MIP 6 - Fixed Income Portfolio Management Flashcards
What are the 4 key activities in the investment management process?
- Setting the investment objective (return, risk, and constraints)
- Developing and implementing a portfolio strategy
- Monitoring the portfolio
- Adjusting the portfolio
List the 5 strategies for managing FI portfolio against a bond market index, from the least tracking error to most
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Pure bond indexing (or full replication)
- Attempts perfect match (own all bonds in index)
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Enhanced indexing by matching primary risk factors
- Primary risk factors: interest rate level, yield curve twists, and spreads
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Enhanced indexing by small risk factor mismatches
- Match duration, while actively managing smaller risk factors (sector, quality, term structure etc.)
- Active management by larger risk factor mismatches
- Full-blown active management (most aggressive mismatches)
Describe disadvantages of Pure Bond Indexing in FI portfolio management
- Very difficult and rarely done in practice
- Expensive and inefficient
- Many bonds in an index are illiquid and rarely traded
Describe advantages of Enhanced Indexing by matching primary risk factors in FI portfolio management
- Lower cost than pure indexing – uses only a sample of the bonds in the index
- Still affected by broad market events (due to primary risk factor match)
- Manager can enhance yield by selecting under-valued bonds
Describe disadvantages of Enhanced Indexing by matching primary risk factors in FI portfolio management
more tracking error with the index
List the 3 reasons for using indexing
- Lower fees than managed accounts
- Outperforming an index (after costs) is difficult to do consistently
- Excellent diversification
Describe the risk factors to consider when choosing an index (in pure and enhanced FI strategies)
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Market value risk of portfolio should be similar to benchmark
- Longer portfolios tend to have higher MV risk (higher sensitivity to interest rate changes)
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Income risk should be similar to benchmark
- Longer portfolios tend to have less income risk (more stability)
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Liability framework risk – should match A/L investment characteristics
- Use longer bonds for longer liabilities
Yield Curve Risk Factors (indexing FI strategies)
Yield curve = major source of risk for most bonds
- Parallel shifts account for 90% of bond value changes
- Twists (points move in different directions)
- Other curvature changes
Describe the 3 risks when assessing an index’s
sensitivity (indexing strategies)
- Interest rate risk – changes in level of interest rates (parallel shifts)
- Largest risk source (90%)
- Yield curve risk – changes in yield curve shape (twists, curvature)
- Spread risk – changes in spread over Treasuries (credit risk)
Cell-matching a.k.a. stratified sampling Indexing (Pure and Enhanced)
divides the benchmark into risk cells
- Manager chooses bonds from each cell to match the overall index
Multi-factor model Indexing (Pure and Enhanced)
makes use of a set of factors that drive bond returns
List the primary bond risk factors.
- Duration and convexity – price sensitivity to parallel yield shifts
- Key rate duration and present value distribution of cash flows
- Sector and quality percent
- Sector duration and contribution
- Quality (credit) spread duration contribution
- Sector/coupon/maturity cell weights
- Issuer exposure (manage event risk)
Definition and challenge of Effective duration
- Measures the linear (first order) sensitivity to small parallel shifts in interest rates
- Problem: Perfectly parallel shifts in the yield curve are rare
Convexity adjustment
Estimates additional price change due to larger yield curve shifts that comes from curvature (second order effects)
Key rate duration
Measures the sensitivity to a small change in a single key rate
- Hold all other rates on the yield curve constant except one
- Useful for testing bulltet and barbell strategies
Present value distribution of cash flows (Primary bond risk factors) and formula
- Measure sensitivity to non-parallel yield curve changes
- This approach is basically matching the portfolio’s KRDs to the index (i.e. weighting each KRD by the PV of cash flows for that key rate)
When is Sector/coupon/maturity cell weights more feasible than convexity matching
when call exposure is a concern
Describe tracking risk and its formula components
standard deviation of the portfolio’s active return over time
Describe the main disadvantage of using enhanced bond management strategies
add costs –> must be earned on top of a passive return
Describe strategies to overcome the high costs of enhanced indexing
- Lower cost enhancements – reduce trading costs and management fees
- Issue selection enhancements – attempt to find undervalued securities
- Yield curve positioning – find consistently mispriced maturities
- Sector and quality positioning (2 forms)
- Call exposure positioning – e.g. under-weight in callable bonds if you expect falling interest rates
Two strategies of Sector and quality positioning to overcome high costs of enhanced indexing
- Tilt toward short duration corporates
- offer best yield spread per unit of duration risk
- Periodic over- or under-weighting of sectors or qualities
- over-weight on Treasuries if spreads are expected to widen
Describe some additional activities that are carried out by active FI managers
- Exploit index mismatches (based on manager’s expertise)
- Extrapolate market expectations from market data (e.g. analyze forward rates)
- Independently forecast inputs (interest rates, volatility, spreads, etc.) and compare with market’s expectations
- Example: manager may believe forward rates are too high -> increases duration mismatch by increasing portfolio duration
- Estimate relative values of securities to identify areas of under- or over-valuation
Define total return with respect to bond returns and list one shortcoming
- takes into account coupon income, reinvestment income, and change in price
- A simple total return estimate does not reflect the risk of being wrong (since it’s only one scenario)
Formula and specifications of total return with respect to bond returns
manager must specify the investment horizon, expected reinvestment rate, and expected future price to calculate the total return
Describe the purpose and benefits of scenario analysis.
should be performed to see returns under different sets of assumptions
- Assess distribution of possible outcomes (wider distribution = more risk)
- Reverse scenario analysis: determine the interest rate movements that would trigger acceptable outcomes
- Calculate contribution of individual components (e.g. impact of a yield twist)
- Evaluate merits of entire trading strategy
How do amount and timing of liabilities impact FI portfolio strategy?
The more unknown the amount or timing of liabilities, the less effective passive strategies are (i.e. active management is needed)
- For a typical life or annuity product, the amount of the liability will be known, but the timing will not.
- However, certain products have unknown amounts and timing (e.g. a VA GMDB).
FI dedication strategies
Specialized fixed-income strategies designed to accommodate specific
funding needs of an investor
- Includes immunization and cash flow matching
List extensions of Classical single period Immunization
- Extensions for non-parallel shifts
- Relax the fixed horizon requirement
- Return maximization (risk and return trade-offs)
- Contingent immunization
Describe Immunization strategies
- Lock in a rate of return over a specified horizon regardless of interest rate changes
- Price changes offset with reinvestment income changes
Classical Single-Period Immunization and important Characteristics
Results in a fixed-income portfolio that produces an assured return for a specific time horizon
- Specified time horizon
- Assured rate of return over a fixed holding period
- Insulation from the effects of interest rate changes on the portfolio value at the horizon date
List extensions of Cash Flow Matching
- symmetric
- combination (horizon) matching
List the 2 requirements for classical single period immunization
Requires offsetting price risk and reinvestment risk
- Portfolio duration = liability horizon (duration)
- PV of portfolio cash flows = PV of liability cash flows
Does investing in a coupon bond matching liability yield and horizon guarantee that the liability will be met?
No…because the bond’s duration will be shorter than the liability
Describe 2 ways that a portfolio’s duration can change that will require rebalancing an immunized portfolio
- As market yields change (convexity effects)
- With the passage of time (duration naturally falls as the bond approaches maturity
- Also if the liability duration changes
Key point: an immunized portfolio must be continually rebalanced to stay duration-matched
- Must balance transaction costs of rebalancing with the risk of duration mismatches
Define the immunized target rate of return.
total portfolio return assuming no change in the term structure
Will only equal YTM if the yield curve is flat
If yield curve is positively sloped, total return < YTM
If yield curve is negatively sloped, total return > YTM
Dollar duration (DD) and portfolio DD
- Change in portfolio value (price) for a 100 bps change in yield
- Portfolio Dollar Duration = Portfolio Duration * Portfolio Value * 0.01
- Also simply the sum of the individual bonds’ DD
Bond Duration and Portfolio duration
- % change in bond price P for a 100 bps change in yield
- For example, a bond has duration of 5, it means that the bond’s price will fall 5% if there is a 1% parallel increase in yield curve.
- The duration of a portfolio = price-weighted average of the individual bonds’ durations
Formula for portfolio duration
Formulas for Macauley and Modified duration
Describe the steps required for rebalancing to the desired level of dollar duration.
- Calculate the new (or current) portfolio DD
- Calculate the rebalancing ratio:
- Target DD /New DD - 1
- Calculate amount of cash needed for rebalancing:
- Rebalancing Ratio * MV of Portfolio
what does a rebalancing ratio = 10% mean?
it means each position in the portfolio should be increased 10%
get back to the target (or original) DD based on the new yield curve
Controlling position in portfolio rebalancing
A particular security in the portfolio that is used to control the portfolio’s DD
- Instead of applying a rebalancing ratio to all positions, calculate the adjustment needed for a single position
- Derivatives can also be used (covered later)
Define spread duration.
measures the change in market value of a risky bond if spread changes by 100
basis points
- mainly applicable to bonds/portfolios with credit risk (credit spreads)
3 major types of spread that can be used for spread duration
- Nominal spread – spread above the yield of a certain maturity Treasury
- Static spread (zero-volatility spread) – constant spread above the Treasury spot curve such that PV cash flows = current price
- Option-adjusted spread (OAS) – current spread over the benchmark yield minus the portion attributable to the embedded options
Compare and Contract OAS and static spread durations
- OAS is like the static spread, but solved for stochastically so that the effect of embedded options is properly reflected.
- Callable bond will only be called in down scenarios
- Stochastic analysis could capture those scenarios, not just the current yield curve
- OAS is less then static spread, reflecting the possible lost yield in future down scenarios
- However, callable bonds still have higher yield spread than non-callable bonds of the same maturity, to compensate for call risk
Portfolio spread duration
market weighted average of each bond’s spread duration