Analysis of Investments and Management of Portfolios by Keith C. Brown Frank K. Reilly

1. Analysis of Investments and  Management of Portfolios  by Keith C. Brown & Frank K. Reilly Performance, Style, and Strategy Passive Management Strategies Active Management Strategies Core-Plus Management Strategies Matched-Funding Strategies Contingent and Structured Strategies

2. 19-2 Bond Portfolio PerformanceStyle and Strategy Bond Portfolio Performance Fixed-income portfolios generally produce both less return and less volatility than found in other asset classes (e.g., domestic equity, foreign equity) Exhibit 19.1 shows this in the examination of the investment performance of different long-term securities over the 21-year time horizon 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

3. 19-3 Bond Portfolio PerformanceStyle and Strategy Bond Portfolio Style The investment style of a bond portfolio can be summarized by its two most important characteristics: credit quality and interest rate sensitivity The average credit quality of the portfolio can be classified as high (Govt, AAA, AA Corporate), medium(A, BBB), and low grades(Below BBB rated) The interest rate sensitivity of the bond portfolio can be separated as short-term(<3 years), intermediate-term(3 � 6.5 years), and long-term(above 6.5 years) See Exhibit 19.2

4. 19-4 Exhibit 19.2

5. 19-5 Bond Portfolio PerformanceStyle and Strategy Bond Portfolio Strategies Passive Portfolio Strategies Active Management Strategies Core-plus Management Strategy Matched-funding Techniques Contingent Procedure (Structured Active Management) See Exhibit 19.3

6. 19-6 Exhibit 19.3

7. 19-7 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 Can by modified by trading into more desirable positions 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

8. 19-8 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 Active Strategy Attributes (Exhibit 19.5) Scalability Sustainability Risk-adjusted performance Extreme values

9. 19-9 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 See Exhibit 19.6

10. 19-10 Exhibit 19.6

11. 19-11 Active Management Strategies High-Yield Bond Research Several investment houses such as Merrill Lynch, First Boston, Lehman Brothers, etc., have developed specialized high-yield groups that examine high-yield bond issues and monitor high-yield bond spreads 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

12. 19-12 Bond Swaps Types 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 Active Management Strategies

13. 19-13 Active Global Bond Investing An active approach to global fixed-income management must consider the following three interrelated factors 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

14. 19-14 Core-Plus Management Strategies A combination of passive and active styles ( a form of enhanced indexing) 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. 19-15 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

16. 19-16 Matched-Funding Techniques Immunization Strategies The process is intended to eliminate interest rate risk that includes: Price Risk Coupon Reinvestment Risk 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

17. 19-17 Matched-Funding Techniques 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

18. 19-18 Matched-Funding Techniques 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

19. 19-19 Matched-Funding Techniques 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 See Exhibit 19.17

20. 19-20 Exhibit 19.17

21. 19-21 Contingent and Structured Strategies Contingent procedures for managing bond portfolios are a form of what has come to be called structured active management Contingent Immunization (Exhibit 19.20) 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

22. 19-22 The Internet Investments Online http://www.ryanalm.com http://www.finpipe.com http://www.finpipe.com