FI & Rel. Value for Global Credit PM - R23/24 Flashcards
What are the increasing degrees of active bond portfolio management, from indexing to active management?
- Pure bond indexing
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Enhanced indexing by matching primary risk factors (sampling)
- maintains exposure to index’s primary risk factors
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Enhanced indexing by small risk factor mismatches
- same duration as index
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Active management by larger risk factor mismatches
- slight difference in duration vs index
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Full blown active management
- no limits on duration
What are the four primary considerations when selecting a bond benchmark?
Market value risk - varies directly with maturity. The greater the risk aversion, the lower the acceptable market risk, and the shorter the benchmark maturity.
Income risk - varies indirectly with maturity. The more dependent the client is upon a reliable income stream, the longer the maturity of the benchmark.
Credit risk - benchmark should match portfolio.
Liability framework risk - applicable only to portfolios managed according to a liability structure and should always be minimized.
Describe and evaluate techniques, such as duration matching and the use of key rate durations, by which an enhanced indexer may seek to align the risk exposures of the portfolio with those of the benchmark bond index.
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Duration
- Obviously linear in nature. Consider convexity.
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Key rate duration
- Sensitivity to twists in the yield curve
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Present value distribution of cash flows (PVD)
- measures the propotino of the index’s total duration that is attributable to cash flows.
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Sector/quality percent
- match the weights of both
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Sector duration contributions
- match the proportion of index duration contributed by each sector / quality (below)
- Quality spread duration contribution
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Sector/coupon/maturity cell weights
- Difficult to measure callability, so better off to match sector, coupon and maturity weghts
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Issuer exposure
- Have a sufficient number of securities to minimize event risk.
Contrast and demonstrate the use of total return analysis and scenario analysis to assess the risk and return characteristics of a proposed trade.
Total Return Analysis
Accurate as the most likely return given the environment; only for one change in rates.
Scenario Analysis
Better holistic understanding and is an excellent risk assessment and planning tool.
Evaluates the impact of the trade under all reasonable sets of assumptions.
What is the formula for dollar duration?
DDp = -(MDp)(0.01)(Portfolio Value)
Where MD = Modified Duration
Adjusting Portfolio Dollar Duration
What are the 3 steps?
Dollar duration changes as interest rates change or as time passes. To re-adjust portfolio DD:
Step 1. Move forward in time and include a shift in the yield curve, using the new market values and durations, calculate the dollar duration of the portfolio at this point in time.
Step 2. Calculate the rebalancing ratio
Step 3. Multiply by the desired percentage change in step 2. This number is the amount of cash needed for rebalancing.
Rebalancing Ratio = old DD / new DD
%Chg = rebalancing ratio - 1
What is spread duration?
Spread duration measures the sensitivity of non-treasury issues to a change in their spread above treasuries of the same maturity. The spread is a function of perceived risk as well as market risk aversion.
- Nominal Spread
- Zero-Volatility Spread
- Option-Adjusted Spread
Z-volatility spread: The constant spread that will make the price of a security equal to the present value of its cash flows when added to the yield at each point on the spot rate Treasury curve where a cash flow is received . In other words, each cash flow is discounted at the appropriate Treasury spot rate plus the Z-spread.
What is classical immunization?
Classical immunization is the process of structuring a bond portfolio that balances any change in the value of the portfolio with the return from the reinvestment of the coupon and principal payments received throughout the investment period.
The goal is so if interest rates rise, the gain in reinvestment income >= the loss in portfolio value
If interest rates decrease, the gain in portfolio value >= the loss in reinvestment income.
To effectively immunize a single liability:
Select a bond (or bond portfolio )with an effective duration equal to the duration of the liability
Set the present value of the bond (or bond portfolio) equal to the PV of the liability
How do you immunize a single liability?
Select a bond or bond portfolio with an effective duration equal to the duration of the liability.
Set the PV of the bond (or bondp) equal to the present value of the liability
Without rebalancing, classical immunization only works for a 1-time instantaneous change in interest rates. Portfolios cease to be immunized for a single liability when interest rates flucturate more than once or time passes.
Since active management exposes the portfolio to additional risks, immunization strategies are also risk-minimizing strategies.
What are three modifications or extensions to classical immunization theory?
- Use of multifunctional duration or key rate duration. The manager will focus on certain key interest rate maturities.
- Multiple liability immunization. The goal is ensuring that the portfolio contains sufficient liquid assets to meet each of the liabilities as it ocmes due.
- Allowing for increased risk, or relaxing the minimum risk requirement of classical immunization. The manager intends to pursue increased risk strategies that can lead to excess portfolio value (so long as he does not risk jeoparidizing the liability structure)
What is contingent immunization?
Contingent immunization is the combination of active management strategies and passive management techniques (immunization). As long as the rate of return on the portfolio exceeds a prespecified safety net return, the portfolio is managed actively.
If the portfolio return declines to the safety net return, the immunization mode is triggered to “lock in” the safety net return. The safety net return is the minimum acceptable return as designated by the client.
What are three risks to immunization, and can you describe them?
Interest rate risk - the primary concern.
Contingent claim risk - aka call risk or prepayment risk. Downside risk (after interest rates have fallen) as the manager might lose not only the higher stream of coupons but may need to reinvest the principal at a reduced rate of return.
Cap risk - If a bond has a floating rate, they may be subjected to a cap. If so, then when interest rates rise, they may not fully adjust and would affect the immunization capability of the portfolio
Can you identify and describe the three main immunization strategies?
*List two advantages and a disadvantage for the last one.
Multiple Liability Immunization
- DurationPortfolio = DurationLiabilities
- PV of assets = PV of liabilities
- range of asset durations > range of liability durations
Cash flow matching - selecting bonds that may have CFs that correspond to those of the liability stream.
Combination matching - aka horizon matching - creates a duration matched portfolio that is also cash flow matched during the first few years.
- advantages: provides liquidity in the initial period
- reduces the risk associated with nonparallel shifts in the yield curve
- disadvantage = cost
Compare risk minimization with return maximization in immunized portfolios.
Basically a trade-off. Sometimes the return is worth it, as in the concept behind contingent immunization. The manager who has an ability to lock in a specific rate may pursue active management to generate excess value.
Risk minimization produces an immunized portfolio with a minimum exposure to any arbitrary interest rate change subject to the duration constraint.This objective may be too restrictive in certain situations. If a substantial increase in the expected return can be accomplished with little effect on immunization risk, the higher-yilding portfolio may be preferred in spite of its higher risk.
Discuss the implications of cyclical supply and demand changes in the primary corporate bond market and the impact of secular changes in the market’s dominant product structures.
*List 3 implications associated with these product structures
Cyclical changes are changes in the number of new bond issues. Increases in the number of new bond issues are sometimes associated with narrower spreads and relatively strong returns. Corporate bonds often perform best during periods of heavy supply.
Secular changes. In all but the high-yield market, intermediate-term bullets dominate the corporate bond market. Bullet maturities are not callable, putable, or sinkable. Callable issues still dominate the h_igh-yield segment._
- Securites with embedded options trade at a premium due to their scarcity
- Managers seeking longer durations pay a premium b/c of the tendency toward intermediate maturities
- Credit-based derivatives will be increasingly used to take advantage of return and/or diversification benefits across sectors, structures, and so forth.
