(9-11) CFA 3 - Readings 11-13 Flashcards
Reading 11 - Section 3
Classifying Fixed-Income Mandates
Overview:
Fixed-income mandates encompass two broad categories: Liability-Based Mandates and Total Return Mandates. These mandates cater to varying investor needs and goals within the fixed-income landscape.
- Liability-Based Mandates:
Objective: Manage investments considering future obligations, focusing on asset/liability management (ALM) or liability-driven investments (LDIs).
Approaches: Cash flow matching and duration matching, aiming to ensure future liabilities are covered by bond or fixed-income derivative cash flows.
Use Cases: Widely used by entities like pension plans and insurance companies to cover and minimize risks associated with future cash outflows.
- Total Return Mandates:
Objective: Manage to track or outperform market-weighted fixed-income benchmarks (e.g., Bloomberg Barclays Global Aggregate Bond Index).
Investor Base: Utilized by diverse investors, including individuals, foundations, endowments, and retirement plans.
Approaches:
Pure Indexing: Close replication of a bond index with a target of zero active return and risk compared to the benchmark.
Enhanced Indexing: Seeks slight outperformance while maintaining proximity to benchmark risk factor exposures.
Active Management: Allows more significant deviations from benchmark indices, potentially yielding higher returns but with increased risk and higher management fees.
ESG Considerations in Fixed-Income Mandates:
Some fixed-income mandates incorporate environmental, social, and governance (ESG) factors into their investment process.
Analysts and portfolio managers assess company operations and resource management practices to evaluate their alignment with sustainable business models.
Companies deemed unfavorable in ESG criteria might be anticipated to face ESG-related incidents in the future.
Conclusion:
Fixed-income mandates cater to distinct investor objectives, whether focusing on future obligations with liability-driven investments or aiming for returns relative to market benchmarks. Additionally, integrating ESG considerations reflects a growing trend toward responsible and sustainable investing within fixed-income strategies.
Reading 11 - Section 5
Bond Market Liquidity
Overview:
The liquidity of fixed-income securities, which refers to their tradability without significantly affecting their prices, varies extensively among different bond types and market structures.
- Variability in Fixed-Income Liquidity:
Market Dynamics: Compared to equities, fixed-income markets are generally less liquid, comprising diverse bonds with various features, such as maturity dates, coupon rates, and redemption features.
Market Structure: Fixed-income markets often operate as over-the-counter (OTC) dealer markets, incurring search costs for locating desired bonds and requiring multiple quotes for advantageous pricing.
Transparency Challenges: Transparency in bond markets is lower than in equity markets due to limited transaction data and quotes, affecting liquidity, search costs, and price transparency, particularly tied to issuer credit quality.
- Factors Affecting Bond Liquidity:
Post-Issuance Liquidity: Newly issued bonds (‘on-the-run’) of highly creditworthy issuers are more liquid compared to similar, previously issued ones (‘off-the-run’), primarily due to inventory availability with dealers.
Liquidity Premium: Investors demand higher yields for holding illiquid bonds to compensate for potential trading costs and bid-ask spreads, termed as a liquidity premium.
Market Sub-Sector Variations: Liquidity differs across bond sub-sectors based on issuer type, credit quality, issue size, and maturity, with sovereign government bonds typically more liquid than others.
- Impact on Fixed-Income Portfolio Management:
Pricing Challenges: Limited recent transaction pricing data in corporate bond markets poses challenges, prompting the use of matrix pricing to estimate current market yield and price.
Portfolio Construction: Investor preferences for liquidity affect portfolio choices, leading to a trade-off between yield to maturity and liquidity. Longer-term bonds may offer higher yields but lower liquidity.
Market Dealer Dynamics: Dealers manage bond inventory, with less liquid bonds often staying longer in inventory and commanding higher bid-ask spreads, impacting trading costs and portfolio decisions.
- Alternatives to Direct Investment:
Mutual Funds and ETFs: These provide liquidity and diversification benefits compared to direct bond investments. ETFs offer more tradability throughout the trading day.
Exchange-Traded Derivatives: Futures and options on futures offer exposure to underlying bonds with standardized terms, documentation, and pricing.
OTC Derivatives: Interest rate swaps, total return swaps, and credit swaps offer tailored portfolio exposure, although they require consideration of counterparty risk and regulatory constraints.
Conclusion:
Bond market liquidity significantly influences fixed-income portfolio management, affecting pricing accuracy, portfolio composition, and consideration of alternative investment vehicles. Understanding liquidity variations among bond types and market sectors is crucial for effective portfolio construction and decision-making in fixed-income investing.
Reading 12 - Section 2
Liability-Driven Investing (LDI)
- Scenario and Conceptualization:
Investor Perspective: Consider a 45-year-old investor planning retirement at 65, aiming for a stable post-retirement income. The focus here is on the fixed-income segment of their portfolio.
Investment Approach: The goal involves building a bond portfolio over 20 years, aiming to eventually sell the bonds to purchase an annuity for a consistent lifetime benefit post-retirement.
Interest Rate Volatility: The investor’s 20-year horizon is crucial in assessing the impact of future interest rate fluctuations on retirement income, framing the initial understanding of managing interest rate risk.
- LDI vs. Asset-Driven Liabilities (ADL):
LDI & ADL Defined: LDI and ADL are subsets of Asset Liability Management (ALM). In LDI, assets are managed based on existing liabilities, whereas in ADL, liabilities are structured to manage interest rate risks of existing assets.
LDI Examples: Life insurance companies manage liabilities from underwritten policies, while defined benefit pension plans create portfolios of rate-sensitive liabilities, managing assets accordingly.
ADL Illustrations: Companies aligning short-term debt with short-term contracts or those with revenue tied to business cycles prefer variable-rate liabilities, correlating interest rates with business performance.
- Analysis of Liabilities in LDI Strategy:
Liability Analysis: LDI strategies begin with an evaluation of liability size and timelines, involving various types of liabilities.
Classification Scheme (Exhibit 1): Different types of liabilities require effective duration calculations based on initial yield curve assumptions, allowing assessment via yield curve shifts.
Conclusion:
LDI involves managing assets based on existing liabilities, critical in scenarios like pension plans or insurance companies where liabilities are well-defined. Understanding liability types and their interest rate sensitivity is fundamental in constructing portfolios aligned with future financial obligations.
Reading 12 - Section 3
Liability-driven investing (LDI) stands as a strategic approach used in managing multiple liabilities’ interest rate risks. However, examining a single liability provides a clearer insight into a classic investment strategy known as interest rate immunization. The fundamental concept behind immunization involves structuring and managing a fixed-income bond portfolio to minimize the variance in realized returns over a specific known time span. This variance is a result of future interest rate volatility.
One of the most straightforward ways to immunize a single liability’s interest rate risk is by purchasing a zero-coupon bond that matures precisely when the obligation is due, matching the bond’s face value with the liability amount. The absence of coupon payments in such bonds eliminates reinvestment risk, and holding it to maturity removes price risk. However, availability might limit zero-coupon bonds in many financial markets.
Exhibits 2 and 3 depict the relationship between immunization and the duration of coupon-bearing fixed-income bonds. In these examples, a change in the yield curve affects bond value, countered by changes in coupon reinvestment, eventually balancing out at the bond’s Macaulay duration. This duration represents the point where price and coupon reinvestment effects neutralize each other for varying interest rates.
An illustrative example further demonstrates the strategy’s application. A portfolio comprising different bonds with varying yields and durations is structured to pay off a specific liability. The portfolio’s features, including market value, coupon payments, yields, and durations, align with achieving a rate of return that fulfills the obligation. The portfolio’s characteristics, such as Macaulay duration and convexity, are analyzed to ensure it closely matches the investment horizon.
Immunization, however, isn’t a static buy-and-hold strategy. Rebalancing becomes essential over time to maintain the portfolio’s target duration, aligning it with the liability’s due date. It involves managing a portfolio of coupon-bearing bonds that replicate the performance of a zero-coupon bond over time. This process continuously matches the portfolio’s Macaulay duration with that of the zero-coupon bond, minimizing structural risks associated with shifts and twists in the yield curve.
While parallel yield curve shifts are sufficient for immunization, the strategy can withstand some non-parallel shifts, though significant twists in the yield curve pose risks. Structural risk in immunization strategy arises from portfolio design and can be mitigated by minimizing dispersion and convexity, emphasizing the importance of maintaining a portfolio’s characteristics that align with the liability’s profile.
In summary, the hallmarks of a bond portfolio aimed at immunizing a single liability include matching the market value with the present value of the liability, aligning the portfolio’s Macaulay duration with the due date, and minimizing the portfolio’s convexity statistic. Regular rebalancing to maintain these characteristics is crucial, balancing the need to align with the investment horizon against transaction costs.
Reading 12 - Section 4
Cash Flow Matching:
Objective: Ensure sufficient cash inflows to cover liabilities.
Method: Build a portfolio of fixed-income bonds that align with scheduled cash outflows.
Benefits: Enhances credit rating; accounting defeasance possible.
Consideration: Dedicated bond portfolios used due to difficulties in buying back widely held bonds.
Duration Matching:
Objective: Align portfolio of fixed-income bonds with rates needed to pay off debt liabilities.
Approach: Structure and manage a bond portfolio to track performance for multiple debt liabilities.
Advantages: Helps in mitigating interest rate risks associated with changes in yield and market values.
Derivatives Overlay:
Objective: Rebalance an immunizing portfolio amidst yield curve shifts.
Method: Use futures contracts on government bonds to adjust the risk profile cost-effectively.
Purpose: Maintains the underlying portfolio while adapting to changes in the yield curve.
Contingent Immunization:
Condition: Active bond portfolio management if a surplus exists above a designated threshold.
Strategy: Pursue active investment strategies to reduce the cost of retiring debt without falling below the funding threshold.
Consideration: Liquidity and risk management are critical when actively managing the surplus.
Reading 13 - Section 2
Key Yield Curve and Fixed-Income Concepts for Active Managers:
Expected Fixed-Income Portfolio Returns due to Change in Benchmark Yields:
The anticipated returns for fixed-income portfolios under a yield curve change are composed of various elements:
Coupon Income: The regular interest payments received from bond holdings.
Rolldown Return: Changes in bond prices as they move closer to maturity.
Expected Price Changes due to Investor’s Views:
Benchmark Yields: Predicted changes in benchmark yields.
Yield Spreads: Foreseen alterations in spreads between different bond yields.
Currency Value Changes: Anticipated shifts in currency values impacting bond prices.
Factors Affecting Fixed-Income Portfolio Returns due to a Change in Benchmark Yields:
1. Yield Curve Dynamics:
Representation: Yield curves display yields-to-maturity for various maturities of specific issuers.
Model Assumptions: Assumptions in yield curve models may vary, impacting curve shapes and points.
Influence of On-The-Run and Off-The-Run Bonds: Inclusion of less liquid off-the-run bonds affects the curve’s shape, often pulling it higher.
2. Yield Curve Risk Factors:
Level, Slope, and Curvature Movements: Yield curve changes are categorized into parallel shifts (level), twists (slope), and curvature shifts.
Principal Components Analysis: Identifies that level changes contribute significantly more to yield curve shifts than slope or curvature.
3. Yield Curve Characteristics:
Level Changes: Parallel shifts in yields-to-maturity across maturities.
Slope Changes: Flattening or steepening of the yield curve indicated by differences in long- and short-term bond yields.
Shape or Curvature Changes: Reflects the relationship between short, mid, and long-term yields.
4. Duration and Convexity:
Duration: Measures linear bond price changes concerning yield-to-maturity alterations.
Convexity: Represents non-linear price behavior concerning yield changes, especially for larger movements.
Importance: Duration management typically holds more significance for level changes, while convexity is associated with slope and shape shifts.
Reading 13 - Section 3
Yield Curve Strategies in Fixed-Income Portfolio Management:
Market Expectations and Strategy Alignment:
The yield curve typically slopes upward, indicating higher yields for longer maturities. This suggests market expectations of rising or stable inflation and robust economic growth.
Active managers base strategies on growth and inflation forecasts, aligning with the yield curve’s implied future characteristics or diverging from them.
Static Yield Curve Strategies:
Duration and Leverage: Managers position portfolios by adjusting duration or leveraging, enhancing yield returns in an upward-sloping yield curve environment.
Cash-Based Strategies: Buying and holding bonds with longer durations, utilizing the “repo carry” trade, or “rolling down” the yield curve by buying longer-maturity bonds for higher returns.
Dynamic Yield Curve Strategies:
Divergent Rate Level Views: Portfolio adjustments for expected parallel shifts in the yield curve, capitalizing on rate level changes.
Divergent Yield Curve Slope Views: Strategies for yield curve steepening or flattening by combining positions in short- and long-term maturities.
Divergent Yield Curve Shape Views: Employing butterfly strategies—combining long and short maturities—to capitalize on anticipated changes in the yield curve’s shape.
Derivatives-Based Strategies:
Using futures contracts or interest rate swaps to increase duration exposure beyond benchmarks or to simulate cash-based strategies like the repo carry trade.
Derivatives offer implicit leverage but require adequate cash or collateral to cover margin requirements.
Performance Evaluation:
Key Rate Durations: Assessing a portfolio’s sensitivity to changes in different segments of the yield curve, comparing it to the benchmark’s key rate durations.
Duration and Convexity: Recognizing that duration and convexity are crucial for gauging risks and returns, especially in strategies with complex bond positions.
Risk Mitigation and Scenario Analysis:
Strategically positioning portfolios to benefit from or protect against anticipated shifts in the yield curve, based on economic scenarios, interest rate forecasts, and market conditions.
Trade Execution and Optimization:
Understanding the dynamic nature of yield curves and implementing strategies at opportune times based on expectations and risk-reward assessments.
Regulatory and Liquidity Considerations:
Complying with regulatory requirements regarding derivatives usage, maintaining cash or eligible collateral for margin purposes, and managing liquidity risks in less liquid bond markets.
