Active Bond Portfolio Management Strategies

1. Active Bond Portfolio Management Strategies Zvi Wiener Based on Chapter 17 in Fabozzi Bond Markets, Analysis and Strategies http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

2. Main Steps • 1. Setting investment objectives • 2. Establishing investment policy • 3. Selecting a portfolio strategy • 4. Selecting assets • 5. Measuring and evaluating risk and performance Fabozzi Ch 17

3. Setting Investment Objectives • Pension funds • Insurance: life, property and causality • Banks • Mutual funds • Money managers • Main idea ALM! • ALM=Assets-Liabilities Management Fabozzi Ch 17

4. Establishing Investment Policy • Asset allocation • Regulatory constraints • Tax and reporting implications • Credit policy • Maximal loss • Modern approach: benchmarking! • Tracking error Fabozzi Ch 17

5. Selecting a portfolio strategy • Active versus passive strategies • Indexing and indexing plus • Structured portfolio strategies • Immunization • Cash flow matching • Debt management! • Other types of assets: GNMA, callable, etc. Fabozzi Ch 17

6. Measuring Risk and Performance • Relative to benchmark • Yield versus volatility • Exposure: • duration • convexity •  •  •  • ,  Fabozzi Ch 17

7. Measuring Risk and Performance • http://www.aimr.org/ • VaR = Value-at-Risk • RAROC = risk adjusted return on capital • Tracking error • Historical simulations • Stress tests • Scenario analysis Fabozzi Ch 17

8. Active Portfolio Strategies • Interest rates expectations strategies • Yield curve strategies • bullet strategy = concentrated durations • barbell strategy = two extreme maturities • ladder strategy = uniform distribution • Read dollar convexity in ch. 17 • Futures and other derivatives are very useful • Credit management Fabozzi Ch 17

9. Debt Management • New area! • Very little theoretical work is done • Various recipes exists • For example: government debt, corporate loans, etc. • Major problem is to quantify assets. Fabozzi Ch 17

10. Example • X – price = 80, duration = 5 • You have $10M notional of bond X. • This means $8M market value. • If IR will go 1% up, you will lose 5% of market value, i.e. $400,000. Fabozzi Ch 17

11. Example • Y – price = 90, duration = 4 • You can exchange your portfolio to bond Y. • You will buy $10*8/9 = $8.9M notional of Y • Or $8M market value. • If IR go 1% up you will lose • 4% of $8M = $360,000 Fabozzi Ch 17

12. Advanced Financial Instruments • Forwards and Futures • Options plain and embedded • Swaps – IRS, currency, asset swaps, credit • CMO, CLO, CBO, CDO • Repos and reverse repos (read ch. 17) • Credit derivatives: CLN, credit default swap Fabozzi Ch 17

13. Repos • Repurchase agreement – a sale of a security with a commitment (by the seller) to buy it back (from the purchaser) at a specified price and date. • It is a collateralized loan. • Interest rate is repo rate • $ interest = $ amount * repo rate * term/360 • General collateral or special collateral. Fabozzi Ch 17

14. Home AssignmentChapter 17 • Ch. 17: Questions 6, 9, 16, 18, 20, 21, 23 • May be more questions from Alon. • Read materials from major investment banks on the course website. Fabozzi Ch 17

15. Course summary • Fixed income instruments • Government and non-government bonds • Agencies, municipals, corporate • Prices and yields • Typical embedded options • Term structure of IR • Duration, convexity • Bond portfolio management Fabozzi Ch 17

16. Treasuries Investment grade Swap • Par Speculative grade Rating • Strips, zeros Duration Yield • Volatility Convexity Callable • LIBOR Puttable CP, CD • Spread Immunization Swap • TIPS Floater Debenture • Securitization GNMA, MBA Collateral • Convertible Default risk Yield curve • MTN Transition matrix Default • CMO, CDO, CBO, CLO, IRS, repo Fabozzi Ch 17

17. Exam • 11-Dec-02, 15:00-17:00, 4 טבע • 20-25 multiple choice questions • No correct answer may be a correct answer! • Mark the closest answer • Do not lose precision in calculations • Write your calculations on the exam • If you have specific questions before the exam, please contact me or Alon. Fabozzi Ch 17

18. Useful Internet Sites • http://www.smartmoney.com/bonds/This site contains a good source for current rates, the current and past yield curves, and explanations of how the shape of the yield curve can affect economic performance. It also has a summary of current economic factors that are influencing rates. http://www.bondresources.com/The site listed above has price and yield curve information and the ability to chart Treasury securities over time. • http://www.bloomberg.com/marketsThe site listed above has price and yield curve information and the ability to chart Treasury securities over time. • http://www.investinginbonds.comThe site listed above has price and yield curve information and the ability to chart Treasury securities over time. • http://www.stls.frb.org/Historical information on interest rates and other economic factors are available in the Federal Reserve Economic Data Base (FRED) at the address shown above. Data in FRED can be downloaded in a spreadsheet format. Fabozzi Ch 17

19. Useful Internet Sites • http://cnnfn.cnn.com/markets/bondcenter/rates.htmlGeneral price information can be found at the site listed above. http://www.investinginbonds.com/Detailed information on bonds can be found at this site. It is comprehensive and has many related links. • http://www.bondsonline.com/docs/bondprofessor-glossary.htmlDetailed information on bonds can be found at this site. It is comprehensive and has many related links. • Rating agencies: • http://www.standardandpoors.com/ratings/corporates/index.htm • http://www.moodys.comhttp://www.fitchinv.com • http://www.maalot.co.il/ Fabozzi Ch 17

20. Useful Internet Sites • http://www.bondweek.com/default.asp • http://www.federalreserve.gov/otherfrb.htmhttp://www.federalreserve.gov/releases/ • http://www.bondsonline.com/ • http://bonds.yahoo.com/rates.html • http://bonds.yahoo.com/search.html • http://www.isda.org/index.html • http://www.aimr.org/ Fabozzi Ch 17

21. Slides from my previous lecture, • or swaps, • http://pluto.mscc.huji.ac.il/~mswiener/teaching/FRM02S/frmHUJI02s.htm • http://pluto.mscc.huji.ac.il/~mswiener/teaching/FRM02S/intro_swap_mkt.pdf • or credit derivatives • FRMJorion22CreditDerivatives.ppt Fabozzi Ch 17

22. Negative convexity area Callable Bond price non-callable callable yield Callable bond = noncallable – call option price Fabozzi Ch 17

23. Option-Free Bond • Price = present value of the cash flow discounted at spot rates. Years YTM Market Value 1 3.5% 100 2 4.0% 100 3 4.5% 100 Years Spot rate Forward (1y) 1 3.500% 3.500% 2 4.010% 4.523% 3 4.541% 5.580% Fabozzi Ch 17

24. Option-Free Bond • 5.25% coupon bond with 3 years to maturity: Fabozzi Ch 17

25. r3,HHH r2,HH r1,H r3,HHL r2,HL r1,L r3,HLL r2,LL r3,LLL r0 Fabozzi Ch 17

26. r3e6 r2e4 r1e2 r3e4 r2e2 r0 r1 r3e2 r2 r3 Fabozzi Ch 17

27. Note that Fabozzi Ch 17

28. Option-Adjusted Spread OAS • OAS is the spread over the spot rate curve that is due to the embedded options. • Modified duration often assumes fixed cashflow. • A better measure is option-adjusted or effective duration. Fabozzi Ch 17

29. Effective Duration • P- -price if yield is decreased by y • P+ -price if yield is increased by y • P0 – initial price of the bond Fabozzi Ch 17

30. Effective Convexity Fabozzi Ch 17