Bond Portfolio Strategies for Efficient Management

1. Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementSeventh Editionby Frank K. Reilly & Keith C. Brown Chapter 20

2. Chapter 20 - Bond Portfolio Management Strategies Questions to be answered: • What are the four major bond portfolio management strategies? • What are the two specific passive portfolio management strategies available?

3. Chapter 20 - Bond Portfolio Management Strategies • What are the five alternative strategies available within the active management category? • What is meant by care-plus bond management and what are some plus strategies? • What is meant by matched-funding techniques, and what are the four specific strategies available in this category?

4. Chapter 20 - Bond Portfolio Management Strategies • What are the major contingent procedure strategies that are also referred to as structured active management strategies? • What are the implications of capital market theory for those involved in bond portfolio management?

5. Chapter 20 - Bond Portfolio Management Strategies • What is the evidence on the efficient market hypothesis as it relates to bond markets? • What are the implications of efficient market studies for bond portfolio managers?

6. Alternative Bond Portfolio Strategies 1. Passive portfolio strategies 2. Active management strategies 3. Matched-funding techniques 4. Contingent procedure (structured active management)

7. Passive Portfolio Strategies • Buy and hold • A manager selects a portfolio of bonds based on the objectives and constraints of the client with the intent of holding these bonds to maturity • Indexing • The objective is to construct a portfolio of bonds that will equal the performance of a specified bond index

8. Active Management Strategies • Interest-rate anticipation • Risky strategy relying on uncertain forecasts • Ladder strategy staggers maturities • Barbell strategy splits funds between short duration and long duration securities • Valuation analysis • The portfolio manager attempts to select bonds based on their intrinsic value • Credit analysis • Involves detailed analysis of the bond issuer to determine expected changes in its default risk

9. Active Management Strategies • Yield spread analysis • Assumes normal relationships exist between the yields for bonds in alternative sectors • Bond swaps • Involve liquidating a current position and simultaneously buying a different issue in its place with similar attributes but having a chance for improved return

10. Pure Yield Pickup Swap Substitution Swap Tax Swap Swap strategies and market-efficiency Bond swaps by their nature suggest market inefficiency Bond Swaps

11. A Global Fixed-Income Investment Strategy Factors to consider • The local economy in each country including the effects of domestic and international demand • The impact of total demand and domestic monetary policy on inflation and interest rates • The effect of the economy, inflation, and interest rates on the exchange rates among countries

12. This involves having a significant (core) part of the portfolio managed passively in a widely recognized sector such as the U.S. Aggregate Sector or the U.S. Government/Corporate sector. The rest of the portfolio would be managed actively in one or several additional “plus” sectors, where it is felt that there is a higher probability of achieving positive abnormal rates of return because of potential inefficiencies Core-Plus Bond Portfolio Management

13. Matched-Funding Techniques • Dedicated Portfolios • Dedication refers to bond portfolio management techniques that are used to service a prescribed set of liabilities • Pure Cash‑Matched Dedicated Portfolios • Most conservative strategy • Dedication With Reinvestment • Cash flows do not have to exactly match the liability stream

14. Immunization Strategies A portfolio manager (after client consultation) may decide that the optimal strategy is to immunize the portfolio from interest rate changes The immunization techniques attempt to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates Matched-Funding Techniques

15. Components of Interest Rate Risk Price Risk Coupon Reinvestment Risk Immunization Strategies

16. Classical Immunization • Immunization is neither a simple nor a passive strategy • An immunized portfolio requires frequent rebalancing because the modified duration of the portfolio always should be equal to the remaining time horizon (except in the case of the zero-coupon bond)

17. Duration characteristics Duration declines more slowly than term to maturity, assuming no change in market interest rates Duration changes with a change in market interest rates There is not always a parallel shift of the yield curve Bonds with a specific duration may not be available at an acceptable price Classical Immunization

18. Horizon matching Combination of cash-matching dedication and immunization Important decision is the length of the horizon period Matched-Funding Techniques

19. Contingent Procedures • A form of structured active management • Constrains the manager if unsuccessful • Contingent immunization • duration of portfolio must be maintained at the horizon value • cushion spread is potential return below current market • safety margin • trigger point

20. Implications of Capital Market Theory and the EMH on Bond Portfolio Management • Bonds and Total Portfolio Theory • Bonds and Capital Market Theory • Bond Price Behavior in a CAPM Framework • Bond-Market Efficiency

21. www.ryanlabs.com www.bondbasics.com www.cms-info.com www.cboe.com/education/strategy/interestrate.htm www.finpipe.com www.prusec.com/ladder.htm www.deanwitter.com/tfi/milp.html The InternetInvestments Online

22. End of Chapter 20 • Bond Portfolio Management Strategies

23. Future topicsChapter 21 • An Introduction to Derivative Markets and Securities