chapter 19 fixed-income portfolio management. chapter 19 questions what are three major...

Chapter 19

FIXED-INCOME PORTFOLIO MANAGEMENT

Chapter 19 Questions

What are three major bond-portfolio management strategies?

What are the two specific strategies for passive portfolio management?

What are the five strategies available for active portfolio management?


What is meant by core-plus bond management and what are some plus strategies?

What do we mean by matched-funding techniques, and what are the four specific strategies for these techniques?

How are futures contracts used to hedge against cash deposits or withdrawals from a bond portfolio?


How are futures used to change the systematic risk (i.e., duration) of an actively managed portfolio?

What are some of the general advantages of using futures and options in bond-portfolio management?

Alternative Bond Portfolio Strategies

1. Passive portfolio strategies

2. Active management strategies

3. Matched-funding techniques

Passive Portfolio Strategies

Passive strategies emphasize buy-and-hold, low energy management

Try to earn the market return rather than beat the market return

Passive Portfolio Strategies

Buy and hold Buy a portfolio of bonds and hold them to maturity Can by modified by trading into more desirable

positions

Indexing Match performance of a selected bond index Performance analysis involves examining tracking

error for differences between portfolio performance and index performance

Active Management Strategies

Active management strategies attempt to beat the market

Mostly the success or failure is going to come from the ability to accurately forecast future interest rates


Interest-rate anticipation Risky strategy relying on uncertain forecasts of

future interest rates, adjusting portfolio duration Ladder strategy staggers maturities Barbell strategy splits funds between short

duration and long duration securities

Valuation analysis A form of fundamental analysis, this strategy

selects bonds that are thought to be priced below their estimated intrinsic value


Credit analysis Determines expected changes in default risk Try to predict rating changes and trade

accordingly Buy bonds with expected upgrades Sell bonds with expected downgrades

Credit analysis models such as Altman’s Z-score model may be useful for predicting changes in ratings

High yield bonds may warrant special attention


Yield-spread analysis Monitor spread within and across sectors, bond

ratings, or industries Trade in anticipation of changing spreads

Bond swaps Selling one bond (S) and buying another (P)

simultaneously Swaps to increase current yield or YTM, take

advantage of shifts in interest rates or realignment of yield spreads, improve quality of portfolio, or for tax purposes


Bond Swaps Pure yield pickup swap

Swapping low-coupon bonds into higher coupon bonds

Substitution swap Swapping a seemingly identical bond for one that is

currently thought to be undervalued

Tax swap Swap in order to manage tax liability (taxable & munis)

Swap strategies and market-efficiency Bond swaps by their nature suggest market inefficiency

A Global Fixed-Income Investment Strategy

Factors to consider1. The local economy in each country including the

effects of domestic and international demand

2. The impact of total demand and domestic monetary policy on inflation and interest rates

3. The effect of the economy, inflation, and interest rates on the exchange rates among countries

Core-Plus Bond Management

A combination approach of passive and active bond management stylesA large, significant part of the portfolio is passively managed in one of two sectors: The U.S. aggregate sector, which includes mortgage-

backed and asset-backed securities The U.S. Government/Corporate sector alone

The rest of the portfolio is actively managed Often focused on high yield bonds, foreign bonds,

emerging market debt Diversification effects help to manage risks

Matched-Funding Techniques

Classical (“pure”) immunization strategies attempt to earn a specified rate of return regardless of changes in interest rates Must balance the components of interest rate risk

Price risk: problem with rising interest rates Reinvestment risk: problem with falling interest rates

Immunize a portfolio from interest rate risk by keeping the portfolio duration equal to the investment horizon

Duration strategy superior to a strategy based only a maturity since duration considers both sources of interest rate risk

Matched-Funding Strategies

Many immunization strategies are designed to take the sting out of rising interest rates for a bond portfolio!


Immunization StrategiesDifficulties in Maintaining Immunization

StrategyRebalancing required as duration declines

more slowly than term to maturityModified duration changes with a change in

market interest ratesYield curves shift


Dedicated portfoliosDesigning portfolios that will service liabilitiesDifferent types: Exact cash match

Conservative strategy, matching portfolio cash flows to needs for cash

Useful for sinking funds and maturing principal payments Dedication with reinvestment

Does not require exact cash flow match with liability stream Great choices, flexibility can aid in generating higher

returns with lower costs


Horizon matchingCombination of cash-matching and

immunizationWith multiple cash needs over specified

time periods, can duration-match for the time periods, while cash-matching within each time period

Derivatives in Fixed-Income Management

Derivatives can be used to modify portfolio risk and return

Using derivative for asset allocationAdjusting allocations in the underlying

assets can be very expensiveLess costly to achieve a similar asset

allocation exposure using derivatives, especially for temporary adjustments


To control portfolio cash flowsHedging portfolio cash inflows and outflows

Treasury bond futures contractTypically used contract for risk

management of fixed-income portfoliosDelivery in T-bonds, meeting criteria

Those that are delivered are the cheapest-to-deliver (CTD) that satisfies contract


Determining How Many Contracts to Trade to Hedge a Deposit or Withdrawal

This is the hedge ratio, and it depends on: Conversion factor

Adjusts the CTD bond to 8% (required for delivery) Duration adjustment factor

Reflects the difference in interest rate risk between the CTD bond and the portfolio being hedged

Factor AdjustmentDuration Factor ConversionContract 1 of Value

FlowCash


Determining How Many Contracts to Trade to Adjust Portfolio DurationHere futures contracts are used to adjust the duration of a portfolio, thereby managing interest rate riskWeighted average approachTarget duration = Contribution of current

bond portfolio + contribution of the futures component


Using Futures in Passive Fixed-Income Portfolio Management

Will use futures primarily to manage deposits and withdrawals

Will not use futures to actively adjust duration due to interest forecasts


Using Futures in Active Fixed-Income Portfolio ManagementModifying systematic risk Changing the portfolio duration in light of interest

rate forecasts Lengthen duration if rates are expected to fall

Modifying unsystematic risk Opportunities are more limited here, but can adjust

exposure to various sectors to take advantage of expected yield changes


Changing the Duration of a Corporate Bond PortfolioThere are no corporate bond futures contracts, so strategies are based on using T-bond futures Corporate bond yields also impacted by changes

in default risk, unlike T-bond yields T-bonds are a “cross hedge” instrument Differences could impact the number of contracts

required to hedge a corporate bond portfolio


Modifying the Characteristics of an International Bond PortfolioPositions in foreign bonds are positions in both securities and currencies Futures and option contracts allow the portfolio

manager to manage the risks of the currency and the security separately

In a passive strategy, the manager can hedge the risk exposure

In an active strategy, the manager can adjust the exposure to try to benefit from expected changes in exchange rates