Session 7 - Fixed Income (I) Flashcards
Inflation protection on Inflation-linked bond
- both principal and coupons are protected from inflation
Inflation protection on Floating-coupon bonds
- only coupons are protected from inflation
Inflation protection on Fixed-coupon bonds
- principal and coupons are not protected from inflation
Cash flow matching
- have an asset that matures with the same amount and at the time the liability is due
- no need for reinvestment
- difficult to do/find in real life
- defaults & optionality (explicit & implicit) will create mismatches
- only rebalance (not required) to lower costs
Duration Matching
- match the duration AND the present value of the asset and liabilities so they both fluctuate by the same amount with interest rate changes
- protects only against parallel shifts in the yield curve
- only immunized for a period of time as yields and market conditions change, need to be rebalanced
- defaults & credit downgrades cause issues
Contingent immunization
- hybrid of immunization and active management
- MVA – MVL = surplus
- the PM can pursue active investment strategies, as if operating under a total return mandate, as long as the surplus is above a designated threshold
- if performance is poor & surplus evaporates, mandate reverts
to a purely passive strategy
Role of Fixed Income
- diversification benefits - low correlation with equities
- generally less volatile than any other major asset classes
- benefits of regular cash flows - better planning to meet future liabilities
- inflation hedging potential
Liability-Based Mandates
- managed to match or cover expected liability payments with future projected cash inflows (structured mandates, asset/liability management - ALM, liability-driven investments - LDI)
- banks, pensions, insurance
4 types of Liability-Based Mandates
- Cash-flow matching
- Duration Matching
- Contingent immunization
- Horizon matching
Horizon matching
- combines cash-flow & duration matching
- ST liabilities are covered by CF matching while LT
- liabilities are covered by duration matching
3 Types of Total Return Mandates
- Pure indexing
- Enhanced indexing
- Active Management
Pure indexing
- attempts to replicate a bond index as closely as possible (target RA & 𝝈𝑹𝑨 are both zero)
- rebalance the same as the index
- full replication approach ⇒ produce a portfolio that is a perfect match to the index (very difficult & costly)
- many issues are illiquid/infrequently traded
- sampling approach ⇒ select a sample of issues while matching risk factor exposures of the benchmark (duration, credit/sector/call/prepayment risk)
Enhanced Indexing
– attempts to match the benchmark’s Primary risk factors and generate modest outperformance
- allows for minor risk factor mismatches (target 𝝈𝑹𝑨 < 50 bps/yr.)
Active Management
– allows for larger risk factor mismatches relative to the benchmark, most notably duration
- highest portfolio turnover, highest fees
Bond Market Specific Liquidity
- most bonds have less active secondary markets (vs. equities) (many do not trade on a given day)
- bonds are very heterogeneous
- bond markets are typically OTC dealer markets (search cost, price discovery)
- liquidity is highest right after issuance (supply not yet bought up by buy-and-hold investors)
- liquidity affects bond yields – illiquidity premiums
- compensate for exit costs prior to maturity
- premium depends on the issuer, issue size, date of maturity
Liquidity among Bond Market Subsectors
- subsectors can be categorized by issuer type, credit quality, issue size, maturity
- issuers: - sovereign government bonds, non-sovereign gov’t. bonds, gov’t. related bonds, corporate bonds (a.k.a. credits) - securitized bonds
Sovereigns vs. Corporates Bond Market Subsectors
- Sovereigns/ – typically more liquid, larger issuance size, use as benchmark bonds, acceptance as collateral in the repo market, well-recognized issuers
- high credit quality issuers more liquid than lower credit quality issuers
- Corporates/ many more issuers, smaller issue size, a wide range of credit quality (IG → HY)
- low credit quality issues, may be difficult to even find a dealer with inventory (or even willing to take them into inventory)
- small issues typically excluded from bond indexes with minimum issue size requirements
- liquidity varies across other dimensions (issue size, maturity)
Effects of Liquidity on Fixed-Income Port. Mgmt./
1) Pricing – many issues may have stale prices or prices that are often estimated (recent transaction prices may not be valid) so matrix pricing can be used
2) Portfolio Construction
- trade-off between yield & liquidity
- buy-and-hold investor will prefer illiquid bonds for the higher yield (illiquidity premium)(longer maturities, small issues, private placements)
- illiquid bonds will also have wider bid-ask spreads (dealer risk – likely to remain in inventory longer)
3) Alternatives to Direct Investment in Bonds
- fixed-income derivatives are often more liquid than
their underlying bonds (futures, options on futures, interest rate swaps, credit default swaps)
- fixed-income ETFs & mutual funds
Yield Income
coupon payments + reinvestment income (current yield)
Rolldown Yield
⇒ change in price by the passage of time (pulled to par)
– amortization of premium/discount
- assumes an unchanging yield curve
Rolling yield
Yield income + Rolldown Return
E(credit losses)
= PD × LGD (prob. of def. × loss given def.)
Leverage formula
[𝒓𝑰𝑽𝑬 + 𝑽𝑩(𝒓𝑰 − 𝒓𝑩)] / 𝑽𝑬
Methods of Leverage
1) Futures Contract
2) Swap Agreements
3) Structured Financial Instruments - inverse floaters
4) Repurchase Agreements
5) Securities lending
Repurchase Agreements
- a sale & a repurchase (basically a collateralized loan)
- difference between the sale & repurchase price called the repo rate (= interest)
- typically overnight → few days (maybe longer)
- repo may be:
– cash-driven – borrow cash to buy assets
– security-driven – borrow particular securities - protection against default provided by collateral
high quality → 97% - 99% borrowing capacity – called the ‘haircut’ - lower quality/higher volatility → lower capacity
Securities lending
– like repos, except that cash is required as collateral (or high-quality bonds)
- when bonds are used as collateral, income earned flows back to borrower Rebate rate = coupon – lending rate
– if the borrowed securities are difficult to borrow, the lending rate may be greater than the coupon
income of collateral
- typically open-ended agreements
Risks of Leverage
– magnified losses, higher risk, forced liquidations
Equity Duration Formula
(𝑫𝑨𝑨 − 𝑫𝑳𝑳) / E