sector specialists within their firms. Generalist portfolio managers, working in a 'hub and spoke' structure, draw on the insights of these sector specialists to construct the overall portfolios (see Figure 2).

Our approach to the market is primarily top down, with a focus on total return (income plus capital appreciation). Major shifts in portfolio strategy are driven by long term, or secular, trends such as demographics, political factors, and structural changes in the global economy. Each year, PIMCO debates the impact of these secular forces and arrives at a 3-5 year outlook for the direction of interest rates.

This interest rate outlook is used to set a general maturity/duration range for portfolios against their benchmarks. Shorter-term, cyclical considerations - such as recent monetary and fiscal policies, the state of investment demand on the part of businesses, and consumer confidence - also influence this target duration range. In order to cap clients' exposure to violent swings in the market, we aims to keep portfolio duration fairly close to the benchmark index (typically one and a half years above or below index duration)

Forecasting the slope of the yield curve and interest rate volatility are also critical to managing US bond portfolios. Given a duration target, a portfolio consisting of a mixture of long and short bonds (called a barbell structure) will perform differently from a portfolio invested purely in intermediate bonds (a bullet structure), depending on changes in the slope of the curve and volatility.

Volatility also influences choice of coupon, quality, the use of futures and options, and the pricing of complex securities. And volatility can have a dramatic impact on the relative performance of bond market sectors. Increasing volatility, for instance, benefits non-callable bonds such as Treasuries, while declining volatility will favour callable instruments such as corporates and mortgages.

How do these insights translate into a strategy for a typical portfolio?

In early November, PIMCO's managers were targeting portfolio durations at about six months above benchmarks to benefit from price gains as rates continue to fall. A Fed ease was expected to result in a steeper yield curve, so managers held fairly bulleted portfolios of intermediate term bonds (five to 10 years) that would outperform in such an environment. Managers were also using futures and options strategies, if clients allowed, to pick up basis points from a steeper curve. Though lower rates can trigger increased prepayments, we were overweighting mortgages in order to add yield. The recent market turmoil had made them relatively cheap. On the other hand, though corporate yield spreads over Treasuries had widened, we were underweight investment grade corporates because they remained vulnerable to earnings disappointments. Managers were, however, holding onto selected below-investment-grade bonds in non-cyclical industries that are better able to withstand an economic downturn.

Making such complex decisions requires advanced quantitative tools - another marked difference from the way bonds are managed in Europe. So US fixed income houses often employ professionals with scientific or mathematical training - so-called rocket scientists - to develop formal mathematical models of fixed interest securities. These models are used to find value, and also to control risk, in what are often highly complex and diverse portfolios.

Because sector rotation, for instance, depends largely on changes in relative valuations and spreads, managers need good models. They use these not only to evaluate sector opportunities but to identify specific securities that offer good value. A handful of managers with the resources to do so, such as PIMCO, have gone a step further and developed their own state-of-the-art analytics in-house.

Alongside these advanced analytics, a few managers, including ourselves, have also devoted time and money to developing a wide array of tools to measure and monitor risk. Basically, these gauge a portfolio's sensitivity to key variables that might affect the performance of different sectors.

One big advantage of an in-house system is that it enables portfolio managers to evaluate or stress-test securities under a far wider variety of market conditions than off-the-shelf models permit. Also, managers with their own models don't have to rely on Wall Street analysts. As a result, they can disguise or even hide their outlook and strategy from Wall Street, reducing the risk of an investment bank taking the other side on a trade.

To sum up, fixed income managers in the US have to cope with far more complexity than their European counterparts. To be successful, they need to combine a thorough understanding of the market's diversity with state-of-the-art quantitative tools, and a well-thought-out organisational structure that uses the firm's professionals to best advantage.

Lee R Thomas, PhD, is managing director and senior international portfolio manager at PIMCO