Chapter 19

1. Chapter 19 FIXED-INCOME PORTFOLIO MANAGEMENT

2. 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?

3. Chapter 19 Questions • 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?

4. Chapter 19 Questions • 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?

5. Alternative Bond Portfolio Strategies 1. Passive portfolio strategies 2. Active management strategies 3. Matched-funding techniques

6. Passive Portfolio Strategies • Passive strategies emphasize buy-and-hold, low energy management • Try to earn the market return rather than beat the market return

7. 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

8. 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

9. Active Management Strategies • 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

10. Active Management Strategies • 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

11. Active Management Strategies • 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

12. Active Management Strategies • 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

13. A Global Fixed-Income Investment Strategy • Factors to consider 1. 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

14. Core-Plus Bond Management • A combination approach of passive and active bond management styles • A 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

15. 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

16. Matched-Funding Strategies Many immunization strategies are designed to take the sting out of rising interest rates for a bond portfolio!

17. Matched-Funding Techniques • Immunization 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

18. Matched-Funding Techniques Dedicated portfolios • Designing portfolios that will service liabilities • Different 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

19. Matched-Funding Techniques • Horizon matching • Combination of cash-matching and immunization • With multiple cash needs over specified time periods, can duration-match for the time periods, while cash-matching within each time period

20. Derivatives in Fixed-Income Management • Derivatives can be used to modify portfolio risk and return • Using derivative for asset allocation • Adjusting allocations in the underlying assets can be very expensive • Less costly to achieve a similar asset allocation exposure using derivatives, especially for temporary adjustments

21. Derivatives in Fixed-Income Management • To control portfolio cash flows • Hedging portfolio cash inflows and outflows • Treasury bond futures contract • Typically used contract for risk management of fixed-income portfolios • Delivery in T-bonds, meeting criteria • Those that are delivered are the cheapest-to-deliver (CTD) that satisfies contract

22. Derivatives in Fixed-Income Management 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

23. Derivatives in Fixed-Income Management Determining How Many Contracts to Trade to Adjust Portfolio Duration • Here futures contracts are used to adjust the duration of a portfolio, thereby managing interest rate risk • Weighted average approach • Target duration = Contribution of current bond portfolio + contribution of the futures component

24. Derivatives in Fixed-Income Management 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

25. Derivatives in Fixed-Income Management Using Futures in Active Fixed-Income Portfolio Management • Modifying 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

26. Derivatives in Fixed-Income Management Changing the Duration of a Corporate Bond Portfolio • There 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

27. Derivatives in Fixed-Income Management Modifying the Characteristics of an International Bond Portfolio • Positions 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