Fundamental valuation strategies:

The objective of fundamental bond analysis is the same as that of fundamental stock analysis. It involves determining a bonds intrinsic value by estimating the required rate for discounting the bonds cash flows and then comparing that value with the bonds market price. The active management of a bond portfolio using a fundamental strategy, in turn, involves buying bonds that are determined to be underpriced and selling or avoiding those determined to be overpriced. This rate, R, depends on the current level of interest rates as measured by the risk-free rate, Rf, and the bonds risk premiums: default risk premium (DRP), liquidity premium (LP), and option-adjusted spread (OAS):

R R f DRP LP OAS
Fundamentalists use various models such as regressions, multiple discriminate analysis and the option pricing models to estimate the various spreads. A variation of fundamental bond strategies is a yield pickup swap. In a yield pickup swap, investors or arbitrageurs try to find bonds that are identical, but for some reason are temporarily mispriced or trading at different yields. When two identical bonds trade at different yields, abnormal returns can be realized by going long (buy) in the underpriced (higher yields) bond and short (sell) in the overpriced (lower yield) bond, then closing the positions once the prices of the two bonds converge. To profit from a yield pickup swap, the bonds must be identical. It could be the case that two bonds appear to be identical but are not. For example, two bonds with the same durations, default ratings and call features may appear to be identical when, in fact, they have different marketability characteristics that explain the observed differences in their yields. The strategy underlying a yield pickup swap can be extended from comparing different bonds to comparing a bond with a portfolio of bonds constructed to have the same features. For example, suppose a portfolio consisting of an AAA quality, 10-year, 10% coupon bond and an A quality, 5-year, 5% coupon bond is constructed such that it has the same cash flows and features as say an AA quality, 7.5-year, 7.5% coupon bond. If an AA quality, 7.5-year, 7.5% coupon bond and the portfolio do not provide the same yield, then an arbitrageur or speculator could form a yield pickup swap by taking opposite positions in the portfolio and the bond. A fundamentalist could also use this methodology for identifying underpriced bonds: buying all AA quality, 7.5-year, 7.5% coupon bonds with yields exceeding the portfolio formed with those features. Other active strategies: Tax Swaps Swaps of callable and non callable bonds

Tax Swaps: In a tax swap, an investor sells one bond and purchases another in order to take advantage of the tax laws. For example, suppose a bond investor purchased $10,000 worth of a particular bond and then sold it after rates decreased for $15,000, realizing a capital gain of $5,000 and also a capital gains tax liability. One way for the investor to negate the tax liability would be to offset the capital gain with a capital loss. If the investor were holding bonds with current capital losses of say $5,000, he could sell those to incur a capital loss to offset his gain. Except for the offset feature, though, the investor may not otherwise want to sell the bond. If this were the case, then the investor could execute a bond swap in which he sells the bond needed for creating a capital loss and then uses the proceeds to purchase a similar, though not identical, bond. Thus, the tax swap allows the investor to effectively hold the bond he wants, while still reducing his tax liability. For the capital loss to be tax deductible the bond purchased in the tax swap cannot be identical to the bond sold; if it were, then the swap would represent a wash sale that would result in the IRS disallowing the deduction. In contrast to the IRSs wash sales criterion on stocks, though, the wash sale criterion used for bonds does permit the purchase of comparable bonds that have only minor differences. Another type of tax swap involves .

This swap can be used if the tax rate on capital gains differs from the tax rate on income. If it does, then an investor might find it advantageous to swap a low coupon bond for a high coupon bond with the same duration. Callable/Non-callable Bond Swaps: During periods of high interest rates, the spread between the yields on callable and non-callable bonds is greater than during periods of relatively low interest rates. Accordingly, if investors expect rates to decrease in the future, causing the spread between callable and non-callable bonds to narrow, they could capitalize by forming a callable/non-callable bond swap short (sell) in the callable bond and long (buy) in the non-callable one. To effectively apply this bond swap requires investors to not only forecast interest rate changes, but to also forecast changes in the spread. Similar swaps can also be extended to bonds with and without other option features such as, putable and non-putable bonds