Lecture 11 - Bond Portfolio Management II Flashcards
What does passive bond management assume?
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.
Passive managers take bond prices as…
Fairly set and seek to control only the risk of their fixed income portfolio.
What are the two strategies for passive bond management?
- Indexing strategy.
- Immunisation techniques.
Both classes accept market prices as being correct but the two strategies differ greatly in terms of…
Risk exposure.
What is the aim of bond index funds?
- 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.
What is full replication?
Means to construct a portfolio to buy every security/bond in the market index according to the weight of the market bond index.
What are the disadvantages of full replication?
- Difficult to purchase.
- Thinly traded.
- Rebalancing problem means there are transaction costs and trading costs occur.
What is stratified sampling?
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.
Immunisation techniques are used to…
Shield overall financial status from interest rate risk. They attempt to achieve a zero risk profile/portfolio.
Immunisation balances…
Reinvestment risk (related to reinvestment of coupons) and price risk (related to interest rate sensitivity).
Duration-matched assets and liabilities let the asset portfolio meet the…
Firm’s obligations despite interest rate movement.
Duration (assets) equals…
Duration (liabilities).
Immunisation is widely used by…
Pension funds, insurers, and banks.
If the portfolio duration is chosen appropriately, the two effects…
Price risk and reinvestment risk can cancel out exactly.
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…
Unaffected by interest rate fluctuations. Free from interest rate risk.
If yield/interest rate increases then reinvestment risk has a…
Positive impact on the accumulated value of the payment.
If yield/interest rate increases then price risk has a…
Negative impact on the accumulated value of the payment.
If yield/interest rate decreases then reinvestment risk has a…
Negative impact on the accumulated value of the payment.
If yield/interest rate decreases then price risk has a…
Positive impact on the accumulated value of the payment.
Even if a portfolio is immunised, the portfolio manager still cannot…
Rest.
Rebalancing is required…
To realign the portfolio’s duration with the duration of the obligation (as interest rates change and/or time passes).
There is a trade off between perfect immunisation and what?
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.
Cash flow matching is a more direct form of immunisation that requires…
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.
Cash flow matching in a multi period basis is referred to as a…
Dedication strategy.
Active bond management.
Managers think they have superior ability. The markets are not perfectly efficient and they think they can beat the market and want to.
What are the two sources of potential profit in active bond management?
- Interest rate forecasting.
- Anticipate movements across the fixed income market.
- Increase portfolio duration if interest rate declines. - Identification of relative mispricing within the fixed income market.
- Buy underpriced securities and sell overpriced securities.
Homer and Liebowitz (1972) summarise bond swaps. What are bond swaps?
Active bond management strategies.
What is substitution swap?
- Exchange of one bond for another more attractively priced bond with similar attributes.
- Buy underpriced securities and sell overpriced.
- Related to mispricing.
What is intermarket spread swap?
- Switching from one segment of the bond market to another.
- For example, government bond to corporate bonds.
- Related to yield spread.
- Related to mispricing.
What is rate anticipation swap?
- Switch made between bonds of different durations in response to forecasts of interest rates.
What is pure yield pickup swap?
- 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.
What is a tax swap?
- 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.
