Topic 4 - Bonds ((v) Steps of international bond portfolio management)

Question 1

International Portfolio Strategies

Answer 1

1. Benchmark selection

2. Bond market selection
• Important macroeconomic parameters:
• monetary and fiscal policy
• public spending
• balance of payments
• inflationary pressures
• cyclical and political factors

3. Sector selection/credit selection
   • government, regional and municipal bonds
   • Mortgage-backed and public loan backed bonds.
   • Investment grade corporate bonds
   • Inflation indexed bonds
   • Emerging market bonds
4. Currency Management
5. Duration/yield management
6. Yield enhancement techniques
   • For example, yield spread analysis to identify arbitrage opportunities

Question 2

The basic inputs to simulate scenario on the value of a portfolio

Answer 2

Investment strategy is based on forecasted scenarios for interest rates, currencies and quality spreads.

• The three basic inputs are:

1. Changes in default-free yield curve for each currency
2. Changes in quality spreads
3. Changes in exchange rates.

Question 3

International Portfolio Strategies (Benchmark Selection)

Answer 3

Benchmark Selection

The benchmark used is a bond index. The benchmark for bonds is open to more discussion than for equity. It depends in part on the investment objective; for example, do we want a global bond portfolio or an international one (e.g., ex-U.S. for a U.S. investor)? But even the logic of using market capitalization weights is open to debate. For equity, market cap weights represent the relative economic importance of corporations throughout the world. For bonds, market cap weights are influenced by the relative national budget deficits. For example, a country with chronic large budget deficits will see its government bonds have a relatively large weight in a global bond index. Do investors want to follow an investment policy favoring lax budget policy? Other questions influence the choice of benchmark:

■ What types of issuers should be included? If corporates are included, do we put a threshold on their credit quality (e.g., no junk bonds)? Should we include debt from emerging countries? In other words, do we use a broad index or a narrow one?

■ Do we include all countries/currencies, or do we restrict the benchmark to major ones (e.g., G7 countries)?

■ Do we allow all maturities, or do we constrain the maturity of bonds included (e.g., only bonds with a long maturity)?

■ Is the benchmark unhedged against currency risk, or is it hedged?

Benchmarks selected are usually some of the widely accepted bond indexes discussed. But index providers can also calculate “customized” or “normal” portfolios, as defined by a money manager or a specific client.

Question 4

International Portfolio Strategies (Bond Market Selection)

Answer 4

Bond Market Selection

Managers will differ from national benchmark weights, and over or underweight some markets based on interest rate and currency forecasts. More than for common stocks, the observation that all bonds issued in a given currency behave similarly tends to justify a top-down market/ currency approach. For an international investor, the major differences in performance are caused by the selection of currency markets. All fixed-interest bond prices are influenced by changes in interest rates in the respective currencies, as well as the translation in the domestic currency. For example, the dollar performance of all British government bonds is influenced primarily by two factors: movements in British interest rates and movements in the pound/dollar exchange rate. In comparison, the difference in performance within a market segment is relatively small. When investing in international bonds, the volatility of the foreign exchange is often larger than the volatility of the bond market, measured in local currency. This has been observed repeatedly in empirical studies.

Hence, the overweighting of a market is both a bet on changes in local market yields and a bet on the currency. Such a decision must be based on sound economic analysis. Among economic fundamentals that bond managers follow for each country, one can cite the following:

■ Monetary and fiscal policy
■ Public Spending
■ Current and forecasted public indebtedness
■ Inflationary pressures
■ Balance of payments
■ International comparison of the real yields
■ National productivity and competitiveness
■ Cyclical factors
■ Political factors

Question 5

International Portfolio Strategies (Sector selection/credit selection)

Answer 5

Sector Selection/Credit Selection

In many countries and currencies, governments used to be the main issuers. Now, banks and corporations are increasingly borrowing on the bond markets. Within a given currency market (e.g., bonds issued in euros), there are also different segments grouping bonds issued by different types of issuers. Prices on different segments of the same currency market are not fully correlated. Besides the yield curve on government securities, different additional factors affect prices on each segment. The yields on each segment reflect a quality spread over government bonds. The quality spread is influenced by credit risk, liquidity, and possibly some specific institutional and tax aspects. Hence, bond managers tend to over- or underweight some segments based on their forecast of these factors. Commonly used segments within a currency market are the following:

■ Government securities
■ Regional states and municipalities bonds
■ Mortgage-backed and public-loan-backed bonds (e.g., the huge German Pfandbrief market)
■ Investment-grade corporates
■ Junk bonds
■ Inflation-indexed bonds
■ Emerging-country debt

Question 6

International Portfolio Strategies (currency management(

Answer 6

Currency Management For default-free bonds, there are two main sources of unanticipated excess return: currency and duration-adjusted interest rate movements. The volatility of exchange rates tends to be higher than that of bond prices, so currency management is an important component of active global bond management.

When investing in international bonds, the choice of a market often also implies the choice of a currency. If the manager forecasts a depreciation of a foreign currency, she can reduce the currency exposure by reducing the weight of that market relative to benchmark weights. Alternatively, the manager can retain the same market exposure and hedge the currency risk using forward contracts. Currency management requires a good understanding of the previously developed break-even analysis.

Question 7

International Portfolio Strategies (duration/yield curve management)

Answer 7

Duration/Yield Curve Management

In each currency market, the manager can adjust the duration of the portfolio according to a forecast about changes in the level of interest rates and deformations in the yield curve. The average duration in each market and segment provides an estimate of the portfolio’s sensitivity to yield movements. If an increase in yields is expected in one market segment, the manager can trade bonds to reduce the duration of this segment. Another alternative is to retain the same bonds but to reduce the interest rate exposure through various derivatives, such as interest rate futures or swaps.

Question 8

International Portfolio Strategies (yield enhancement techniques)

Answer 8

Yield Enhancement Techniques

Numerous techniques are proposed to add value to the performance of the basic strategy. Some specialized trading techniques are used to provide incremental returns with very little risk (e.g., securities lending). These techniques evolve over time and are too specialized to be described here.

Valuation techniques are used to detect the cheapest bonds to buy (undervalued) when the portfolio has to be rebalanced. Spread analysis is often used to assess the relative value of two securities with fairly similar characteristics. This spread analysis can even lead to an arbitrage between two bonds. The idea is very simple. Two bonds with close characteristics should trade at very similar prices and YTM. Each day, a manager computes the spread between the two bond prices and plots them. Because of market inefficiencies, the spread is likely to be high above (or below) its average, or “normal,” value at some point in time. This is the time to arbitrage one bond against the other. This spread analysis is conducted in terms of YTM rather than in terms of prices. Other bond portfolio management techniques are more complex and involve instruments such as futures, swaps, or option contracts.

A typical way to enhance return on a bond portfolio is to add securities with higher promised yield, because of the borrower’s credit risk. Investors can also obtain higher yields by investing in emerging-country bonds, for which the credit risk stems from the risk that a country will default on its debt servicing. Managers must be aware that the higher yield is a compensation for the risk of default. If this risk materializes, the realized yield on the bond investment can be very bad.

Other bonds have been designed as fairly complicated securities with uncertain cash flows, which offer some plays on interest rate, currencies, or other variables. Some of these more complicated bonds, often called structured notes, are presented in the next section.

To summarize, the investment strategy is based on forecasted scenarios for interest rates, currencies, and quality spreads. Note that exchange rate movements are correlated, to some extent, with interest rate changes so that the two forecasts are not independent. Given the current portfolio, managers can simulate the effect of a scenario on the value of the portfolio. This simulation also suggests which secu- rities to sell and buy, given the forecasted scenario. The three basic inputs are

■ changes in the default-free yield curve for each currency,
■ changes in quality spreads (e.g., changes in the spread between the domestic and international segments), and
■ changes in exchange rates.

Yield enhancement techniques can help individual security selection.