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8 September 2017 Financial Analysts Journal Book Review

Inside the Yield Book: The Classic That Created the Science of Bond Analysis (a review)

  1. Martin S. Fridson, CFA
The third edition of Inside the Yield Book builds on the previous editions with valuable insights into duration targeting. The authors convey their mathematically elegant findings with the same clarity and accessibility that characterized the writing of Leibowitz and Homer more than 40 years ago, before abstruse formulas began to permeate fixed-income analysis.

This third edition of an undisputed classic marches backward in time, presenting the newest material first, followed by the material that was added in the second edition (2004), and concluding with the original 1972 treatise of Martin Leibowitz and Sidney Homer. The new volume includes the preface to the 2004 edition, in which Leibowitz, now a managing director with the Morgan Stanley research department’s global strategy team, retraces the path that led to his collaboration with Homer, founder of the legendary Salomon Brothers bond market research department. As Leibowitz recounts, the duo’s revelations about the importance of reinvestment rates outraged many bond market veterans of the time, who viewed the work as an attack on the long-accepted approach to measuring yield.

Leibowitz and Homer collected their path-breaking research into a slender volume that quickly became standard homework for newcomers to bond desks.1 Reproduced as the final 162 pages of the present volume, the original Inside the Yield Book explained how and why volatility differs among bonds priced at a premium, at par, and at a discount. The authors also brought order to a previous welter of confusion regarding bond swaps by defining four distinct types—namely, substitution, intermarket spread, rate anticipation, and pure yield pickup. Once again upsetting conventions, the authors demonstrated the inadequacy of the prevailing methods of evaluating the profitability of swaps.

The second edition marked the advance of bond analysis to grander applications than simply devising swaps to exploit minor inefficiencies arising from market frictions. Interest rate volatility increased sharply following the abandonment of the Bretton Woods Agreement in 1971. Institutional investors desperately sought a way to preserve the predictability of their returns in the face of greater uncertainty about reinvestment rates. Leibowitz’s research team at Salomon Brothers was a leader in providing the solution—bond immunization. As detailed in the middle section of the present volume, immunization is a method of ensuring a future portfolio value without resorting to the use of zero-coupon bonds, most of which are comparatively low-yield government bonds. The trick is to match duration to investment horizon and then continuously rebalance the portfolio to maintain that equivalence.

Even greater sophistication is reflected in the new edition’s first section, in which Leibowitz is joined by Anthony Bova of Morgan Stanley Equity Research’s global strategy team and Stanley Kogelman, president of Delft Strategic Advisors, LLC, and principal at Advanced Portfolio Management, with a special acknowledgement of the late Terry Langetieg. This section focuses on duration targeting, a widespread approach to bond management in which duration is held constant over time.

In a duration-targeted portfolio, the authors write, “returns converge back toward the initial yield, so the multiyear volatility turns out to be far less than that suggested by the initial duration.” In essence, the gain (loss) in market value that results from a drop (rise) in interest rates is offset by the reduced (increased) reinvestment rate. Leibowitz et al. present a theoretical model suggesting that although a wide range of interim returns is possible, the annualized return of a five-year-duration portfolio should wind up being close to the portfolio’s initial yield in six to nine years. They then show that actual returns over the period 1977–2011 conformed to their model.

Nonspecialists will be pleased that the authors convey their mathematically elegant findings with the same clarity and accessibility that characterized the writing of Leibowitz and Homer more than 40 years ago, before abstruse formulas began to permeate fixed-income analysis. Elementary math and illuminating, yet simple, graphs tell the evolving story of bond analysis very effectively.

One final note on this essential-as-ever book: The dust jacket mentions that Sidney Homer was posthumously inducted into the Fixed Income Analysts Society’s Hall of Fame in 1997. It was this book reviewer who nominated him, believing that no such pantheon was complete without such a seminal figure. Leibowitz had already been honored by being selected as the very first inductee. Notwithstanding the pair’s many other valuable contributions, highlighted by Homer’s monumental A History of Interest Rates (2005, fourth edition, Wiley Finance), Hall of Fame recognition would have been justified by the publication of Inside the Yield Book alone.


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