Fixed Income Flashcards
Roles of Fixed income in portfolio
Diversification benefits
Regular cash flow
Inflation hedging potential
Liability based
managed to match or cover expected liability payments with future projected cash inflows
Cash flow matching
attempts to ensure all future liabilities are match by CFs from bonds (no need for reinvestment or bond sales)
Duration matching
match the duration of the assets and liabilities
assets and liabilities should be affected similarly by a change in rates
derivatives overlay
close duration gaps between assets and liabilities or alter risk exposures of the assets
contingent immunization
when A>L, combines immunization with active management
duration matching vs cash flow matching
complexity : High vs Low
rebalancing : frequent rebalancing required vs not required but desirable
YC assumption: parallel YC shifs vs None
mechanism: risk of shortfall minimized by matching duration and MV of liability stream vs bond portfolio match liabilities
Total return mandates
Pure indexing : no deviation from risk factors, zero tracking risk
Enhanced indexing : match primary risk factors
Active management : deviation from primary risk factors
Bond market liquidity
- very heterogenous
- typically OTC
- liquidity highest after issuance
- less active secondary market
TRS as alternative to direct investment in bonds
- smaller intial outlay vs ETF and MFs
- investor doesn’t legally own the securities : rollover risk, require due dill
- allow investors to have access in subset of FI market
- need to collat mark to market position frequently
leverage
rl(VE+Vb)-Vbrb/Ve
methods of leverage
future contracts : gain exposure to underlying without actually transact it
swap agreement: collat may need to be posted
repurchase agreement:
security lending: collaterized by cash or high credit quality bonds
risk of leverage
alters risk-returns properties of a portfolio
magnifies losses
higher risk
forced liquidation
LDI
assets are managed to meet future liabilities
ADL
assets are given and liabilities are driven to manage IR risk
Laddered portfolio
provides both liquidity and diversification over time
spread bonds more/less evenly along the YC
better protection from structural risk
balance cash flow reinvestment and market price risk
bonds mature each year and are reinvested at the long end of the ladder
liquidity: always a bond close to redemption -> low duration, stable price
Derivatives overlay
manage a duration gap without using assets
contingent immunization
hybride passive-active strategy
MVa - MVl > 0
active investment strategy as operating under a total return mandate but if performance is poor and surplus evaporates return to passive strategy
contingent immunization and rates change
if we expect lower rates (higher bond price), overhedge MVa so MVa rise in value and bring sensibilities
if we expect higher rates (lower bond price), underhedge MVa so MVa decline in value and remove sensibilities
Risks in LDI
- Model risk : whenever assumptions are made on future events and used to assess key parameters
- Measurement error: approxmate portfolio duration with weighted average durations of individual bonds instead of cash flow yield
- spread risk: in derivatives, underluing of hedge may be treasuries but underlying of liabilities may be corpo bonds
- counterparty risk: when not collaterized
Risk in swaption
spread risk
collaterization exhausted risk
credit risk
quality of an index
unambiguous : components and weights are clearly defined
investable : all should be investable
measurable : index returns are readily calculable on a reasonably frequent basis
ETFs as alternative to direct investment in FI
greater liqudity
can trade at discount that can persist and throught out the day
Expectation of a static YC
Buy and hold : buy a bond with a duration greater than the benchmark
Rolling the YC : higher coupon income + capital appreciation by selling the bond at a higher price
Repurchase: buy a bond financed in the repo market
YC inversion
Extreme version of flattening in which the spread between long term and short term YTM falls below zero
Key rate duration
measure portfolio sensitivity over multiple maturities
What cause a difference of YC between two countries ?
difference of inflation
difference of economic growth
difference of monetary/fiscal policy
yield spread disadvantage
curve slope and maturity mismatch
will not be a good measure of carry return
only useful in relative value with bonds same maturity
benchmark can change over time
I spread advantage
better used as a way to express the price of a bond relative to a curve
can more accurately measure carry return
CDS basis
difference between the Z spread on an issue and the CDS spread of the same maturity for the same issuer
CDS spread - Z spread
negative basis trade = buy a bond, buy a CDS
Structural credit model (bottom up)
use market variable to estimate asset value
define the likelihood of default as the prob of the assets falling below liab, with zero net assets
Covered bonds perform relatively well in a downturn versus other fixed-income bonds with real estate exposure because the investor also has recourse to the issuer.
CDOs are securities whose underlying cash flows are the interest and principal of the underlying debt instruments that are pledged as collateral. Whenever the value of a CDO is different from the value of its underlying collateral (in this example, the CDO value is lower as implied by the BB rating of its underlying debt instruments), an arbitrage opportunity exists.
Liquidity risk
Liquidity risk is associated with exhausting available collateral funds to meet margin calls on derivative positions or to pay benefits.
Model risk
Model risk refers to making incorrect assumptions regarding future liabilities or approximations being inaccurate.
Spread risk
when hedging the liabilities, the yield of high-quality bonds is used in the discounting process, whereas most investment solutions use a more diversified and lower-quality portfolio of corporate bonds
Portfolio with the lowest duration/convexity will suffer the less from rise in IR
