HOW TO BUILD A PORTFOLIO OF INTEREST-BEARING BONDS FOCUSING ON MARKET MISPRICING

Abstract

Previous research on bond investment typically aimed to analyzes discount bonds yet mid-and-long term discount bonds do not exist in the market. Therefore, we have difficulty in applying it to actual investment activity. In this paper, we propose an investment strategy to build a portfolio of interest-bearing bonds, which are tradable. First, we look into the statistical nature of market mispricing which we defined as the difference between the observed price and the theoretical price of Japanese Government Bond. Next, capitalizing on the feature of mean reversion and low correlation among issues that market mispricing has, we discuss how to construct a coupon bond portfolio as opposed to an optimal portfolio of discount bonds regarded as a benchmark and to construct long-short strategy of coupon bonds. As a result of empirical analysis, we found that both an investment into a coupon bond whose duration is closest to that of corresponding discount bond and a diversified investment into coupon bonds with a certain range of duration are effective as passive investing. We also found that an investment into comparatively cheap issues in terms of market mispricing is profitable as active investing. In addition, as an investment type to seek absolute return, we discovered that long/short trading between the issues with a specific duration performs well.