Lecture 11 - Bond Portfolio Management II

Question 1

What does passive bond management assume?

Answer 1

Passive bond managers assume that the market is efficient. No one can beat the market. The best way for bond management is to accept prices of the bonds.

Question 2

Passive managers take bond prices as…

Answer 2

Fairly set and seek to control only the risk of their fixed income portfolio.

Question 3

What are the two strategies for passive bond management?

Answer 3

• Indexing strategy.

- Immunisation techniques.

Question 4

Both classes accept market prices as being correct but the two strategies differ greatly in terms of…

Answer 4

Risk exposure.

Question 5

What is the aim of bond index funds?

Answer 5

• To create a portfolio that mirrors the composition of an index that measures the broad bond market.
• Bond market indexes such as Bloomberg Barclays, Merrill Lynch, JP Morgan.
• Similar to stock market indexing.

Question 6

What is full replication?

Answer 6

Means to construct a portfolio to buy every security/bond in the market index according to the weight of the market bond index.

Question 7

What are the disadvantages of full replication?

Answer 7

• Difficult to purchase.
• Thinly traded.
• Rebalancing problem means there are transaction costs and trading costs occur.

Question 8

What is stratified sampling?

Answer 8

A cellular approach to construct a sample of bonds with similar characteristics in the general market index. Characteristics such as coupon rate and time to maturity etc.

Question 9

Immunisation techniques are used to…

Answer 9

Shield overall financial status from interest rate risk. They attempt to achieve a zero risk profile/portfolio.

Question 10

Immunisation balances…

Answer 10

Reinvestment risk (related to reinvestment of coupons) and price risk (related to interest rate sensitivity).

Question 11

Duration-matched assets and liabilities let the asset portfolio meet the…

Answer 11

Firm’s obligations despite interest rate movement.

Question 12

Duration (assets) equals…

Answer 12

Duration (liabilities).

Question 13

Immunisation is widely used by…

Answer 13

Pension funds, insurers, and banks.

Question 14

If the portfolio duration is chosen appropriately, the two effects…

Answer 14

Price risk and reinvestment risk can cancel out exactly.

Question 15

For a horizon equal to the portfolio’s duration (i.e. duration-matched assets and liabilities), the accumulated value of the investment fund at the horizon date will be…

Answer 15

Unaffected by interest rate fluctuations. Free from interest rate risk.

Question 16

If yield/interest rate increases then reinvestment risk has a…

Answer 16

Positive impact on the accumulated value of the payment.

Question 17

If yield/interest rate increases then price risk has a…

Answer 17

Negative impact on the accumulated value of the payment.

Question 18

If yield/interest rate decreases then reinvestment risk has a…

Answer 18

Negative impact on the accumulated value of the payment.

Question 19

If yield/interest rate decreases then price risk has a…

Answer 19

Positive impact on the accumulated value of the payment.

Question 20

Even if a portfolio is immunised, the portfolio manager still cannot…

Answer 20

Rest.

Question 21

Rebalancing is required…

Answer 21

To realign the portfolio’s duration with the duration of the obligation (as interest rates change and/or time passes).

Question 22

There is a trade off between perfect immunisation and what?

Answer 22

Trading costs. If we have perfect immunisation trading costs will be very high. If we reduce trading costs we will not have perfect immunisation. Need to compromise.

Question 23

Cash flow matching is a more direct form of immunisation that requires…

Answer 23

Matching cash flows from a bond portfolio with those of an obligation. Cash flow pattern of the bond/asset should be the same as the cash flow pattern of the obligation. If this is the case we do not need to care about interest rate risk. It may not be feasible due to bond selection constraints.

Question 24

Cash flow matching in a multi period basis is referred to as a…

Answer 24

Dedication strategy.

Question 25

Active bond management.

Answer 25

Managers think they have superior ability. The markets are not perfectly efficient and they think they can beat the market and want to.

Question 26

What are the two sources of potential profit in active bond management?

Answer 26

1. Interest rate forecasting.
   - Anticipate movements across the fixed income market.
   - Increase portfolio duration if interest rate declines.
2. Identification of relative mispricing within the fixed income market.
   - Buy underpriced securities and sell overpriced securities.

Question 27

Homer and Liebowitz (1972) summarise bond swaps. What are bond swaps?

Answer 27

Active bond management strategies.

Question 28

What is substitution swap?

Answer 28

• Exchange of one bond for another more attractively priced bond with similar attributes.
• Buy underpriced securities and sell overpriced.
• Related to mispricing.

Question 29

What is intermarket spread swap?

Answer 29

• Switching from one segment of the bond market to another.
• For example, government bond to corporate bonds.
• Related to yield spread.
• Related to mispricing.

Question 30

What is rate anticipation swap?

Answer 30

• Switch made between bonds of different durations in response to forecasts of interest rates.

Question 31

What is pure yield pickup swap?

Answer 31

• Moving to higher-yield, longer-term bonds to capture the liquidity premium.
• Aim is to get higher return by investing higher.
• Can be risky.
• If interest rates decline then pure yield pickup swap can be profitable.
• If interest rates increase, then pure yield pickup swap will suffer from a large loss.

Question 32

What is a tax swap?

Answer 32

• Swapping two similar bonds to capture a tax benefit.
• Very complex and difficult to tax swap in reality because investors face different brackets of tax so individual cases need to be considered.