LA 8: RB 16 - Bond Portfolio and Management Strategies

Question 1

Are bond portfolios an excellent tool for (w.r.t. to risk)?

Answer 1

Bond portfolios are an excellent tool for diversifying risk.

Question 2

What are the two most important characteristics in the investment style of a bond portfolio?

Answer 2

• Credit quality of the bond

- Interest rate sensitivity

Question 3

What are the general classifications of the AVERAGE CREDIT QUALITY of a bond portfolio?

Answer 3

high
medium
low

Question 4

What are the general classifications of the INTEREST RATE SENSITIVITY of a bond portfolio?

Answer 4

Short-term
Intermediate-term
Long-term

Question 5

What are the types of passive portfolio strategies ?

Answer 5

a. Buy and hold

b. Indexing

Question 6

What are the types of Active management strategies ?

Answer 6

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)

Question 7

What are the types of core-plus management strategies?

Answer 7

a. Enhanced indexing

b. Active/passive ‘plus’ sectors

Question 8

What are the types of matched-funding techniques strategies?

Answer 8

a. Dedicated: exact cash match
b. Dedicated: optimal cash match
c. Classical immunization
d. Horizon matching

Question 9

What is a buy-and-hold strategy?

Answer 9

– 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

Question 10

What is an indexing strategy? How is performance analysis performed?

Answer 10

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

Question 11

What is an active management strategy?

Answer 11

• 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

Question 12

How does Interest rate anticipation work?

What sub-strategies are there and how do they work?

Answer 12

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

Question 13

How does valuation analysis strategy work? What is success dependent on?

Answer 13

– 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.

Question 14

How does the credit analysis strategy work?

Answer 14

– 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

Question 15

How does the yield spread analysis strategy work?

Answer 15

– 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

Question 16

How does a bond swapping strategy work?

Answer 16

– Involve liquidating a current position and simultaneously buying a different issue in its place with similar attributes but having a chance for improved return

Question 17

What types of bond swaps are there?

Answer 17

– Pure yield pickup swap
– Substitution swap
– Tax swap
– Swap strategies and market‐efficiency

Question 18

What is a Pure yield pickup swap?

Answer 18

• Swapping low‐coupon bonds into higher coupon

bonds

Question 19

What is a Substitution swap?

Answer 19

• Swapping a seemingly identical bond for one that is currently thought to be undervalued

Question 20

What is a Tax swap?

Answer 20

• Swap in order to manage tax liability (taxable & municipals)

Question 21

What is do bond swaps suggest by the use of swap strategies w.r.t. market‐efficiency?

Answer 21

• Bond swaps by their nature suggest market inefficiency

Question 22

What interrelated factors must an active approach to global fixed‐income management consider?

Answer 22

– 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

Question 23

What are Core-Plus Management Strategies?

Answer 23

• A combination of passive and active styles ( a form of enhanced indexing)
• The core portion is effectively managed as an index fund

Question 24

How do Core-Plus Management Strategies work?

Answer 24

• 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

Question 25

Why are Core-Plus Management Strategies implemented?

Answer 25

– Diversification effects help to manage risks

• Increased opportunities for exploiting managers security selection skills

Question 26

What is the goal of Matched-Funding Strategies?

Answer 26

Some investors have liabilities that need to be met from their investments – need to follow a matched funding strategy

Question 27

What are the types of Matched-Funding Strategies?

Answer 27

– Dedicated portfolios
– Immunization strategies
– Horizon matching

Question 28

What assumption is important w.r.t Matched-Funding Strategies?

Answer 28

Important assumption of strategies is that liabilities are predictable with some degree of precision (eg insurance companies, pension funds etc)

Question 29

How does the Exact cash match (Matched-Funding Strategies) work?

Answer 29

• Conservative strategy, matching portfolio cash
  flows to needs for cash
• Useful for sinking funds and maturing principal
  payments

Question 30

How does the Dedication with reinvestment (Matched-Funding Strategies) work?

Answer 30

• Does not require exact cash flow match with
  liability stream
• Great choices, flexibility can aid in generating
  higher returns with lower costs

Question 31

How do immunisation strategies work? And when are they applied?

(Matched-Funding Techniques)

Answer 31

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

Question 32

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)

Answer 32

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

Question 33

What are the difficulties associated with maintaining immunisation?

Answer 33

– Rebalancing required as duration declines more
slowly than term to maturity
– Modified duration changes with a change in
market interest rates
– Yield curves shift

Question 34

What is horizon matching? What is important w.r.t to horizon matching?

(Matched-Funding Techniques)

Answer 34

– Combination of cash‐matching dedication and
immunisation
- Length of the horizon period is important

Question 35

How does horizon matching work?

Answer 35

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)

Question 36

What do Contingent procedures for managing bond

portfolios are a form part of?

Answer 36

Contingent procedures for managing bond
portfolios are a form of what has come to be
called structured active management

Question 37

How does Contingent immunisation work?
What is the cushion spread?
What is the safety margin?
What is the trigger point?

Answer 37

– 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

Question 38

What does contingent immunization provide for the portfolio manager?

Answer 38

Provides flexibility for the portfolio manager to engage in active portfolio strategies