Investment Analysis and Portfolio Management First Canadian Edition

1. Investment Analysis and Portfolio Management First Canadian Edition By Reilly, Brown, Hedges, Chang 16

2. Chapter 16Bond Portfolio Management Strategies • Bond Portfolio Performance, Style, and Strategy • Passive Management Strategies • Active Management Strategies • Core-Plus Management Strategies • Matched-Funding Strategies • Contingent and Structured Strategies

3. Bond Portfolio Performance, Style, and Strategy • Fixed-income portfolios generally produce both less return and less volatility than found in other asset classes (e.g., domestic equity, foreign equity) • The low historical correlation between fixed-income and equity securities—Reilly and Wright (2004) calculated this to be 0.27—has made bond portfolios an excellent tool for diversifying risk

4. Bond Portfolio Performance, Style, and Strategy • Investment style of a bond portfolio can be summarized by two important characteristics: • credit quality • interest rate sensitivity • Average credit quality of the portfolio can be classified as high, medium, and low grades • Interest rate sensitivity of the bond portfolio can be separated as: • short-term • intermediate-term • long-term

5. Bond Portfolio Performance, Style, and Strategy

6. Bond Portfolio Performance, Style, and Strategy • Bond Portfolio Strategies (Exhibit 16.3) • Passive Portfolio Strategies • Active Management Strategies • Core-plus Management Strategy • Matched-funding Techniques • Contingent Procedure (Structured Active Management)

7. Bond Portfolio Performance, Style, and Strategy

8. Passive Management 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 • Can by modified by trading into more desirable positions

9. Passive Management Strategies • Indexing • The objective is to construct a portfolio of bonds that will track the performance of a bond index • Performance analysis involves examining tracking error for differences between portfolio performance and index performance

10. 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 • Active Strategy Attributes • Scalability • Sustainability • Risk-adjusted performance • Extreme values

11. 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

12. Active Management Strategies • Valuation analysis • 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

13. Active Management Strategies • Credit Analysis Models • High-Yield Bond Research • Modified Z-score model • Exhibit 16.7, p. 503 • Yield spread analysis • Assumes normal relationships exist between the yields for bonds in alternative sectors (Chapter 12) • Active Bond Transactions • Pure Yield Pickup Swap • Substitution Swap

14. Active Global Bond Investing • An active approach to global fixed-income management must consider the following three interrelated factors: • Local economy in each country including the effects of domestic and international demand • Impact of total demand and domestic monetary policy on inflation and interest rates • Effect of the economy, inflation, and interest rates on the exchange rates among countries

15. Core-Plus Management Strategies • Combination of passive and active styles (a form of enhanced indexing) • Large part of the portfolio is passively managed in one of two sectors: • U.S. aggregate sector, which includes mortgage-backed and asset-backed securities • U.S. Government/corporate sector alone • Rest of the portfolio is actively managed • Often focused on high yield bonds, foreign bonds, emerging market debt • Diversification effects help to manage risks

16. Matched-Funding Strategies • Dedicated Portfolios • Designing portfolios that will service liabilities • 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

17. Matched-Funding Strategies • Immunization Strategies • Process is intended to eliminate interest rate risk that includes: • Price Risk • Coupon Reinvestment Risk • Portfolio manager (after client consultation) may decide that the optimal strategy is to immunize the portfolio from interest rate changes • Immunization techniques attempt to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates

18. Matched Funding Strategies • Classical Immunization • 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 • An immunized portfolio requires frequent rebalancing because the modified duration of the portfolio always should be equal to the remaining time horizon

19. Matched Funding Strategies • Difficulties in Maintaining Immunization Strategy • Rebalancing required as duration declines more slowly than term to maturity • Modified duration changes with a change in market interest rates • Yield curves shift

20. Matched-Funding Strategies • Horizon matching • Combination of cash-matching dedication and immunization • Important decision is the length of the horizon period • With multiple cash needs over specified time periods, can duration-match for the time periods, while cash-matching within each time period

21. Matched-Funding Strategies

22. Contingent & Structured Strategies • Contingent procedures for managing bond portfolios are a form of what has come to be called structured active management

23. Contingent & Structured Strategies • Contingent Immunization • Duration of portfolio must be maintained at the horizon value • Cushion spread is potential return below the current market return • Safety margin is a portfolio value above the required value • Trigger point refers to the minimum return that will stop active portfolio management

24. Contingent & Structured Strategies

25. Contingent & Structured Strategies

26. Contingent & Structured Strategies