Chapter 16: Managing Bond Portfolios Flashcards
What are some Fixed Income (Bond) Strategies for Passive Managers?
Passive Strategies (less hands-on):
- Indexing: You invest in a portfolio that mimics a market index (like the S&P 500), aiming to match its performance.
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Immunization: used to ‘immunize’ interest rate risk.
- Match the duration of the assets and liabilities;
the negative effects of price risk (from rising rates) and reinvestment rate risk (from falling rates) offset each other. ; Regular rebalancing is necessary to maintain.
- Match the duration of the assets and liabilities;
- Cash Flow Matching and Dedication: You invest in bonds that provide cash flows (interest and principal) that match the timing of your future cash needs, like paying off debts.
what is Immunization Strategy?
the immunization strategy involves:
1. matching the duration of bond assets with the duration of liabilities to ensure that cash flows meet obligations regardless of interest rate movements.
- Price Risk: This is the risk that the market value of bonds will decline if interest rates rise. When rates go up, bond prices typically fall, leading to potential losses in the portfolio’s value.
- Reinvestment Rate Risk: This is the risk associated with reinvesting cash flows (interest payments) at lower rates if interest rates decrease. When rates fall, the interest earned on reinvested cash flows could be lower than expected.
- Cancellation Effect: In a well-structured immunization strategy, the negative effects of price risk (from rising rates) and reinvestment rate risk (from falling rates) offset each other. This means that whether rates rise or fall, the overall value of the bond portfolio should remain stable in relation to the value of the liabilities
What are some Fixed Income (Bond) Strategies for Active Managers?
Active Strategies (more hands-on, trying to beat the market):
* Interest Rate Forecasting: Predicting future interest rates and adjusting the portfolio to profit from those changes.
* If you’re the issuer of the bond and rates decreases, then extend the duartion of the bond because prices are going up (profit from capital gains.
* if you forecast rates are increasing, then decrease the duration of the bond, as you may lose money from capital loss
* Capturing Bond Mispricings:
* Substitution Swap: Exchanging one bond for another with similar characteristics but better value.
* Market mispriced an undervalued bond or overvalued bond (sell).
* Intermarket Spread Swap: Switching between bonds from different markets (e.g., corporate vs. government) to take advantage of price differences.
* Rate Anticipation Swap (Buy or Sell): Buying or selling bonds based on expected interest rate changes.
* Pure Yield Pick-Up Swap: Swapping a low-yield bond for a higher-yield bond to increase income.
* selling lower yield T-bond for higher corporate yield bond
* Tax Swap: Selling a bond to realize a tax loss and buying a similar bond to maintain investment exposure.
What are some Fixed Income (Bond) Strategies for MIXED Passive and Active Managers?
Mixed Passive/Active Strategy:
* Contingent Immunization: A hybrid approach where you start with an active strategy but switch to immunization (passive) if market conditions go against you, protecting your portfolio from further losses.
* going from Active to Passive due to market fluctuations and protecting from further losses
If the price of the bond goes up the the yield goes ____?
down
- Long-term bonds tend to be more price sensitive than short-term bonds to “” “” changes.
- As maturity increases, price sensitivity increases but this rate of reaction slows down.
- Price sensitivity is “” related to a bond’s coupon rate.
(a higher coupon bond has less sensitivity to interest rate changes) - Price sensitivity is inversely related to the “””””” at which the bond is selling.
- interest rate
- Inversely
- Yield to Maturity
What is a Duration of a bond?
Measurement on how long in years, it takes for the purchase price of the bond to be repaid by the bonds cash flows
- Duration is a measure of the average time it takes to receive all cash flows (interest + principal) from the bonds.
Why is duration a key concept?
used as a statistic for effective average maturity of a portfolio, tool in immunization of portfolios, measure of interest rate senesitivity
What are the two formulas to calculate duration?
write it out
Rules for Duartion: there’s a higher duration for
Everything else being equal
Higher duration for:
* lower coupon bonds
* lower YTM bonds
* longer maturity bonds
What is Convexity?
Convexity is the curvature in the relationship between bond prices and interest rates. It reflects the rate at which the duration of a bond changes as interest rates change
- Convexity helps us understand not just how much the price changes, but how the rate of that change itself can change when interest rates fluctuate.
What are the limitations of duration in measuring a bond’s interest rate sensitivity?
Duration assumes a linear relationship between bond price and yield changes.
* In reality, the relationship is curved (convex).
Larger interest rate changes cause bigger errors when using duration to estimate price changes.
- Convexity measures the curve, showing how duration changes as interest rates change.
Why Do Investors Like Convexity?
Bonds with greater convexity tend to have higher prices and/or lower yields, all else equal
What are inverse Floaters?
Inverse floaters – bonds that pay a lower coupon if a specified interest rate increases. Can be created synthetically.
What are some Mortgage Backed Securities and their deritatives?
MBS’s and their derivatives:
CMO’s – collateralized mortgage obligations
IO’s- Interest only strips – entitles the holder to receive only the interest payments from a pool of mortgage loans, while the principal is not included.
- prices fall its useless now) when interest rates fall (due to mortgage prepayments)- people paying off more of their loans
PO’s – Principal only strips – do well when interest rates decrease (as people are paying off their principal)
