R20 - Fixed Income Portfolio Management

Question 1

What is your benchmark if portfolio objective is to fund liabilities and what is benchmark if it is to replicate/outperform an index?

Answer 1

Fund liabilities = liabilities are the benchmark

Replicate/outperform index = bond index is benchmark

Question 2

What is enhanced indexing?

Answer 2

Match all or only most of primary risk factors

Question 3

What are the primary risks of managing to bond market index?

Answer 3

Interest rates
Shape of yield curve
Spreads

Question 4

Pros and cons of full index replication?

Answer 4

+low tracking error
+same risk exposure
+low fees

• trading in illiquid assets costly
• lower expected return than index (operating expenses)

Question 5

Enhanced indexing pros and cons when matching all risk factors?

Answer 5

+less costly (don’t have to buy every single issue like illiquid ones)
+increased expected return
+exposure to primary risk factors of index

• increased risk
• increased tracking error
• increased management fees

Question 6

Pros and cons of enhanced indexing with minor mismatches?

Answer 6

+same duration as index
+increased expected return
+reduced manager restrictions

• increased risk
• increased tracking error
• increased management fees

Question 7

Pros and cons of active management?

Answer 7

+can fine tune duration
+increased exp returns
+reduces restrictions

• increased risk
• increased tracking error
• higher fees

Question 8

What is the market value risk factor in selecting a benchmark?

Answer 8

• duration and degree of price sensitivity to change in interest rates
• –longer duration has higher yields but greater price volatility

Question 9

What is the income risk factor in selecting a benchmark?

Answer 9

-longer maturity fixed income provides a more stable income stream over time

Question 10

What is the credit risk factor in selecting a benchmark?

Answer 10

-higher credit risk securities have higher yield but vulnerable to default and can underperform when spreads widen

Question 11

What is the liability framework risk factor in selecting a benchmark?

Answer 11

• match characteristics of liabilities to minimize risk and stabilize surplus
• –like if you’re a pension match yourself to your liability structure

Question 12

What are challenges to using indexes as benchmarks?

Answer 12

1. Bonds are heterogeneous (each is unique and many illiquid)
2. Index composition changes over time
3. Some vendors subjective in deciding what to include in an index
4. Finding index to precisely match portfolio characteristics can be a challenge
5. Issuers with large issuance become increasingly weighted in index while also maybe more credit risky

Question 13

How to do call matching to align risk exposure:

Answer 13

If index is 10% in 3 to 5 year Treasuries, match the weight but not necessarily every security.

Question 14

How to use multifactor models to align risk exposure:

Answer 14

Regression used to determine risk factor that drives benchmark return. Portfolio then matches those risk factor exposures.

Question 15

Important risk factors for using multifactor models to align risk exposure?

Answer 15

1. Duration - immediate parallel shifts in yield curve; also match convexity to minimize risk from LARGE parallel shifts
   - –key rate duration matching = minimize risk from non parallel shifts (yield curve risk) (key rate durtation measures percent change in portfolio value if one point on yield curve shifts) (example: if 3-year key rate duration is 1.5 then if 3-yr int rates go up 1% then portfolio declines 1.5%

Question 16

Other important risk factors in aligning risk exposure?

Answer 16

• Sector and quality allocation
• Sector/coupon/maturity cell weights
• Sector duration contributions
• Quality spread duration contributions
• Issuer exposure