Fixed Income Flashcards
What are the roles of fixed-income securities in portfolios?
- Diversification
- Steady cash flows
- Potential inflation hedging
What is the classification of fixed-income mandates?
An investment mandate specifies the parameters to which a portfolio must be managed.
A portfolio managed to a liability-based mandate generates future cash inflows that exactly match or otherwise cover expected future cash outflows. This process may also be called asset/liability management (ALM) or liability-driven investments (LDIs).
A portfolio managed to a total return mandate will either track or attempt to outperform a relevant benchmark.
What is the potential inflation-hedging features of bonds.
Floating-rate coupon bonds: apply a market rate to a fixed underlying amount. Protects the coupon income but not the principal amount from inflation.
Inflation-indexed bonds: pay a return directly linked to an index of consumer prices and adjust the principal for inflation. Protects both the coupon income and the principal amount from inflation.
How can fixed-income mandates may be classified?
Liability-based mandates: structured to meet a future liability. The process of structuring the asset returns to satisfy liabilities is referred to as asset-liability management (ALM).
Total return mandates: structured along a continuum from pure indexing (match an index return objective) to enhanced indexing and active management (designed to beat a total return objective).
What is the purpose of immunization in meeting a liability-based mandate?
Immunization structures bond investments to reduce or eliminate risks associated with changing market interest rates (reinvestment risk and price risk).
What are the differences between cash flow matching and duration matching immunization strategies?
Cash flow matching: Coupon and principal repayments from the bond portfolio are structured to make future liability payouts, eliminating the need for reinvestment and reinvestment risk.
Duration matching: The investor matches bond (asset) portfolio duration to the liability portfolio such that interest rate fluctuations that affect liabilities are reflected in the bond portfolio.
What are the 3 considerations for immunization?
- The portfolio must maintain liquidity to meet maturing liabilities and perform periodic rebalancing (created a return drag).
- There is no protection against changes in issuer credit quality or default.
- Effective duration must be used for bonds with embedded options.
What are the differences between contingent immunization and horizon matching as variations of cash flow and duration matching.
Contingent immunization: The manager immunizes the liability portfolio and may actively manage the surplus. The portfolio returns to full immunization if the surplus deteriorates.
Horizon matching: Cash flow matching for short-term liabilities; duration matching for longer-term liabilities. This protects against near-term interest rate risk and provides long-term flexibility.
What is the risk-return objectives of total return mandates?
Objectives frequently key on active return (portfolio less benchmark return) and active risk (annualized standard deviation of active returns).
Active risk may also be known as tracking error or tracking risk.
What is pure indexing?
The manager attempts to replicate the benchmark with zero tracking error but will underperform by transaction costs and expenses.
Managers may match risk factor exposures where benchmark securities are not available. Remaining idiosyncratic risk will be mitigated by a diversified portfolio/index.
What is enhanced indexing?
Allows variation from the benchmark to achieve modest outperformance (0.2% to 0.3% range). Active annual tracking error of 0.5% or less is common. Risk factors are generally matched, especially duration.
Higher management fees, along with potentially higher transaction costs, should be monitored closely to avoid eating up the benefits.
What is active management?
Active management allows greater factor mismatches to attempt higher active return (around 0.5%). Active annual tracking error of 0.5% or more is common.
Duration and other risk factor mismatches are quite large. After fees and expenses, most active managers underperform their benchmarks.
What is the liquidity premium as it relates to bonds?
Securities are considered liquid when their transaction has little price impact.
Dealers require wider spreads to compensate for holding illiquid bonds; investors require a liquidity premium to reimburse the wider dealer spread.
The size of the premium depends on:
* the desirability of the issue/issuer
* the issue size
* maturity
What is bond market liquidity in different subsectors?
Sovereign bonds generally issue in large quantity and have an active market.
In the corporate market, smaller issues may not be includable in indexes due to size and will trade less frequently with less analyst coverage. Longer maturities are also less liquid.
Counterparties may not be willing to inventory low credit issuers.
What is the effect of liquidity on fixed-income portfolio management?
Prices for some bonds are not readily available in the corporate market and matrix pricing (prices for comparable bonds) may be required.
Portfolio managers face a tradeoff where greater liquidity results in lower-yield bonds. PMs may restrict bonds to maturity ranges to avoid selling to meet liability payments.
What is a roll-down return?
It equals the bond’s percentage price change as the bond approaches maturity, assuming an unchanged yield curve.
In the absence of default, the bond’s price approaches par value as the time to maturity decreases.
What is the the notional value of a futures position?
A futures contract’s notional value equals the value of the underlying asset controlled by the contract or the current value of the underlying asset multiplied by the multiplier.
