Fixed Income Markets: Trading & Portfolio Strategies

Posted on Sep 22, 2025 in Finance

The Secondary Bond Market Explained

The secondary market refers to all bond transactions that take place after the bond’s initial settlement in the primary market and before its maturity, early redemption, or cancellation. Unlike equity markets, which have long operated with high levels of organization and transparency, fixed income markets have traditionally been more opaque, especially in terms of price discovery and trade reporting. However, since the financial crisis of 2008-2012, regulation has significantly increased, leading to a more transparent and regulated environment.

In Europe, under the MiFID framework, there are two main types of trading venues: multilateral markets, which include exchanges where transactions are managed with full transparency and equal access to data, and bilateral or over-the-counter (OTC) markets, where trades are privately negotiated and not subject to the same level of reporting or restrictions. The key distinction lies in the transparency of recording and disclosing trades, which directly affects price formation.

Trading in fixed income instruments involves three major components: execution, settlement, and reporting. Execution entails both the retrieval of quotes and the placement of orders, which historically occurred over the phone but now is increasingly managed through electronic platforms such as Bloomberg or Reuters. The process typically follows the sequence: price discovery, quote, order, and trade. A mutual understanding of trading conventions is necessary to determine when a quote becomes binding.

Bond Settlement Processes

Settlement is the process by which the buyer pays and the seller delivers the bond. This involves banks for the payment leg and custodians for the delivery and recordkeeping. Two principal settlement methods exist: Delivery versus Payment (DVP), which ensures that payment and delivery are simultaneous, and Free of Payment (FOP), which does not, thereby increasing risk. Most cash trades settle within T+1 to T+3 days; beyond that, the transaction is considered a forward trade, subject to additional regulations. Settlement requires back-office coordination for figuration, availability of funds and securities, and communication between settlement agents.

The Role of Custodians in Bond Markets

Custodians play a crucial role in safeguarding securities. Client holdings are kept in segregated accounts, separate from the custodian’s own books, to protect clients in the event of bank insolvency.

Regulated or organized markets are those that meet high standards of execution, custody, and information. Institutions are often restricted from investing in assets not traded on these markets. MiFID categorizes multilateral venues in decreasing order of formality as Regulated Markets (RM), Multilateral Trading Facilities (MTF), and Organized Trading Facilities (OTF). OTC transactions, while still dominant in fixed income due to the market’s complexity and institutional nature, fall outside these categories. However, retail access to bond trading is improving through brokers like Schwab or Interactive Brokers.

Secondary Market Bond Trade Types

In a cash trade, the buyer acquires the bond in exchange for payment of the agreed price plus accrued interest. The buyer obtains the right to future coupon payments, but must compensate the seller for interest earned up to the settlement date. Government bonds usually settle T+1, while corporate or credit bonds settle T+2 or T+3.

In a forward trade, where settlement exceeds T+3, the buyer effectively receives financing. The seller adds to the price a financing cost and a risk premium, since they are exposed to price changes between trade and settlement. Meanwhile, the buyer assumes counterparty risk and must mark the trade to market from the execution date.

Understanding Repurchase Agreements (Repos)

A repo is a short-term, collateralized loan where one party sells securities and agrees to repurchase them later at a higher price. The initial transaction provides cash to the seller (who is effectively borrowing), while the buyer (lender) receives the securities as collateral and earns repo interest. Despite legal transfer, economic exposure remains with the seller.

The repo rate is the agreed interest rate on the cash. Repos are widely used for short-term financing and are categorized as money market instruments. The reverse side of a repo—when the buyer lends cash—is called a reverse repo.

To mitigate credit risk, lenders often apply a repo margin or haircut, ensuring that the value of collateral exceeds the loan. Margins typically range between 1–3%, but may rise significantly with lower-rated or illiquid securities. Collateral is also marked to market regularly to adjust for price movements.

In Example 1, Deutsche Bank (DB) enters into a one-week repo with RBC, selling EUR 100 million in zero-coupon bonds at 102.25%. On maturity, DB repurchases them for EUR 102.26 million, reflecting a repo rate of 0.75%.

Example 2 shows how DB, expecting falling yields, buys a government bond and finances it through a 90-day repo with BBVA. As yields fall and bond prices rise, DB sells the bond and profits after repaying the repo loan and interest.

Example 3 illustrates a short strategy. DB anticipates rising yields and borrows bonds via reverse repo to sell them. After yields rise (prices fall), DB repurchases the bonds cheaper, returns them, and pockets the difference after repo costs.

Swap Pricing and Hedging Strategies

To determine swap pricing, expected forward rates derived from the yield curve are used. For example, given increasing forward rates, the fixed rate in the swap must match the average expected floating rate plus a spread for risk and margin.

One common use of swaps is to hedge a fixed-rate bond portfolio. By paying fixed and receiving floating, an investor offsets the decline in bond value when rates rise. If interest rates indeed rise by 0.50%, and the portfolio has a duration of 5, the portfolio loses roughly 2.5% in value. An IRS structured to gain 2.5% in that same scenario will perfectly hedge the exposure.

Unwinding a swap can be done by entering an offsetting swap or requesting a cancellation price from a dealer based on the net present value of remaining flows. A perfect hedge assumes both swaps have symmetrical terms and timing.

Accrued Interest & Day Count Conventions

Different bonds use different day count conventions for interest:

• Corporate bonds: 30/360 basis (each month = 30 days, year = 360)
• US Treasuries (UST): Actual/365 (real number of days in each month, year = 365)

For example:

1. A USD corporate bond sold at 99.25% with 46 accrued days and a 5% coupon results in accrued interest of USD 3,194.
2. A UST bond with 55 accrued days and a 3.8% coupon yields accrued interest of USD 2,863.

These calculations ensure fair compensation for the bondholder who is selling before the next coupon date.

Fixed Income Portfolio Management

Managing a bond portfolio involves executing a set of strategies aimed at achieving a specific return target. Portfolio managers or traders make decisions based on expected movements in interest rates, the yield curve shape, and changes in issuer credit quality. The challenge is not only being right about the future, but acting before others do—anticipating trends, not reacting to them.

The style and bias of management will always depend on the portfolio’s target. Results must be assessed not only based on return, but also on the risks taken to achieve them. This is especially relevant in institutional setups, where clients, benchmarks, and market context must all be taken into account. The process is relatively straightforward when there is one individual client, but more complex for mutual or pension funds.

Setting Fixed Income Portfolio Targets

Portfolio managers typically work toward targets like maximizing profitability, beating a benchmark, or achieving a specific return within a set time frame—known as the Investment Horizon (IH). In IH-based portfolios, like pension funds or guaranteed capital products, the bond duration is usually aligned with the IH, with room left for reinvestments and occasional substitutions. In portfolios with no fixed horizon (e.g., open-ended investment funds), managers focus more on market momentum and arbitrage, taking and closing positions as short-term opportunities arise. Importantly, portfolio management is not about passively holding bonds for coupons—it’s a continuous decision-making process inspired by clear objectives.

Fixed Income Risk-Return Trade-Off

Performance cannot be judged by returns alone. It must be evaluated in relation to risk taken—both duration risk and credit risk. Deviating from a benchmark’s duration or credit exposure introduces risk, and so does active trading. Clients often don’t see the portfolio’s day-to-day positioning, so we evaluate managers by looking at the volatility of returns over time. A portfolio that generates stable returns is generally preferable to one with the same average return but high volatility, assuming risk appetite is limited.

Evaluating Performance with the Sharpe Ratio

The Sharpe Ratio is a key measure used to evaluate the return of a portfolio relative to its risk. It is calculated as: Sharpe Ratio = (Portfolio Return – Risk-Free Rate) / Standard Deviation of Excess Return. It shows how much return is earned per unit of risk. For example, Portfolio 1 may return 8% with 5.5% volatility, and Portfolio 2 may return 12% with 12.5% volatility. Despite the higher return, Portfolio 2 may have a lower Sharpe ratio—indicating it took disproportionately more risk. A ratio above 1 is considered very good. However, the Sharpe ratio assumes normally distributed returns, which is rarely the case in financial markets (where extreme events are more common). It also does not distinguish between upward and downward volatility. Madoff’s fund, for instance, had consistently high Sharpe ratios—until it collapsed. Short track records can also distort Sharpe values. Adjusting for the risk-free rate in the Sharpe formula removes the effect of leverage. A manager running the same strategy with different leverage levels should ideally show the same Sharpe ratio, though raw return/volatility metrics would suggest otherwise.

Fixed Income Portfolio Performance Assessment

A full assessment of portfolio performance includes:

1. A fair risk–return comparison (like Sharpe ratio)
2. Benchmark comparison
3. A clear agreement between manager and client (the “contract”)

Performance must always be measured relative to a reference, such as an index or peer group. Losing 2% while the market loses 10% can be considered a success. Likewise, a 6% gain in a market rising 25% may be poor.

Benchmarking is now essential. The Bloomberg Barclays Aggregate Bond Index (“Agg”) is the most widely used benchmark in the US bond market, including Treasuries, corporates, MBS, ABS, and municipals. It includes only investment-grade securities, with minimum size and maturity requirements.

The Client-Manager Investment Contract

A portfolio manager and client must agree on strategy, risk levels, performance benchmarks, and return objectives. Regulation, especially after 2008, now demands more transparency. Under MiFID II, investors must complete self-assessment forms to match them with the appropriate risk profiles (conservative, moderate, aggressive). Many investors and even professionals overestimate their risk tolerance—often realizing it only when losses occur.

Value at Risk (VAR) for Bank Clients

In banks, traders manage risk portfolios under strict limits. Their “contract” is with the bank, which sets soft (target) and hard (absolute) limits on exposure. These limits are defined using Value at Risk (VAR), which measures the maximum expected loss over a time period at a certain confidence level.

Examples include:

• 95% 1-day VAR → 5% chance of losing more than the stated amount in a day.
• 99% 5-day VAR → 1% chance of losing more than that over five days.

VAR uses historical data but estimates forward-looking risk. Like the Sharpe ratio, it assumes normal distribution, which doesn’t fully reflect extreme market events.

Active vs. Passive Fixed Income Management

Passive management aims to replicate a benchmark by purchasing its components (or an approximate portfolio) and maintaining that structure. Management activity is limited to reinvesting cashflows and adjusting for time decay or changes in the benchmark. Passive investing has grown, especially under the efficient market hypothesis, which assumes prices reflect all relevant information.

Active management, by contrast, assumes markets are inefficient. Managers seek to outperform benchmarks by exploiting pricing inefficiencies, misinterpreted public information, or temporary dislocations. Despite academic support for passive investing, active management remains valuable—especially in volatile or inefficient markets. Note that active doesn’t necessarily mean frequent trading; it simply involves making strategic deviations from the benchmark.

Active Strategies Under Stable Yield Curves

• Buy and Hold: Although it may seem passive, choosing a portfolio that diverges from the benchmark in terms of duration or yield can be an aggressive bet. The manager holds the position expecting higher yield, assuming the curve remains stable.
• Riding the Yield Curve: Based on a roll-down strategy, the manager buys bonds at higher yields (e.g., 5-year maturity) and holds them as they become shorter-term bonds (e.g., 4-year), selling them later at lower yields and higher prices. Works best when the yield curve is upward-sloping and stable.
• Sell Convexity: If volatility is expected to remain low, the manager may sacrifice convexity (i.e., insurance against rate moves) to earn higher yields. This can be done by writing options or holding callable bonds or MBS, which embed short option positions (negative convexity).
• Carry Trades: Involve borrowing at low rates and investing in higher-yielding instruments, either across currencies or within the same curve. These trades rely on rate stability and leverage to profit from the yield differential, but they carry interest rate and FX risk.

Active Management & Maturity Choices

Strategies based on short-term rate expectations depend heavily on the maturity structure of the portfolio. Three classic approaches are:

1. Bullet: All bonds concentrated at one point (e.g., 10-year). Best when the curve steepens.
2. Barbell: Bonds at two ends (e.g., 2-year and 30-year). Best when the curve flattens.
3. Laddered: Bonds maturing at regular intervals. Offers consistent performance and reinvestment flexibility.

Directional Trades for Rate Changes

If rates are expected to fall, a bullish strategy involves buying bonds (long), extending duration. If rates are expected to rise, a bearish strategy involves shorting bonds (short), reducing duration. For example, buying a 3-year bond with 2% coupon at a YTM of 1.75%, and selling it after rates drop to 1.5%, can result in a net profit. The profit comes from price appreciation, accrued interest, and must subtract financing costs.

Fixed Income Spread Strategies

When managers have no directional view on rates but believe one bond will outperform another, they use spread trades. These involve simultaneously buying one bond and selling another. The key is that the bonds have comparable duration (volatility), which must be duration-weighted in the trade.

Credit Spread Trading focuses on relative improvement/deterioration in credit quality. For example, buying a corporate bond expected to improve its rating and selling a government bond. If spreads tighten (credit improves), profit is made regardless of rate direction, as long as the bonds’ durations are matched.

Curve Trading (e.g., 2s10s steepener) bets on the shape of the yield curve changing. To express a steepening view, the manager buys more of the short bond (e.g., 2-year) and sells less of the long bond (e.g., 10-year), adjusting for volatility (e.g., 5x the amount in 2-year if its volatility is 1/5 that of the 10-year). Profit is made when the slope widens, regardless of whether overall rates rise or fall.

Understanding Interest Rate Swaps (IRS)

An Interest Rate Swap is a financial derivative contract between two parties who agree to exchange streams of interest payments over a predetermined period, based on a notional principal that is never actually exchanged. The most common type of IRS is a fixed-for-floating swap, where one party pays a fixed interest rate and the other pays a floating rate, typically indexed to Euribor.

Key Terms Agreed in an IRS Trade

At the time the swap is executed, the parties agree on several key terms: the notional amount, the fixed interest rate (called the swap rate), the reference index for the floating leg (usually 6-month Euribor or similar), the payment frequency (commonly semi-annual or annual), and the maturity of the swap. The trade date is also usually the first setting date for the floating leg. The effective date—when interest begins to accrue—is typically T+2. The first payment date will occur at the end of the first interest period.

IRS Payment Mechanics

At each payment date, both the fixed and floating payments are calculated based on the notional principal, but only the net difference is exchanged between the parties. The fixed-rate payer will pay the agreed fixed interest, while the floating-rate payer will pay the rate determined by the reference index during the period. For example, if Bank A pays a fixed 2% per annum and Bank B pays 6-month Euribor, at each settlement date, the party whose obligation exceeds the other’s pays the net amount. If Euribor has risen above the fixed rate, Bank B benefits; if it falls below, Bank A benefits.

Counterparty Risk in Swaps

Counterparty risk in swaps refers to the possibility that one party may default and fail to meet its payment obligations. Since swaps are over-the-counter (OTC) instruments, they are not cleared through an exchange, and each party bears the risk of the other’s insolvency. Swap dealers (e.g., Goldman Sachs) act as intermediaries to manage this risk, but they themselves also become counterparties. Because no actual principal is exchanged, the risk is tied to the net present value of the remaining cash flows. This exposure grows if market rates move significantly in favor of one party. To reduce risk, institutions often deal with highly rated swap dealers, and many large dealers have capitalized subsidiaries specifically for swap transactions.

Defining the Swap Spread

A swap spread is the difference between the swap rate (the fixed rate in a plain vanilla swap) and the yield of a government bond of the same maturity. For example, if a 5-year swap rate is 3% and the 5-year government bond yield is 2.5%, the swap spread is 50 basis points. This spread reflects the credit risk, liquidity, and supply/demand conditions in both the swap and bond markets. Wider spreads typically signal market stress or concerns over counterparty credit risk, particularly during periods of financial instability. The shape of the swap curve can also diverge from the government bond curve, often incorporating future interest rate expectations more rapidly.