Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Re

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

2. Bond Portfolio Management Strategies

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

4. (1) 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 • Two prominent strategies under this approach are the Laddered and Barbell strategies (see next six slides) • Indexing • The objective is to construct a portfolio of bonds that will equal the performance of a specified bond index

5. A laddered strategy distributes fixed income dollars throughout the yield curve. par value maturity • A barbell strategy differs from the laddered strategy in that less investment is made in the middle maturities. par value maturity Classic Passive Management Strategies • A credit barbell is a bond portfolio containing a mix of high-grade and low-grade securities.

6. Classic Passive Management Strategies Insert Figure 19-7 here.

7. Classic Passive Management Strategies Insert Figure 19-8 here.

8. Classic Passive Management Strategies Insert Figure 19-9 here.

9. Classic Passive Management Strategies Insert Figure 19-10 here.

10. rising interest rate falling interest rate interest rate barbell ladder riskfavored favored reinvestmentbarbell ladder rate risk favored favored The Risk of Barbells and Ladders • If durationladdered portfolio > durationbarbell portfolio , • Yield curve inversion means short-term rates are rising faster than long-term rates. Duration as a pure measure of interest rate risk only works for parallel shifts in the yield curve.

11. (2) 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

12. (2) 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

13. 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

14. (3) 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

15. 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 (3) Matched-Funding Techniques

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

17. 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)

18. 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

19. Horizon matching Combination of cash-matching dedication and immunization Important decision is the length of the horizon period (3) Matched-Funding Techniques

20. (4) 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

21. End of Chapter 20 • Bond Portfolio Management Strategies