Fixed Income

Question 1

Discuss roles of fixed-income securities in portfolios and how fixed-income mandates may be classified.

Answer 1

Fixed income as an asset class provides 3-major roles when added to an investment portfolio:
diversification
regular cash flows
inflation protection (floating-rate securities and inflation-linked securities)

There are 2-major classifications of mandates:
liability-based mandates: which invest to fund future liabilities; and
total return mandates:which invest to track or beat a benchmark.

Question 2

What are the types of liability-based mandates for fixed-income securities?

Answer 2

Cash-flow matching: funds liabilities with coupon and par amounts received on the dates the liabilities are paid.

Duration matching: matches asset and liability duration to achieve comparable results. Duration matching generally gives more flexibility in asset selection and, therefore, may meet the objective at a lower cost.

Contingent immunization: is a hybrid of active management with potential immunization. The portfolio must initially be overfunded and can be actively managed. If successful (unsuccessful), the surplus will grow (be lost) and the ultimate cost will end up being lower (higher) than from immunization.

Question 3

What are the types of total return mandates for fixed-income securities?

Answer 3

Pure indexing: which exactly matches the holdings of the index.

Enhanced indexing: which allows modest deviations (but matches duration to control interest rate risk).

Active management: which does not restrict deviations versus the index and allows duration mismatches.

Question 4

Describe fixed-income portfolio measures of risk and return as well as correlation characteristics.

Answer 4

To aggregate duration and convexity measures for a portfolio of fixed-income assets, the cash-weighted average of the durations and convexities of the individual bonds is usually used.

Duration times spread (DTS) = spread duration × credit spread. It reflects the fact that bonds with larger spreads tend to have larger movements in spread.

A manager who expects interest rates to rise (fall) will lower (increase) duration.

A manager who expects credit spreads to widen (narrow) will lower (increase) spread duration.

Relative value analysis involves the ranking of individual bonds according to fundamental value drivers in order to pick the best securities to express a top-down view on markets.

Question 5

Describe bond market liquidity, including the differences among market sub-sectors, and discuss the effect of liquidity on fixed-income portfolio management.

Answer 5

Liquidity in the bond market (ability to buy or sell on a timely basis at or near fair market value) is substantially lower than in equity markets.

Most bonds do not trade or trade infrequently after issuance (said to go “off-the-run”).

The sheer number and variety of individual bond issues is immense.

The market is mostly over-the-counter with trade price and volume not reported.

Liquidity is highest for sovereign government, higher-quality, and most recently issued (on-the-run) bonds.

Smaller issues are generally less liquid.

Question 6

Why are smaller issue bonds generally less liquid?

Answer 6

Bond pricing data are more difficult to obtain.

Portfolio managers have to choose between more-liquid bonds or less-liquid bonds that may offer a liquidity premium.

Derivatives and ETFs are generally more liquid and are an alternative to direct investment in bonds.

Question 7

Describe and interpret a model for fixed-income returns.

Answer 7

Return can be projected (or actual return decomposed) as the sum of the following:
1. Coupon income: annual coupon amount / current bond price.
2. Rolldown return, assuming no change in yield curve: (projected ending bond price [BP] − beginning BP) / beginning BP.
3. Price change due to investor yield change predictions: (–MD × ΔY) + (½ C × ΔY^2).
4. Price change due to investor yield change predictions: (–MD × ΔS) + (½ C × ΔS^2).
5. Currency G/L: projected change in value of foreign currencies weighted for exposure to the currency.

Rolling yield = Coupon income + rolldown return

Question 8

Discuss the use of leverage, alternative methods for leveraging, and risks that leverage creates in fixed-income portfolios.

Answer 8

Leveraged portfolio return can be calculated as rI + [(VB / VE) × (rI − rB)].

If rI exceeds (is below) rB, the leverage enhances (reduces) portfolio return.

Repurchase agreements (and securities lending), futures contracts, and swaps can all be used to leverage return.

In addition to the detrimental effects if rI is less than rB, the lender of the funds can demand repayment, forcing liquidation of portfolio assets at fire sale prices, which can feed a financial crisis.

Question 9

Discuss differences in managing fixed-income portfolios for taxable and tax-exempt investors.

Answer 9

Taxes complicate portfolio management, as managers seeking to maximize return must consider the different tax effects of each portfolio decision.

Question 10

What is Macaulay duration?

Answer 10

Macaulay duration is the weighted average time to receive cash flows.

Macaulay duration increases linearly with maturity.

Question 11

What is Modified duration?

Answer 11

Modified duration is the estimated percentage change in a bond price given a 1% change in yield [measured as Macaulay duration / (1 + the periodic yield of the bond)].

Question 12

What is Effective duration?

Answer 12

Effective duration is the modeled estimated percentage change in a bond price given a 1% change in a benchmark curve. It is used for bonds with embedded options.

Question 13

What is Key rate duration?

Answer 13

Key rate duration (partial duration) is the estimated percentage change in a bond price given a 1% change in a key benchmark maturity yield while other yields remain the same.

Question 14

What is Empirical duration?

Answer 14

Empirical duration is the actual sensitivity of a bond’s price relative to movements in a benchmark rate from a linear regression.

Question 15

What is Money duration?

Answer 15

Money duration (dollar duration) equals modified duration × market value. It gives a sense of size, as well as sensitivity.

Question 16

What is the Price value of a basis point?

Answer 16

Price value of a basis point [DV01 or basis point value (BPV)] equals money duration × 0.0001. It measures the absolute currency sensitivity to a basis point move in rates.

Question 17

What is Convexity?

Answer 17

Convexity measures the curvature of the relationship of price and yield. More-convex bonds are expected to outperform less-convex bonds when yields shift.

Convexity is approximately proportional to duration squared.

Convexity is also directly related to the dispersion of cash flows in time around the Macaulay duration.

Question 18

What is Effective convexity?

Answer 18

Effective convexity models convexity when cash flows are not certain. It is used for bonds with embedded options.

Question 19

What is Spread duration?

Answer 19

Spread duration is the sensitivity of a bond’s price to a unit change in spreads.

Question 20

Describe liability-driven investing.

Answer 20

Liability-driven investing is a form of asset-liability management (ALM) that manages the assets in relation to the characteristics of the liabilities. This is easier when the future liability payouts are known in amount and timing. The liabilities are essentially the benchmark for making decisions.
Asset-driven investing is a less common form of ALM and adjusts the liabilities in relation to the characteristics of the assets.

Question 21

Evaluate strategies for managing a single liability.

Answer 21

Immunization can be used to fund liabilities with a high degree of certainty. The assets are dedicated to this purpose and all cash flows are reinvested until needed for payout.

Cash flow matching is without risk, assuming there are no defaults. Bonds are bought and held in sufficient amount and pay date to meet the liabilities. It is the most restrictive strategy, and so typically costs more (has lowest return).

Duration matching achieves similar results, but is less restrictive in the assets selected. Matching Macaulay duration of the assets to liabilities balances the exposure between price and reinvestment risk. Duration and other portfolio statistics should be based on portfolio yield (IRR).

To immunize a single-period liability:
Initial PVA equals (or exceeds) PVL. (There are exceptions to this for more complex situations where initial portfolio IRR differs from initial discount rate of the liability.)
Match Macaulay durations (DA = DL).
Minimize portfolio convexity.
Rebalance the portfolio to maintain the duration match.

Immunization (duration matching) issues include the following:
The assets have greater convexity than the single date liability; therefore, the portfolio benefits from large parallel shifts but is at risk from curve twists (nonparallel shifts). Minimizing convexity minimizes this structural risk.
Immunization can be interpreted as zero replication, meaning a successful immunization will replicate the price and yield path of a zero-coupon bond that could have been used for a perfect cash flow match immunization.

Question 22

Compare strategies for a single liability and for multiple liabilities, including alternative means of implementation.

Answer 22

Multiple liabilities can be cash flow matched with a portfolio of zero-coupon bonds or coupon-bearing bonds whose cash flows (P&I) most closely match the liability payouts. Duration matching can be done by matching the BPV of the assets and liabilities.

The rules are as follows:
Initial PVA equals (or exceeds) PVL (see the caveat given under single liability rules).
BPVA = BPVL
Asset dispersion of cash flows and convexity exceed those of the liabilities (but not by too much, in order to minimize structural risk exposure to curve reshaping).
Regularly rebalance the portfolio to maintain the BPV match.

Derivatives are often used to adjust the BPV of the assets and hedge or partially hedge the duration gap:
Buying (selling) futures or receive (pay) fixed swaps increases (decreases) asset duration and BPV.
Futures BPV ≈ BPVCTD / CFCTD
BPV = MD × V × 0.0001
Nf = (BPV of liability − BPV of current portfolio) / BPV of futures.
NP for swap = (BPV of liability − BPV of current portfolio) / BPV of 1 NP for the swap.
BPVswap is the difference in BPV between the fixed and floating sides.

Contingent immunization (CI) requires the portfolio be overfunded with a positive surplus (PVA > PVL). If the surplus is positive, the portfolio can be actively managed (not immunized):
If active management is successful, the return will exceed the initially available immunization rate, the surplus will grow, and the ultimate cost of the strategy will be less than immunizing.
If active management fails, the surplus will decline to zero and the portfolio must be immunized. The ultimate cost will exceed that of immunizing.

Question 23

Describe construction, benefits, limitations, and risk–return characteristics of a laddered bond portfolio.

Answer 23

Laddered portfolios:
Can be useful in cash flow matching multiple liabilities.
Provide diversification across the yield curve and natural liquidity as a portion of the bonds come due each year. In an upward-sloping yield curve, this can also be desirable as each maturing bond is rolled over into the longest (and highest yielding) maturity used in the ladder.
Have more convexity than a bullet portfolio because their cash flows are more distributed.
Could be constructed with a sequence of target-date ETFs as an alternative to individual bonds.

Question 24

Evaluate liability-based strategies under various interest rate scenarios and select a strategy to achieve a portfolio’s objectives.

Answer 24

A 100% hedge eliminates the duration gap (matches BPV of assets and liabilities).

In the normal scenario of BPVA < BPVL, a manager who expects interest rates to:
Increase will reduce the hedge size, leaving the BPV of assets less than that of a fully hedged duration gap. Leaving the BPV of assets at a lower level means they will decline in value less as interest rates increase.
Decrease will increase the hedge size, increasing the BPV of assets above that of a fully hedged duration gap. Increasing the BPV of assets means they will increase in value more as interest rates decrease.

Regarding the three swap methods of reducing a negative duration gap (increase BPV of assets):
Entering a receive-fixed swap is generally optimal if interest rates in the future are below the swap’s SFR.
Using a zero-cost collar (buy receiver swaption and sell payer swaption) is generally optimal if interest rates in the future are moderately higher (i.e., between the swap and payer swaption SFRs).
Buying a receiver swaption is generally optimal if interest rates in the future exceed the payer swaption SFR by some amount.

Question 25

Explain risks associated with managing a portfolio against a liability structure.

Answer 25

Risks include:
Hedge amounts are approximations based on assumed durations and ignore convexity.
Duration assumes parallel shifts in the curve.
Twists in the yield curve can create structural risk (risk due to curve reshaping).
Multiple assumptions (model risk) are required to model the characteristics of complex liabilities, such as those in DB plans.
Measurement error issues occur when weighted average characteristics are used instead of portfolio statistics based on portfolio yield (IRR).
Futures base calculations are approximations based on an assumed CTD bond, and that CTD can change.
Spread risk exists if the relationship between asset yield and liability discount rate changes.
Traditionally, OTC derivatives have counterparty risk.
Cash flow risk for exchange-traded and OTC derivatives requiring cash settlement of gain/loss or margin.
Asset liquidity risk if positions cannot be quickly adjusted at near fair market value.

Question 26

Discuss bond indexes and the challenges of managing a fixed-income portfolio to mimic the characteristics of a bond index.

Answer 26

Bond index funds offer low cost diversification. Their goal is to minimize tracking error.

But there are challenges (compared to equity):
A much larger number of bond issues with diverse characteristics exists. This generally makes full replication impractical.
Liquidity has declined post-2008, is often low, and varies by bond issue.
Trading is OTC, and dealers have become less able to supply liquidity.
Most individual bonds rarely trade, and price must be estimated based on matrix pricing.
Bond index composition and characteristics can change.

Enhanced indexing matches the primary risk factors of the index. To minimize tracking error:
Match modified duration—and effective duration if there are option features.
Match key rate durations.
Match weighting exposure to the various bond sectors, quality ratings, issuers, and all other material factors. Cell matching is a common technique used to do this.

Question 27

Compare alternative methods for establishing bond market exposure passively.

Answer 27

Passive bond market exposure can be achieved with:
A separately managed account that replicates the index.
Index mutual funds, either open ended or ETFs.
Synthetic strategies such as receiving a bond index return under a total return swap.

Question 28

Discuss criteria for selecting a benchmark and justify the selection of a benchmark.

Answer 28

Determine the client’s objectives and constraints before finalizing the strategic asset allocation. Then, select a bond index that matches the objectives and constraints as well as the desired asset class characteristics.

Selecting a suitable index is complicated by:
The possible decline in index duration as the bonds age.
The changing characteristics of many indexes over time as the holdings change.

Question 29

Describe the factors affecting fixed-income portfolio returns due to a change in benchmark yields.

Answer 29

The three primary yield curve changes are changes in:
* Level, as measured by a parallel shift in yields across the curve.
* Slope, as measured by long-term yields – short-term yields.
* Curvature, as measured by the butterfly spread:

–(short-term yield) + (2 × medium-term yield) – long-term yield

The five-step return decomposition process can be used to analyze the impact of changes in the yield curve on fixed-income securities:
1. Coupon income = annual coupon amount / current bond price
2. Rolldown return = [projected bond price (BP) assuming no yield curve change − beginning BP] / beginning BP
3. Price change due to investor yield change predictions: (–MD × ΔY) + (½C × ΔY2)
4. Price change due to investor spread change predictions: (–MD × ΔS) + (½C × ΔS2)
5. Currency G/L: projected change in value of foreign currencies weighted for exposure to the currency
The impact of changes in the benchmark yield curve (ΔY) is captured in part 3 of the process.

Question 30

Formulate a portfolio positioning strategy given forward interest rates and an interest rate view that coincides with the market view.

Answer 30

Active strategies when the (upward-sloping) yield curve is expected to be stable:
* Buy and hold—extend duration to get higher yields.
* Rolling down the yield curve—weight the portfolio highest for securities at the long end of the steepest yield curve segments, which maximizes price gains on securities from declines in yield as time passes.
* Repo carry trade—buy a long-term bond using short-term repo financing.
* Long futures—increase the leverage of the portfolio through futures contracts.
* Receive-fixed swap—earn the swap carry of swap fixed rate – MRR.

Question 31

Formulate a portfolio positioning strategy given forward interest rates and an interest rate view that diverges from the market view in terms of rate level, slope, and shape.

Answer 31

hange in Yield Curve Level

A manager expecting a parallel shift down (up) in yields should increase (decrease) the duration of the portfolio.

Strategies to alter the duration of a portfolio are as follows: Duration
Cash bond:
+ Overweight longer-dated bonds
- Short sell bonds/overweight shorter-dated bonds

Swap:
+ Receive fixed
- Pay fixed

Futures:
+ Long contracts
- Short contracts

Change in Slope
* Steepening curve: short sell long-dated bonds and buy short-dated bonds.
* Flattening curve: buy long-dated bonds and short sell short-dated bonds.
A manager with no view on the overall level of yields should structure the trades just listed to be duration neutral. If a manager is bullish (bearish) on the yield level, they should position the portfolio to have positive (negative) duration.

Change in Curvature:
* Increasing curvature (negative butterfly twist): short sell bullet (body), buy barbell (wings)
* Decreasing curvature (positive butterfly): short sell barbell (wings), buy bullet (body)
A manager with no view on the overall level of yields should structure the trades just listed to be duration neutral. If a manager is bullish (bearish) on the yield level, they should position the portfolio to have positive (negative) duration.

Question 32

Formulate a portfolio positioning strategy based upon expected changes in interest rate volatility.

Answer 32

A callable bond (option-free bond and short call option) will rise at a slower rate than an option-free bond as yields fall (exhibiting negative convexity).

A putable bond (option-free bond and long put option) will fall at a slower rate than an option-free bond as yields rise.

Option strategies: Impact on Duration
* Long call on bond prices/bond futures prices = Increase
* Long put on bond prices/bond futures prices = Decrease
* Long payer swaption = Decrease
* Long receiver swaption = Increase

Question 33

Evaluate a portfolio’s sensitivity using key rate durations of the portfolio and its benchmark.

Answer 33

Key rate duration (or partial duration) measures the sensitivity of a portfolio to a movement in a key maturity rate while other rates remain constant.

KeyRateDur = change in portfolio value ÷
(portfolio value × change in key rate)

A high positive (negative) key rate duration at a specific maturity implies that the portfolio will outperform if this maturity rate falls (rises) relative to other maturities.

Question 34

Discuss yield curve strategies across currencies.

Answer 34

The domestic return of a foreign bond with a foreign currency return, RFC, and a return from the DC/FC exchange rate of RFX is as follows:
RDC = (1 + RFC)(1 + RFX) – 1

In efficient markets, covered interest rate parity means that high interest rate currencies trade at a forward discount. This means that a hedged foreign bond position cannot earn excess returns because any interest rate advantage of the foreign bond is offset by the forward discount. Hence, a hedged foreign bond investor earns their, domestic interest rate.

An unhedged manager in a foreign bond will earn the foreign currency return of the bond and any appreciation/depreciation of the foreign currency over the investment horizon (as per the formula just listed). Uncovered interest rate parity theorizes that high interest rate currencies should actually weaken over time. This theory tends not to hold and allows the unhedged manager to earn excess returns from the carry trade (borrow in a low interest rate currency, deposit in a high interest rate currency).

A manager wishing to hedge exposure to a foreign coupon-paying bond should enter a fixed-fixed cross-currency swap as the foreign currency payer and domestic currency receiver.

Question 35

Evaluate the expected return and risks of a yield curve strategy.

Answer 35

The five-step return decomposition process from LOS 13.a can be used to assess the relative performance of different portfolios under different yield curve change scenarios.

Question 36

Describe risk considerations for spread-based fixed-income portfolios.

Answer 36

The two primary components of credit risk are probability of default (POD), usually expressed as an annualized probability, and loss given default (LGD) or loss severity calculated as 1 – recovery rate (RR). The credit valuation adjustment (CVA) of a credit-risky bond is the present value of expected credit losses, calculated as the sum of (POD × LGD × expected exposure) across the life of the bond. The credit-risky bond’s fair value is equal to an equivalent risk-free bond’s value minus the CVA.

The following is a simple approach to estimating the fair credit spread for the next period:

spread ≈ POD × LGD

A plot of credit spreads versus maturity for a class of bonds is called the credit spread curve. This curve is largely driven by the credit cycle linked to the general level of economic activity as follows:

Empirical duration is based on regression of market data of actual bond price returns and benchmark rate changes. Since the actual bond price is driven by both spreads and benchmark rates, empirical duration will be lower than analytical duration for low-quality securities.

Question 37

Discuss the advantages and disadvantages of credit spread measures for spread-based fixed-income portfolios, and explain why option-adjusted spread is considered the most appropriate measure.

Answer 37

Fixed-Rate Bond Credit-Spread Measures

yield spread (benchmark spread) = bond’s YTM – YTM of closest maturity on-the-run government bond

g-spread = bond’s YTM – interpolated YTM of the two adjacent maturity on-the-run government bonds

i-spread (interpolated spread) = bond’s YTM – the maturity interpolated swap fixed rate

asset swap spread (ASW) = bond’s fixed coupon – the maturity interpolated swap fixed rate

zero-volatility spread (z-spread) = bond’s spread over risk-free spot rates

The CDS spread is the fair value of the protection bought under a CDS contract, expressed as a periodic percentage of notional exposure.

CDS basis = CDS spread – z-spread

The option-adjusted spread (OAS) is a bond’s spread over an interest rate tree of potential future risk-free forward-rate paths. The OAS removes the impact of options on the spread and should be used to compare across different types of bonds.

Floating-Rate Note (FRN) Credit-Spread Measures

Quoted margin (QM) is the fixed margin above a floating market reference rate (MRR) making up an FRN coupon.

Discount margin (DM) is the constant spread above the current MRR rate offered by an FRN.

If DM is less (greater) than QM, then the FRN will trade above (below) par.

The rate duration and spread duration of an FRN are given by the following:

Zero-discount margin (Z-DM) is the constant spread above the current term structure of MRR rates offered by an FRN.

The Impact of Spreads on Portfolio Return

The effective spread duration and effective spread convexity of a portfolio are calculated using the following formulas:

The sensitivity of a bond portfolio to changes in spread is given by:

%∆price = (–EffSpreadDur × Δspread) + (½ × EffSpreadCon × Δspread2)

where Δspread is typically defined as the change in the OAS.

The duration times spread (DTS) of a bond portfolio respects the fact that spread changes tend to be proportional to spread size, and is approximately defined as follows:

DTS ≈ EffSpreadDur × spread

The excess return over credit losses expected from a bond portfolio is defined as the excess spread and calculated as follows:

expected excess spread = spread – (EffSpreadDur × ∆spread) – (POD × LGD)

Question 38

Discuss bottom-up approaches to credit strategies.

Answer 38

Bottom-up credit strategies aim to identify the most attractive individual bond investments by focusing on the operating history of the borrower and key financial ratios.

Credit-risk models used on a bottom-up basis can structural or reduced form. Structural models assess the probability of default as the probability of the assets of the borrower falling below the value of their liabilities. Reduced form models assess probability of default and the impact of credit losses through modeling the relationship between macroeconomic variables and the characteristic of the borrower.

An example of a reduced-form model is the Altman’s z-score, which maps key financial ratios to a z-score using linear regression. A z-score greater than 3 implies a low chance of default. A z-score between 1.8 and 3 indicates some chance of default, while a score below 1.8 indicates that default is likely.

Question 39

Discuss top-down approaches to credit strategies.

Answer 39

Top-down credit strategies: focus on macroeconomic factors that are likely to affect the credit portfolio. Managers attempt to form views on the timing of the credit cycle, lowering the credit rating of the portfolio prior to good economic conditions and increasing the credit rating of the portfolio prior to poor economic conditions.

Factor-based credit strategies: focus on identifying factors in fixed-income securities that are rewarded with a risk premium. Four factors that have been identified are carry, defensive, momentum, and value.

ESG techniques: in fixed income include negative screening, use of ESG ratings, and direct funding of ESG initiatives such as green bonds.

Question 40

Discuss liquidity risk in credit markets and how liquidity risk can be managed in a credit portfolio.

Answer 40

Fixed income has historically been an OTC market with low liquidity in off-the-run, smaller, emerging market corporate issues and higher liquidity for on-the-run, larger, developed market sovereign issues.

Transaction costs can be measured through the effective spread:

effective spread for a buy order = trade size × (trade price – midquote)

effective spread for a sell order = trade size × (midquote – trade price)

where: midquote = (bid + ask) / 2

Question 41

Describe how to assess and manage tail risk in credit portfolios.

Answer 41

Value at risk (VaR) is a measure of minimum expected loss occurring in a given time frame with a specified probability.

The three common methods used to generate distributions for VaR calculations are the parametric method, which uses the parameters of the normal distribution; the historical method; and Monte Carlo simulation.

Extensions of VaR include the following:
* Conditional value at risk (CVaR) is the expected loss given the portfolio is experiencing a loss in the tail.
* Incremental VaR (IVaR) (or partial VaR) measures the change in VaR from adding or removing a position in a portfolio.
* Relative VaR measures the VaR of a portfolio’s returns relative to a benchmark.

Question 42

Discuss the use of credit default swap strategies in active fixed-income portfolio management.

Answer 42

Under a credit default swap (CDS), a protection buyer pays a regular fixed coupon to the protection seller periodically over the life of the contract in return for a payment on a prespecified credit event on a reference issuer (or issuers).

If the fair value of the protection (the CDS spread) is different from the fixed coupon paid, then an upfront premium is paid/received by the protection buyer, as follows:
* DS spread = fixed coupon: None
* CDS spread > fixed coupon: [(CDS spread – fixed coupon) × EffSpreadDurCDS] paid to protection seller
* CDS spread < fixed coupon: [(fixed coupon – CDS spread) × EffSpreadDurCDS] paid to protection buyer

The CDS price as a percentage of par is quoted as follows:

CDS price ≈ 1 + [(fixed coupon – CDS spread) × EffSpreadDurCDS]

A CDS long-short strategy involves buying protection on issuers where credit spreads are expected to widen relative to other issuers, while simultaneously selling protection on issuers where credit spreads are expected to narrow relative to other issuers.

A CDS curve trade involves buying protection at maturities where CDS spreads are expected to rise relative to other maturities and selling protection at maturities where spreads are expected to fall relative to other maturities.

Question 43

Discuss various portfolio positioning strategies that managers can use to implement a specific credit spread view.

Answer 43

Static credit spread curve strategies when the (upward-sloping) credit spread curve is expected to be stable include the following:

Lower the credit quality of the portfolio or extend the spread duration of the portfolio.
Sell protection on lower-quality credit issuers or sell protection over longer maturities.

Question 44

Discuss considerations in constructing and managing portfolios across international credit markets.

Answer 44

A manager engaging in cross-border credit strategies should consider whether foreign market reliance on an industry or commodity export limits diversification, any significant sector weight differences between markets, differences in accounting standards, and difference in the magnitude and timing of credit cycles between countries.

The domestic return of a foreign credit investment is given by the following:

RDC = (1 + RFC)(1 + RFX) – 1

Investors in emerging markets should consider institutional factors such as political stability and enforcement of the law, the economic profile of the country, and the exchange rate regime.

Question 45

Describe the use of structured financial instruments as an alternative to corporate bonds in credit portfolios.

Answer 45

Structured credit instruments allow managers to access collateral they could not access directly asset backed securities (ABS), mortgage backed securities (MBS), covered bonds), to tailor their risk exposure through the tranching of securities (collateralized debt obligations [CDO], collateralized loan obligations [CLO]), or both.

Question 46

Describe key inputs, outputs, and considerations in using analytical tools to manage fixed-income portfolios.

Answer 46

Fixed-income analytical tools comprise three major parts: inputs (positions, market data, ratings, and index data), user-defined parameters (models, time horizon, and objectives), and outputs (risk summaries, portfolio construction, trading, and cash management tools).