LA 8: RB 16 - Bond Portfolio and Management Strategies Flashcards
Are bond portfolios an excellent tool for (w.r.t. to risk)?
Bond portfolios are an excellent tool for diversifying risk.
What are the two most important characteristics in the investment style of a bond portfolio?
- Credit quality of the bond
- Interest rate sensitivity
What are the general classifications of the AVERAGE CREDIT QUALITY of a bond portfolio?
high
medium
low
What are the general classifications of the INTEREST RATE SENSITIVITY of a bond portfolio?
Short-term
Intermediate-term
Long-term
What are the types of passive portfolio strategies ?
a. Buy and hold
b. Indexing
What are the types of Active management strategies ?
a. Interest rate anticipation
b. Valuation analysis
c. Credit analysis
d. Yield spread analysis
e. Sector/country analysis
f. Prepayment/option analysis
g. Other (e.g. liquidity, currency, anomaly capture)
What are the types of core-plus management strategies?
a. Enhanced indexing
b. Active/passive ‘plus’ sectors
What are the types of matched-funding techniques strategies?
a. Dedicated: exact cash match
b. Dedicated: optimal cash match
c. Classical immunization
d. Horizon matching
What is a buy-and-hold strategy?
– A manager selects a portfolio of bonds based on the objectives and constraints of the client with the intent of holding these bonds to maturity
– Can by modified by trading into more desirable positions
What is an indexing strategy? How is performance analysis performed?
The objective is to construct a portfolio of bonds that will track the performance of a bond index
– Performance analysis involves examining tracking error for differences between portfolio performance and index performance
What is an active management strategy?
• Active management strategies attempt to beat the market
• Mostly the success or failure is going to come from the ability to accurately forecast future interest rates
• Active strategy attributes (Exhibit 16.5)
– Scalability
– Sustainability
– Risk‐adjusted performance
– Extreme values
How does Interest rate anticipation work?
What sub-strategies are there and how do they work?
Reduce duration when you expect rates to increase and increase duration when you expect rates to decrease.
– Ladder strategy that staggers maturities
– Barbell strategy that splits funds between short duration and long duration securities
How does valuation analysis strategy work? What is success dependent on?
– The portfolio manager attempts to select bonds based on their intrinsic value
– Success is dependent on understanding the characteristics that are important in valuation and being able to accurately estimate the yield cost of these characteristics.
How does the credit analysis strategy work?
– Involves detailed analysis of the bond issuer to determine expected changes in its default risk
– Need to project rating changes before announcements from credit rating agencies.
– Two key areas of analysis: high‐yield bonds & defaulted debt
How does the yield spread analysis strategy work?
– Assumes normal relationships exist between the yields for bonds in alternative sectors
– When abnormal relationship occurs, a bond manager could execute various sector swaps
– The spread widens during economic recession
– Interest rate volatility also affects the spread
How does a bond swapping strategy work?
– Involve liquidating a current position and simultaneously buying a different issue in its place with similar attributes but having a chance for improved return
What types of bond swaps are there?
– Pure yield pickup swap
– Substitution swap
– Tax swap
– Swap strategies and market‐efficiency
What is a Pure yield pickup swap?
- Swapping low‐coupon bonds into higher coupon
bonds
What is a Substitution swap?
- Swapping a seemingly identical bond for one that is currently thought to be undervalued
What is a Tax swap?
- Swap in order to manage tax liability (taxable & municipals)
What is do bond swaps suggest by the use of swap strategies w.r.t. market‐efficiency?
- Bond swaps by their nature suggest market inefficiency
What interrelated factors must an active approach to global fixed‐income management consider?
– The local economy in each country including the
effects of domestic and international demand
– The impact of total demand and domestic
monetary policy on inflation and interest rates
– The effect of the economy, inflation and interest
rates on the exchange rates among countries
What are Core-Plus Management Strategies?
- A combination of passive and active styles ( a form of enhanced indexing)
- The core portion is effectively managed as an index fund
How do Core-Plus Management Strategies work?
• Combine beta investment (index) with alpha component (from active management)
• The rest of the portfolio is actively managed
– Often focused on high yield bonds, foreign bonds, emerging market debt
Why are Core-Plus Management Strategies implemented?
– Diversification effects help to manage risks
• Increased opportunities for exploiting managers security selection skills
What is the goal of Matched-Funding Strategies?
Some investors have liabilities that need to be met from their investments – need to follow a matched funding strategy
What are the types of Matched-Funding Strategies?
– Dedicated portfolios
– Immunization strategies
– Horizon matching
What assumption is important w.r.t Matched-Funding Strategies?
Important assumption of strategies is that liabilities are predictable with some degree of precision (eg insurance companies, pension funds etc)
How does the Exact cash match (Matched-Funding Strategies) work?
- Conservative strategy, matching portfolio cash
flows to needs for cash - Useful for sinking funds and maturing principal
payments
How does the Dedication with reinvestment (Matched-Funding Strategies) work?
- Does not require exact cash flow match with
liability stream - Great choices, flexibility can aid in generating
higher returns with lower costs
How do immunisation strategies work? And when are they applied?
(Matched-Funding Techniques)
The immunisation techniques attempt to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates
The process is intended to eliminate INTEREST RATE RISK that includes:
- Price Risk
- Coupon Reinvestment Risk
What is the classical immunisation?
Why use this metric to immunise rather than merely the maturity?
What does this strategy require to occur often?
(Matched-Funding Techniques)
Immunise a portfolio from interest rate risk by keeping the portfolio duration equal to the investment horizon
Duration strategy superior to a strategy based
only a maturity since duration considers both sources of interest rate risk
Rebalancing because the mod duration MUST = rem time horizon
What are the difficulties associated with maintaining immunisation?
– Rebalancing required as duration declines more
slowly than term to maturity
– Modified duration changes with a change in
market interest rates
– Yield curves shift
What is horizon matching? What is important w.r.t to horizon matching?
(Matched-Funding Techniques)
– Combination of cash‐matching dedication and
immunisation
- Length of the horizon period is important
How does horizon matching work?
Duration‐match for the time periods,
while cash‐matching within each time period
Cash matching fills in the failed arrears of the duration matching (e.g. the near term)
What do Contingent procedures for managing bond
portfolios are a form part of?
Contingent procedures for managing bond
portfolios are a form of what has come to be
called structured active management
How does Contingent immunisation work?
What is the cushion spread?
What is the safety margin?
What is the trigger point?
– Duration of portfolio must be maintained at the horizon value
– Cushion spread is potential return below the current market return
– Safety margin is a portfolio value above the required value
– Trigger point refers to the minimum return that will stop active portfolio management
What does contingent immunization provide for the portfolio manager?
Provides flexibility for the portfolio manager to engage in active portfolio strategies
