Lecture 13 Flashcards
Passive managers take bond prices as
Fairly set. Seek to control only risk fixed income portfolios
Passive bond portfolio strategies (2)
- Indexing
- Immunisation
Bond-index portfolio has same risk-reward profile as
Bond market index to which it is tied
Immunisation strategies seek to
Establish virtually zero-risk profile in which interest rate movements have no impact on the value of a firm
Bond index funds create
Portfolio that mirrors the composition of an index that measures the broad market
Bond index funds buy shares
In each firm in index in proportion to the market value of outstanding equity
Bond index fund problems (4)
- Contain numerous issues, many infrequently traded
- Difficult to purchase each security in proportion to market value
- Rebalancing problems > bonds continually dropped/ added to index
- Bonds generate interest income > must be invested > complicated job of fund manager
It is infeasible to precisely replicate a broad bond of indexes therefore
Stratified sampling/ cellular approach is taken
Immunisation aims to
Insulate portfolios from interest rate risk altogether
In immunisation, investors are more concerned with
Protecting the future value of portfolios
Many banks have natural mismatch between
Asset and liability maturity structures
When interest rates change
Assets change in value more than liabilities
Immunisation seeks to match
Interest rate exposure of assets and liabilities by matching their duration, and ensuring the price and reinvestment risk exactly cancel out
Two types of interest rate risk
- Price risk
- Reinvestment rate risk
Price risk =
Risk that interest rates will rise, and bond prices fall
Reinvestment rate risk =
Risk of a change in coupon payment
Increases in interest rates cause (2)
- Capital losses
- Increase rate at which reinvestment income grows
If portfolio duration is chosen appropriately, the two effects can cancel out exactly
Horizon date =
Portfolio’s duration
Rebalancing =
Realigning the proportion of assets in a portfolio as needed to realign the duration with that of the obligation
Immunisation is a passive strategy because
It does not involve attempts to identify undervalued securities
Sources of potential value of active bond management (2)
- Interest rate forecasting
- Identification of relative mispricing
Interest rate forecasting =
Anticipate movements across the spectrum of fixed income market. If interest rates fall, managers increase the portfolio duration
Identification of relative mispricing
Within the fixed income market
Portfolio rebalancing activities
Bond swaps
Substitution swap =
Exchange bond for nearly identical substitute (motivated by belief tat the market has temporarily mispriced the two bonds)
Intermarket spread swap =
Pursued when the investor believes the yield is spread between two sectors’ bond markets is temporarily out of line
Rate anticipation swap =
Pegged to interest rate forecasting. If the investor believes rates will fall, they will swap into longer duration bonds
Pure yield pick up swap =
Increasing return by holding higher yield bonds. When the yield curve is upward sloping, the yield pick up swap entails moving into longer-term bonds to earn a high rate of return
Tax swap =
Swap to exploit some tax advantage
