S9 Flashcards
Pure bond indexing (PBI) adv/dadv
Adv:
- Returns before expenses track the index (zero or very low tracking error)
- Same risk factor exposures as the index
- Low advisory and administrative fees
Dadv
- Costly and difficult to implement
- Lower expected return than the index
Enhanced indexing by matching primary risk factors (sampling) adv/dadv
Adv --------------- - Less costly to implement - Increased expected return - Maintains exposure to the index's primary risk factors Dadv -------------- - Increased management fees - Reduced ability to track the index (i.e., increased tracking error) - Lower expected return than the index
Enhanced indexing by small risk factor mismatches adv/dadv
Adv ------------- - Same duration as index - Increased expected return - Reduced manager restrictions Dadv -------------- - Increased risk - Increased tracking error - Increased management fees
Active management by larger risk factor
mismatches adv/dadv
Adv ---------- - Increased expected return - Reduced manager restrictions - Ability to tune the portfolio duration Dadv -------------- - Increased risk - Increased tracking error - Increased management fees
Full-blown active management adv/dadv
Adv ------------- - Increased expected return - Few if any manager restrictions - No limits on duration Dadv --------- - Increased risk - Increased tracking error - Increased management fees
4 primary considerations when selecting a benchmark
(1) market value risk,
(2) income risk,
(3) credit risk,
(4) liability framework risk.
Market value risk varies directly with
maturity. Greater the risk aversion =>
lower the acceptable market risk => shorter the appropriate maturity of the portfolio and benchmark.
Income risk varies indirectly with
maturity. More dependent client on
reliable income stream = > longer the appropriate maturity of the portfolio and benchmark.
The credit risk of the benchmark should closely match
the credit risk of the portfolio.
Liability framework risk is applicable only to portfolios
managed to meet a liability
structure and should always be minimized.
Risk profiling the index requires measuring
the index’s exposure to
- duration,
- key rate duration,
- cash flow distribution,
- sector and quality weights,
- duration contribution
Duration = Effective duration (a.k.a. option-adjusted or adjusted duration), which is
- used to estimate the change in the value of a portfolio given a small parallel shift in the yield curve.
- underestimating the increase and overestimate the decrease in
the value of the portfolio…
… due to convexity
Key rate duration measures
portfolio’s sensitivity to twists in the yield curve
Present value distribution of cash flows measures
proportion of the index’s total duration attributable
to cash flows (both coupons and redemptions) falling within selected time periods
Bond (non MBS) - 3 primary risk factors, 2 secondary
Interest rate, yield curve, spread / credit, optinality
Interest rate risk - what and how measured
Measures - exposure to yield curve shifts
Using - duration
Yield curve risk - what and how measured
Measures - Exposure to yield curve twists
Using:
- PV distribution of CF
- Key rate duration
Spread risk - what and how measured
Measures - exposure to spread changes
Used - spread duration
Credit risk - what and how measured
Measures - exposure to credit changes
Using - duration contribution by credit rating
Optionality risk - what and how measuread
Measures - Exposure to call or put
Using - delta
Tracking error
The standard deviation of alpha across several periods.
Categories of Fixed income portfolio management
(1) pure bond indexing,
(2) enhanced indexing by matching primary risk factors,
(3) enhanced indexing by small risk factor mismatches,
(4) active management by larger risk factor mismatches
(5) foil-blown active management.
Enhanced Indexing by Matching Primary Risk Factors
enhance the portfolio return by utilizing a
sampling approach to replicate the index’s primary risk factors while holding only a percentage of the bonds in the index
Enhanced Indexing by Small Risk Factor Mismatches
maintaining the exposure to large risk factors, (e.g. duration), the manager slightly tilts the portfolio towards other, smaller risk factors by pursuing relative value strategies
Active Management by Larger Risk Factor Mismatches
Same as “Enhanced Indexing by Small Risk Factor Mismatches “ but mismatches are larger and Duration may differ from benchmark.
Liniar duration under/over estimates
Under estimates increase, overestimate decline of the bond.
MBS primary risk exposures include
sector, prepayment, and convexity risk.
BEY = bond equivalent yield =
semianual x 2
EAR = effective annual return =
(1 + semiannual)^2 -1
goal of classical immunization is to fo rm a portfolio so that:
- If interest rates increase, the gain in reinvestment income = or > loss in portfolio value.
- If interest rates decrease, the gain in portfolio value = or > loss in reinvestment income.
Immunization of a Single Obligation - steps
1 . Select a bond (or bond portfolio) with an effective duration equal to the duration of
the liability.
2 . Set the present value of the bond (or bond portfolio) equal to the present value of the liability.
portfolios cease to be immunized for a single liability when:
- Interest rates fluctuate more than once.
- Time passes.
Bond characteristics that must be
considered with immunization
credit rating, liquidity, embedded options
reinvestment risk (in immuization) is low if
zero coupon bonds are used / cash flows are concentrated around the horizon
duration contribution =
bond weight * bond duration
bond dollar duration =
- (modified or effective duration) * 0.01 * bond price
steps in adjusting portfolio duration
- Determine new duration
- Determine rebalancing ratio = Old Dollar Duration / New Dollar Duration
- Increase/decrease existing bonds using rebalancing ratio OR adjust one (controlling) bond to rebalance… the latter may also minimize needs of cash for rebalancing if it has largest duration.
amount of the spread is a function of
- perceived risk
- market risk aversion
spread duration measures the
sensitivity of non-Treasury issues to a change in
their spread above Treasuries of the same maturity
3 spread duration measures for fixed rate bonds
- nominal spread
- zero volatility spread
- option adjusted spread
Nominal spread is the spread between
the nominal yield on a non-Treasury bond
and a Treasury of the SAME maturity.
Zero-volatility spread (or static spread) is the spread that
must be added to the Treasury spot rate curve to force equality between the:
PV of a bond’s CF (discounted at the Treasury spot rates plus the static spread)
= market price of the bond + accrued interest.
Option-adjusted spread (OAS) is determined
using a binomial interest rate tree.
To address the deficiencies in classical immunization, 4 extensions have been offered:
(1) multifunctional duration (using key rate duration)
(2) multiple-liability immunization,
(3) relaxation of the minimum risk requirement, and
(4) contingent immunization.
Contingent immunization is
- combination of active management and passive management techniques (immunization).
- immunization not used as long as the rate of return on the portfolio exceeds a pre-specified safety net return
Contingent immunization strategy :
Period: 3-year
Value: at par $20 million of 15-year bonds
Coupon: 9%, semiannual
Current rate of return for immunized strategies: 9%
Willing to accept a return of 8% (safety net return)
SCENARIO IF IMMUNIZATION RATE JUMPS TO 12%
- Cushion spread = 9%-8% = 1%
- Required terminal value
= 20Mn * (1 + 8%/2)^(3*2) = 25.3Mn - Required assets needed at initial implementation
= 25.3Mn / (1+9%/2)^(3*2) = 19.4Mn - Safety margin = 20 - 19.4Mn = 0.6Mn
- If immunization rate jumps from 9 to 12% after purchase of the bonds then:
- portfolio at new immunization rate of 12% has value of 15.6Mn (PMT 4.5%20Mn, N 152, I 12/2%,
- minimum target value at the current immunization rate: Required TV = 25.3Mn (from #2) and assets required 25.3 / (1+12/2%)^3*2 = 17.8Mn which is more than current portfolio value
====»_space;> DECISION IMMUNIZATION REQUIRED.
Two fa ctors can cause fa ilure to attain the minimum target return in spite of eff ective
monitoring procedures
- Adverse movements in market yields that occur too quickly for management to trigger the immunization mode soon enough
- The lack of assurance that the immunization rate will be achieved once the immunization mode is activated.
M2 = Maturity variance is the variance of the
DIFFERENCES in the maturities of the BONDS used in the immunization strategy and the maturity date of the LIABILITY.
Multiple-liability immunization is possible if the following 3 conditions are satisfied (assuming parallel rate shifts)
- Assets and liabilities have the same present values.
- Assets and liabilities have the same aggregate durations.
- The range of the distribution of durations of individual assets in the portfolio exceeds the distribution of liabilities.
CF matching steps
- Selects a bond with a maturity date equal to that of the last liability payment date.
- Buys enough in par value of this bond such that its principal and final coupon fully fund the last liability.
- Using a recursive procedure (i.e., working backwards), chooses another bond so that its maturity value and last coupon plus the coupon on the longer bond fully fund the second-to-last liability payment and continues until all liability payments have been addressed.
CF matching vs multiple liability immunization
CF matching is more:
- restrictive
- expensive
- simpler to understand
Combination matching or horizon matching definition / adv / dadv
combination of:
- multiple liability immunization
- cash flow matching (just for initial years)
adv:
- provides liquidity in first years
- reduces risk of non-parallel shifts, often happening in first years
dadv - expensive
Interest rate risk - components ?
Reinvestment risk
Price risk
three rebalancing methods
using new funds
changing particular security weight
using derivatives
How and why corporate bonds perform during periods of heavy supply
Perform Best. Valuation of new issues validates the prices of outstanding issues, which relieves pricing uncertainty and
reduces all spreads
Secular CHANGES in bond market and IMPLICATIONS
- Callable issues dominate the high yield market, but less so.
- Intermediate term, bullet maturity bonds (non callable/sinkable/puttable) dominate investment grade
IMPLICATIONS: - securities with embedded options trade at premium due to scarcity
- longer duration trade at premium due to scarcity relative to intermediate term
- credit based derivatives increasingly used to take advantage of return/diversification across sectors/structure
Rationale for secondary trade
N YY CCC SS
- new issue swaps - for superior liquidity
- Yield/spread pickup (this is largest secondary trade)
- Yield curve adjustment trades - anticipating shifts in yield curve
- Credit upside trade - identifying issues likely to be upgraded
- Credit defense (opposite of credit upside trade)
- Cash flow reinvestment
- Sector rotation trades - into sectors likely to outperform
- Structure trades - e.g. moving to callable structures in anticipation of smaller volatility
Forms of spread analysis
- mean reversion analysis - comparing current and historical spreads
- quality spread analysis - finding securities with possible change in spread
- percentage yield spread analysis = current vs historical yield ratio = CORPORATE BONDS / TREASURIES of same duration
Duration of Short term bullet structure.
1-5 years.
Duration of Medium term bullet structure.
5-12 years
When and Why 20 year bond structures attractive
Attractive during positively sloped yield curve.
Higher yields than 10-15 year structures but lower duration (i.e. risk)
Duration and Attractiveness of long term bullet structures
30 years.
Attractive: positive convexity at the cost of increased effective duration
Early retirement provision - types
Callable bonds (callable by issuer)
Sinking fund - annually a portion of bonds is retired (repurchased)
Putable bonds
Credit analysis - analytic framework
- CAPACITY TO PAY in corporate credit analysis.
- QUALITY OF COLLATERAL and the servicer are important in the analysis of asset backed securities.
- ABILITY TO ASSESS AND COLLECT taxes for municipal bonds.
- An assessment of the COUNTRIES ABILITY to pay (economic risk) and WILLINGNESS to pay (political risk) for sovereign bond issuers.
Relative Valuation Methodologies
TPL SSSS CC A
Total return analysis Primary market analysis Liquidity and trading analysis Secondary trading rationales Secondary trading constraints Spread analysis Structural analysis Credit curve analysis Credit analysis Asset allocation/sector analysi
Reasons for not trading
Portfolio constraints.
“Story” disagreement.
Buy and hold.
Seasonality.
Bond portfolio trading constraings
Quality constraints.
Restrictions on structures and foreign bonds.
High-yield corporate exposure limits for insurance companies.
Structure and quality restrictions for European investors.
Floating rate requirements for commercial banks.
Relative value
Ranking of fixed income investments by sectors structures issuers and issues in terms of their expected performance during some future interval
Credit barbell strategy
Taking credit risk in short/intermediate maturities AND gov securities for long duration portfolio buckets.
Implication of dominance of investment grade market by bullet intermediate structure
- premium for securities with embedded options
- lower duration for the all outstanting credit debt
- increased use of credit derivatives to gain exposure to desired structures
Yield curve placement
positioning of portfolio with respect to:
- duration and
- yield curve risk
also known as curve adjustment trades
Sector / quality allocation
allocations based on relative value analysis of different bond market sectors and quality sectors.
Market segmentation factors
factors affecting supply and demand within sectors of bond market due to impediments or restrictions on investors from reallocating funds across those bond sectors.
what is limitation of yield pickup trade
yield is a poor indication of total return
cross over bond market sector
Ba2/BB - Baa3/BBB ranked bonds , i.e. between investment grade and high yield.
credit defense trade needed when investor is concerned with
widening credit spreads due to political, economy, sector, issuer-specific risks
why high yield issuers will keep issuing callable structures
to have the opportunity to refinance at a lower credit spread should credit quality improve
what is appropriate measure of risk for managers who is evaluated relative to some bond index
Deviation of the portfolio from benchmark in terms of
- yield curve exposure
- sector exposure
- quality exposure
- individual issue exposure
analytical models for valuing bonds iwth embedded put options assume
the issuer will fullfill the obligation to repurchase the issue if bondholder exercises the put option.
sovereign plus
top down approach starts with assessment of economic outlook for emerging market and then basing allocations of funds across differerent countries
US credits plus
bottom up focuses on selection of corporate issuers in emerging countries what are expected to outpeform US credit issuers
market segmentation may create relative value opportunities when
spreads get out of line due to obstructions that prevent investors from allocating funds to certain sectors due to regulatory constraints or asset/liability contraints
spread curves show relationship between
spreads and maturity
forward spread is a
breakeven spread because it is the spread that would make the investor indifferent between two alternative investments with different maturities over a given investment horizon
relative value analysis - comparing the
expected AND forward spread
impact of upgade in a below investment grade security
- outpeform due to narrower spread
- more liquid due to broader class of investors
Specifics of European credit market
The homogeneous character of European market (dominated by high quality intermediate) allowed managers to easily compare securities across fixed/floating markets USING SWAPs FRAMEWORK.
Also, financial institutions were willing to use SWAP METHODOLOGY to capture value discrepancies between fixed and floating rate markets
Specifics of US credit market
US managers embraced swap spreads for MBS CMBS Agency and ABS sectors
it is reasonable to expect spreads to revert to historical mean if there have been
no structural changes in the market that would render historical mean and standard deviation USELESS for analyst
when interest rates fall (convexity)
callable bonds exhibit negative convexity, while noncallable exhibit positive convexity
negative convexity characteristic for low coupon vs high coupon bonds
low coupon issues exhibit LESS negative convexity than high coupon
3 risks associated with managing a portfolio against a liability structure
(1) interest rate risk,
(2) contingent claim risk (i.e., call or prepayment risk), and
(3) cap risk
