Ss 9

Front 1

Using a bond index as a benchmark

Back 1

manager might manage a bond fund that mimics a well-diversified bond index. The manager could follow either a passive or an active management approach. If the manager mostly agrees with market forecasts and values, they will follow a passive management approach.

They will construct a portfolio that mimics the index along several dimensions of risk, and the return on the portfolio should track the return on the index fairly closely.

In an active management approach, the manager constructs the portfolio to resemble the index in many ways but, through various active management strategies, hopes to consistently outperform the index.

Front 2

Using liabilities as a benchmark

Back 2

The investment objective when managing a bond portfolio against a single liability or set of liabilities is to maintain sufficient portfolio value to meet the liabilities.

Front 3

Name three advantages to pure bond indexing

Back 3

1. Zero or very low tracking error

2. Exposed to the same risk factors as the index

3. Low advisory and administrative fees

Front 4

Name two disadvantages to pure bond indexing

Back 4

1. Costly and difficult to implement

2. Lower expected return than the index

Front 5

Name five bond portfolio strategies

Back 5

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. Full-blown active management

Front 6

Name three advantages to enhanced indexing by matching primary risk factors

Back 6

1. Less costly to implement than pure bond indexing
2. Increased expected return than pure bond indexing
3. Maintains exposure to the index's primary risk factors

Front 7

Name three disadvantages to enhanced indexing by matching primary risk factors

Back 7

1. Increased management fees
2. Increased tracking error
3. Lower expected return than the index

Front 8

Name three advantages to enhanced indexing by small risk factor mismatches

Back 8

1. Same duration as index
2. Increased expected return relative to pure bond indexing and matching primary risk factors
3. Reduced manager restrictions

Front 9

Name three disadvantages to enhanced indexing by small risk factor mismatches

Back 9

1. Increased risk
2. Increased tracking error
3. Increased management fees

(all three of the above are relative to the more passively managed bond indexes)

Front 10

Name three disadvantages to enhanced indexing by larger risk factor mismatches

Back 10

1. Increased risk
2. Increased tracking error
3. Increased management fees

(all three of the above are relative to the more passively managed bond indexes)

Front 11

Name three disadvantages to full-blown active management

Back 11

1. Increased risk
2. Increased tracking error
3. Increased management fees

(all relative to more passivly managed portfolios)

Front 12

Name three advantages to active management by larger risk factor mismatches

Back 12

1. Increased expected return
2. Reduced manager restrictions
3. Ability to tune the portfolio duration

Front 13

Name three advantages to full-blown active management

Back 13

1. Increased expected return
2. Few if any manager restrictions
3. No limits on duration

Front 14

Pure bond indexing

Back 14

The manager is restriced to constructing a portfolio with all the securities in the index and in the same weights as the index

Front 15

alpha

Back 15

Difference between the portfolio and index returns - that is, the portfolio excess return

Front 16

Tracking error

Back 16

Variability of the portfolio excess return

Standard deviation of the alpha

Front 17

Why is pure bond indexing rarely seen in practice

Back 17

Due to the number of different bond issues in the typical bond index as well as the inefficiences and costs of PBI

Front 18

Enhanced Indexing by Primary Risk Factors

Back 18

Managers will enhance a 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

Outperforms pure bond indexing - underperforms the bond index

Front 19

Enhanced Indexing by Small Risk Factor Mismatches

Back 19

First level of return that is designed to earn about the same return as the index;

While maintaining the exposure to large risk factors (such as duration), the manager slightly tilts the portfolio toward other smaller risk factors by pursuing relative value strategies (ie, identifying undervalued sectors).

The small tilts are only intended to compensate for administrative costs

Front 20

Active management by larger risk factor mismatches

Back 20

Difference between Enhanced Indexing by small risk factor mismatches and larger risk factor mismatches is the degree of the mismatches.

Manager pursues more significant quality and value strategies - example: overweight sectors expected to outperform, identify undervalued securities.

Manager might alter the duration of the portfolio somewhat.

Intent: earn sufficient return to cover administrative as well as increased transactions costs without increasing the portfolio's risk exposure beyond an acceptable level

Front 21

Full blown active management

Back 21

The manager actively pursues tilting, relative value, and duration strategies.

Front 22

What are four primary considerations when selecting a benchmark?

Back 22

1. Market Value Risk
2. Income Risk
3. Credit Risk
4. Liability Framework Fish

Front 23

What are the primary benefits to using an indexing approach?

Back 23

1. Diversification
2. Low costs

Front 24

When is it justifiable to move from a pure bond indexing strategy to more active management?

Back 24

Only when the client’s objectives and constraints permit and the manager’s abilities justify it.

Front 25

A manager should be judged against a benchmark and this benchmark should match what?

Back 25

The characteristics of the portfolio

Front 26

Market value risk

Back 26

The market values of long maturity (i.e., duration) portfolios are more sensitive to changes in yield than the market values of shorter maturity portfolios. From a market value perspective, therefore, the greater the investor’s risk aversion, the shorter the appropriate maturity of the portfolio and the selected benchmark.

Front 27

Income risk

Back 27

If the client is dependent upon cash flows from the portfolio, those cash flows should be consistent and low risk. Since long-term interest rates are generally less variable than short-term rates, long term bonds offer the investor a longer and more certain income stream. The longer the maturity of the portfolio and benchmark, therefore, the lower the income risk. Investors desiring a stable, long-term cash flow should invest in longer-term bonds and utilize long-term benchmarks.

Front 28

Credit Risk

Back 28

The credit risk (i.e., default risk) of the benchmark should closely match that of the portfolio, which is determined according to the portfolio’s position in the client’s overall portfolio of assets.

Front 29

Liability Framework Risk

Back 29

This risk, which is faced when managing a portfolio to meet liabilities, should always be minimized. It concerns mismatches in the firm’s asset and liability structures. For example, a firm with long-term liabilities (e.g., insurance companies, pension funds) should utilize long-term assets and benchmarks. If the liabilities are shorter term, the assets and benchmark should also be shorter term.

Front 30

What are the four points to remember for the exam related to risk and choosing a bond index?

Back 30

1. Market value risk varies directly with maturity. The greater the risk aversion, the lower the acceptable market risk and the shorter the appropriate maturity of the portfolio and benchmark

2. Income risk varies indirectly with maturity. The more dependent the client is upon a reliable income strea, the longer the appropriate maturity of the portfolio and benchmark

3. The credit risk of the benchmark should closely match the credit risk of the portfolio

4. Liability framework risk is applicable only to portfolios managed to meet a liability structure and should always be minimized

Front 31

Duration

Back 31

used to estimate the change in the value of a portfolio given a small parallel shift in the yield curve

Linear measure

Effective duration aka option-adjusted or adjusted duration

Front 32

What is the problem with duration as a measure of risk?

Back 32

Due to the linear nature of duration, which causes it to underestimate the increase and overestimate the decrease in the value of the portfolio, the convexity effect must also be considered.

Front 33

Key rate duration

Back 33

measures the portfolio’s sensitivity to twists in the yield curve by indicating the portfolio's sensitivity to certain interest rates.

Front 34

When matching a portfolio to an index is it sufficient to match effective duration?

Back 34

No.

Due to the nearly endless combinations of assets that will have the same duration as the index, the manager must take the time to ensure that the portfolio also matches the index’s exposure to important key rates. Mismatches can occur when the portfolio and benchmark contain different combinations of bonds with varying maturities and key rate durations but the same overall effective duration.

Front 35

For a valid comparison of the portfolio return to the benchmark return, the bond benchmark must have the same ________ as the managed portfolio

Back 35

Risk profile

Front 36

What are some ways to measure a portfolio's risk profile?

Back 36

1. Duration
2. Key Rate duration
3. Duration contributions
4. Spread durations
5. Sector weights
6. Distribution of cash flows
7. Diversification

Front 37

Stratified Sampling

Back 37

aka Cell Matching

The manager first separates the bonds in the index into cells in a matrix according to risk factors (such as sector, quality rating, duration, callability etc). Then the manager measures the total value of the bonds in each of the cells and determines each cell's weight in the index. Then the manager selects a sample of bonds from each cell and purchases them in an amount that produces the same weight in the portfolio as that cell's weight in the index -

Use this for enhanced indexing by matching primary risk factors

Front 38

Multifactor model

Back 38

Used to construct a porfolio with exactly the same risk factor exposures as the benchmark but with different securities

Front 39

Yield curve twists

Back 39

More common than parallel yield curve shifts.

Unequal changes in interest rates of different maturities or movements in some rates with no accompanying movements in others.

Changes the overall shape of the yield curve

Front 40

Parallel yield curve shifts

Back 40

Rare evends where interest rates of all maturities move by the same amount - either up or down.

Front 41

Present value distribution of cash flows

Back 41

Measures the proporation of the index's total duration attributable to cash flows (both coupons and redemptions) falling within selected time periods.

Describes how the total duration of the index is distributed across its total maturity

Front 42

Sector and quality percent

Back 42

The manager matches the weights of sectors and qualities in the index

Front 43

Sector duration contributions

Back 43

The manager matches the proportion of the index duration that is contributed by each sector in the index

Front 44

Quality spread duration contribution

Back 44

The manager matches the proportion of the index duration that is contributed by each quality in the index. Quality refers to category of bonds by rating.

Front 45

Quality

Back 45

Refers to category of bonds by rating.

Front 46

Sector/coupon/maturity cell weights

Back 46

Convexity is difficult to meausre for callable bonds. To mimic the callability of bonds in the index, the manager is better off matching their sector, coupon, and maturity weights in the index

Front 47

Callability of bonds in the index

Back 47

The sensitify of their prices to interest rate changes

Front 48

Issuer Exposure

Back 48

Measure of the index's event exposure. The manager should use a sufficient number of securities in the portfolio so that the event risk attributable to any individual issuer is minimized

Front 49

What are the primary risk exposures of MBS?

Back 49

Sector
Prepayment
Convexity Risk

Front 50

What measure is used for a bond's optionality

Back 50

Delta

Front 51

What measure is used to measure a bond's credit exposure?

Back 51

Duration contribution by credit rating

Front 52

What measure is used to measure a bond's exposure to spread changes?

Back 52

spread duration

Front 53

What measures are used to measure a bond's exposure to yield curve twists?

Back 53

PVD and key rate durations

Front 54

What measure is used to measure a bond's exposure to interest rate changes (parallel shifts)?

Back 54

Duration

Front 55

Scenario analysis

Back 55

allows a portfolio manager to assess portfolio total return under a varying set of assumptions (different scenarios).

Possible scenarios would include simultaneous assumptions regarding interest rates and spreads at the end of the investment horizon as well as reinvestment rates over the investment horizon.

Change in more than one variable

Front 56

Total return analysis

Back 56

Estimating expected total return under a single set of assumptions (predictions) only provides a point estimate of the investment’s expected return (i.e., a single number). Combining total return analysis with scenario analysis allows the analyst to assess not only the return but also its volatility (distribution) under different scenarios.

Front 57

Why should scenario analysis be used in conjunction with total return analysis?

Back 57

Combining total return analysis with scenario analysis allows the analyst to assess not only the return but also its volatility (distribution) under different scenarios.

Front 58

Sensitivity analysis

Back 58

Often required by regulators -

Special case of scenario analysis where just one variable is altered

Front 59

Immunization

Back 59

A strategy used to minimize interest rate risk.

Can be employed to fund either single or multiple liabilities

Front 60

What are the two components of interest rate risk?

Back 60

1. Price risk
2. Reinvestment rate risk

Front 61

Price risk

Back 61

the decrease in bond prices as interest rates rise (and vice versa)

Front 62

Reinvestment rate risk

Back 62

refers to the increase (decrease) in reinvestment income as interest rates rise (fall).

Front 63

What is the relationship between price risk and reinvestment rate risk

Back 63

Inverse

Front 64

Suppose you have a liability that must be paid at the end of five years, and you would like to form a bond portfolio that will fully fund it. However, you are concerned about the effect that interest rate risk will have on the ending value of your portfolio. Which bonds should you buy?

Back 64

You should buy bonds that result in the effects of price risk and reinvestment risk exactly offsetting each other.

Front 65

How do we accomplish the goal of classic immunization?

Back 65

Use effective duration.

If you construct a portfolio with a duration equal to your liability horizon, the interest rate risk of the portfolio will be eliminated. In other words, price risk will exactly offset reinvestment rate risk.

Front 66

What causes matching the maturity of a coupon bond to the maturity of a future liability an inadequate means of assuring that a liability will be paid?

Back 66

Reinvestment rate risk.

Since future reinvestment rates are unknown, the total future value of a bond portfolio’s coupon payments plus reinvestment income is uncertain.

Front 67

Classic immunization

Back 67

The process of structuring a bond portfolio that balances any change in the value of the portfolio with the return from the reinvestment of the coupon and principal payments received throughout the investment period.

The goal of classical immunization is to form a portfolio so that:

1. If interest rates increase, the gain in reinvestment income is greater than or equal to the loss in portfolio value.

2. If interest rates decrease, the gain in portfolio value is greater than or equal to the loss in reinvestment income.

Front 68

How does one effectively immunize a single liability?

Back 68

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.

Front 69

If portfolio duration is less than liability duration, the portfolio is exposed to ___________

Back 69

Reinvestment risk.

If interest rates are decreasing, the losses from reinvested coupon and principal payments would more than offset any gains from appreciation in the value of outstanding bonds. Under this scenario, the cash flows generated from assets would be insufficient to meet the targeted obligation.

Front 70

If portfolio duration is greater than than liability duration, the portfolio is exposed to ___________

Back 70

Price risk.

If interest rates are increasing, this would indicate that the losses from the market value of outstanding bonds would more than offset any gains from the additional revenue being generated on reinvested principal and coupon payments. Under this scenario, the cash flows generated from assets would be insufficient to meet the targeted obligation.

Front 71

Classical immunization works for what type of yield curve changes

Back 71

Without rebalancing, classical immunization only works for a 1-time instantaneous change in interest rates. In reality, interest rates fluctuate frequently, changing the duration of the portfolio and necessitating a change in the immunization strategy. Furthermore, the mere passage of time causes the duration of both the portfolio and its target liabilities to change, although not usually at the same rate.

Front 72

Portfolios cease to be immunized for a single liability when _________

Back 72

1. Interest rates fluctuate more than once
2. Time passes

Front 73

Is immunization a buy-and-hold strategy?

Back 73

No.

To keep a portfolio immunized it must be rebalanced periodically. Rebalancing is necessary to maintain equality between the duration of the immunized portfolio and the decreasing duration of the liability. Rebalancing frequency is a cost-benefit trade-off. Transaction costs associated with rebalancing must be weighed against the possible extent to which the terminal value of the portfolio may fall short of its target liability.

Front 74

What three characteristics of bonds used to construct an immunized portfolio should be considered?

Back 74

1. Credit Rating
2. Embedded options
3. Liquidity

Front 75

Why is credit rating important to consider when choosing bonds for an immunized portfolio?

Back 75

In immunizing a portfolio, it is assumed that none of the bonds will default. The lower the credit rating of a bond, however, the greater the likelihood of default.

Front 76

Why are embedded options important to consider when choosing bonds for an immunized portfolio?

Back 76

For bonds with embedded options, it may be difficult to estimate duration because cash flows are difficult to forecast.

Front 77

Why is liquidity important to consider when choosing bonds for an immunized portfolio?

Back 77

If a portfolio is to be rebalanced, it will be necessary to sell some of the bonds. Thus, liquidity is an important concern.

Front 78

Optimization procedures

Back 78

Often used to build immunized portfolios

Consider the many variations that typically exist within the universe of available bonds

Front 79

Immunization risk

Back 79

can be thought of as a measure of the relative extent to which the terminal value of an immunized portfolio falls short of its target value as a result of arbitrary (nonparallel) changes in interest rates.

Front 80

What is a key assumption of classical immunization theory?

Back 80

An important assumption of classical immunization theory is that any changes in the yield curve are parallel. This means that if interest rates change, they change by the same amount and in the same direction for all bond maturities. The problem is that in reality, parallel shifts rarely occur, thus, equating the duration of the portfolio with the duration of the liability does not guarantee immunization.

Front 81

How do you select a portfolio that minimizes immunization risk?

Back 81

1. An immunized portfolio consisting entirely of zero-coupon bonds that mature at the investment horizon will have zero immunization risk because there is zero reinvestment risk.

2. If cash flows are concentrated around the horizon (as in a bullet), reinvestment risk and immunization risk will be low.

3/ If there is a high dispersion of cash flows about the horizon date (as in a barbell strategy), reinvestment risk and immunization risk will be high.

Front 82

Portfolio dollar duration

Back 82

The sum of the dollar durations of the individual bonds in the portfolio.

Front 83

What are the two steps in adjusting dollar duration?

Back 83

1. Calculate the new dollar duration
2. Calculate the rebalancing ratio and use it to determine the required percentage change in the value of the portfolio

Front 84

Spread duration

Back 84

Measures the sensitivity of non-Treasury issues to a change in their spread above Treasuries of the same maturity

Allows the manager to both forecast the future performance of the sector and select superior bonds to represent each sector in the portfolio

Front 85

Name the three spread duration measures for fixed rate bonds

Back 85

1. Nominal spread
2. Zero-volatility spread (static spread
3. Option-adjusted spread (OAS)

Front 86

Nominal spread

Back 86

spread between the nominal yield on a non-Treasury bond and a treasury of the same maturity

Front 87

Zero-volatility spread

Back 87

The spread that must be added to the Treasury spot rate curve to force equality between the present value of a bond's cash flows and the market price of the bond plus accrued interest

Front 88

Option-adjusted spread

Back 88

determined using a binomial interest rate tree

Front 89

Portfolio spread duration

Back 89

the market-value weighted average of the individual sector spread durations

Front 90

How is duration different from spread duration

Back 90

In spread duration, the shift is in the spread only indicating an overall increase in risk aversion for all bonds in a given class

Front 91

Name four extentions to classical immunication that help address its deficiencies - these extentions help to immunize a liability

Back 91

1. Multifunctional duration (aka key rate duration)
2. Multiple-liability immunization
3. Relaxation of the minimum risk requirement
4. Contingent immunization

Front 92

Contingent immunization

Back 92

the combination of active management strategies and passive management techniques. As long as the rate of return on the portfolio exceeds a prespecified safety net return, the portfolio is managed actively. If the portfolio return declines to the safety net return, immunization is triggered to lock in the safety net return.

Front 93

Safety net return

Back 93

The minimum acceptable return as designated by the client

Front 94

Multifunctional duration

Back 94

aka - key rate duration

Manager focuses on certain key interet rate maturityes.

Front 95

Multiple-liability immunization

Back 95

Ensuring that the portfolio contains sufficient liquid assets to meet all the liabilities as they come due.

Rather than monitor the value of the portfolio as if the liability is its minimum target value at a single horizon date, there can be numerous certain or even uncertain liabilities with accompanying numerous horizon dates

Front 96

Allowing for increased risk

Back 96

Relaxing the minimum risk requirement of classical immunization.

As long as the manager does not jeopardize meeting the liability structure, he can pursue increased risk strategies that could lead to excess portfolio value (a terminal value greater than the liability)

Front 97

A very low safety net return relative to the returns achievable in the market leads to frequent or infrequent rebalancing?

Could it mean the manager is investing too many or too few funds to the portfolio?

Back 97

Infrequent - the portfolio can experience a significant decrease in value before immunization is required

Too many

Front 98

Trigger rate

Back 98

The rate that triggers a fully immunized strategy

Front 99

A very high safety net return relative to the returns achievable in the market leads to frequent or infrequent rebalancing?

Could it mean the manager is investing too many or too few funds to the portfolio?

Back 99

frequent - can mean little opportunity for active management - particularly in a time of significant interest rate volatility as the trigger rate is easily hit

Front 100

Two factor that can cause failture to attain the minimum target return in spite of effective monitoring procedures for an immunized portfolio?

Back 100

1. Adverse movements in market yields that occur too quickly for management to trigger the immunization mode soon enough

2. The lack of assurance that the immunization rate will be achived once the immunization mode is activated

Front 101

Three risks that the portfolio manager must be aware of when managing a portfolio against a liability structure that relate to market interest rates and the structure of the bonds in the portfolio.

Back 101

1. Interest rate risk
2. Contingent claim risk
3. Cap risk

Front 102

Interest rate risk

Back 102

The primary concern when managing a fixed income portfolio, whether against a liability structure or a benchmark. Since the values of most fixed income securities move opposite to changes in interest rates, changing interest rates are a continual source of risk. To help avoid interest rate risk, the manager will match the duration and convexity of the liability and the portfolio. Convexity can be difficult to measure for some fixed income securities, especially those with negative convexity. This is the concern when fixed income securities are subject to early retirement (e.g., mortgage-backed securities, callable corporate bonds).

Front 103

Contingent claim risk

Back 103

a.k.a. call risk or prepayment risk): Callable bonds are typically called only after interest rates have fallen. This means that the manager not only loses the higher stream of coupons that were originally incorporated into the immunization strategy, she is faced with reinvesting the principal at a reduced rate of return. Thus, contingent claim risk has significant potential to affect the immunization strategy through its effect on the value of the portfolio. To adjust for this potential, rather than simply comparing the portfolio duration to that of the liability, the manager must consider the convexity of the bonds

Front 104

Cap risk

Back 104

refers to a cap on the adjustment to the coupon on a floating rate security. If the bonds are subject to caps when interest rates rise, they might not fully adjust and thus would affect the immunization capability of the portfolio.

Front 105

Single Liability Immunization

Back 105

One strategy is minimizing reinvestment risk (i.e., the risk associated with reinvesting portfolio cash flows). To reduce the risk associated with uncertain reinvestment rates, the manager should minimize the distribution of the maturities of the bonds in the portfolio around the (single) liability date. If the manager can hold bullet securities with maturities very close to the liability date, reinvestment risk is low.

Front 106

Multiple Liability Immunization

Back 106

The key to immunizing multiple liabilities is to decompose the portfolio payment streams in such a way that the component streams separately immunize each of the multiple liabilities. Multiple liability immunization is possible if the following three conditions are satisfied (assuming parallel rate shifts):

1. Assets and liabilities have the same present values.
2. Assets and liabilities have the same aggregate durations.
3. The range of the distribution of durations of individual assets in the portfolio exceeds the distribution of liabilities. This is a necessary condition in order to be able to use cash flows generated from our assets (which will include principal payments from maturing bonds) to sufficiently meet each of our cash outflow needs.

Front 107

General Cash Flow Immunization

Back 107

refers to using cash as part of an immunization strategy even though the cash has not yet been received.

For example, expecting a cash flow in six months, the portfolio manager does not put the entire amount required for immunization into the portfolio today. Instead he looks at the expected cash flow as a zero coupon bond and incorporates its payoff and duration into the immunization strategy.

Front 108

Bullet Strategy

Back 108

Concentrating the maturity of the bonds around the liability date - used in immunizing a single liability

Front 109

Barbell Strategy

Back 109

First bond matures several years before the liability date and the other several years after the liability date. Generally more reinvestment risk than with a bullet strategy

As the maturities of the bullet strategy move away from the liability date and the maturities of the barbell move toward the liability date, the distinction between the two will begin to blur

Front 110

Maturity variance

Back 110

the variance of the differences in the maturities of the bonds used in the immunization strategy and the maturity date of the liability

If all the bonds have the same maturity date as the liabilty, maturity variance is zero. As the dispersion of the maturity dates increases, maturity variance increases.

Front 111

Cash flow matching

Back 111

Used to construct a portfolio that will fund a stream of liabilities out of portfolio returns and asset value such that the portfolio value is zero after the last liability is paid.

Serves as an alternative to immunization for funding a stream of liabilities

1. Select a bond with a maturitydate equal to that of the last liability payment date

2. Buy enough in par value of this bond such that its principal and final coupon fully fund the last liability

3. Working backwards, choose 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 continue until all liability payments have been addressed

Front 112

Risk minimization versus return maximization in immunized portfolios

Back 112

One standard condition for classical immunization is risk minimization. The portfolio manager has many tools to minimize exposure to risks faced when immunizing a portfolio to meet a liability.

Return maximization is the concept behind contingent immunization. Consider the manager who has the ability to lock in an immunized rate of return equal to or greater than the required safety net return. As long as that manager feels he can generate even greater returns, he should pursue active management in hopes of generating excess value.

Front 113

What are the two differences between cash flow matching and multi-liability immunization?

Back 113

1. Cash flow matching depends upon all the cash flows of the portfolio, so expectations regarding short term reinvestment rates are critical. For this reason, managers must use conservative reinvestment assumptions for all cash flows. This tends to increase the overall value of the required immunizing portfolio. An immunized portfolio is essentially fully invested at the duration of the remaining horizon, so only the average reinvestment ratio over the entire investment horizon must be considered.

2. Owing to the exact matching problem, only asset flows from a cash-flow-matched portfolio that occur prior to the liability may be used to meet the obligation. An immunized portfolio is only required to have sufficient value on the date of each liability because funding is achieved through portfolio rebalancing.

Front 114

Cash flow matching

Back 114

Used to construct a portfolio that will fund a stream of liabilities with portfolio coupons and maturity values. To construct the portfolio, the manager first selects a bond with a maturity date and value equal to the last liability. (Maturity value includes the face value and last coupon.) Once that bond has been selected, the manager reduces all earlier liabilities to reflect the other coupons received on that bond.

Another bond is then selected to match the maturity of the second to last liability with a maturity value reflecting the remaining value of that liability. The earlier coupons on the second bond are then applied against all remaining liabilities. This progression of matching the maturity value and date of a bond to each successively closer liability is continued until all the liabilities are funded.

Since it is unlikely that the cash flows from a bond portfolio will exactly match the liabilities, reinvestment risk is inherent in cash flow matching. As such, a minimum-risk immunization approach to funding multiple liabilities is at least equal to cash flow matching, and probably better, since it would be less expensive to fund a given stream of liabilities.

Front 115

In spite of the drawbacks of cash flow matching, why is it occassionally used?

Back 115

Because it is easier to understand than multi-liability immunization

Front 116

Combination matching

Back 116

also known as horizon matching

A combination of multiple-liability immunization and cash flow matching that can be used to address the asset cash flow/liability matching problem.

Creates a portfolio that is duration matched. During the first few years the portfolio would also be cash flow matched in order ot make sure that assets were properly dispersed to meet the near-term obligations

Front 117

What are two advantages that combination matching offers over multiple-liability immunization?

Back 117

1. Provides liquidity in the initial period
2. Reduces the risk associated with nonparallel shifts in the yield curve, which usually take place in the early years

Front 118

What is the primary disadvantage of combination matching relative to multiple liability immunization?

Back 118

Usually more expensive

Front 119

Relative value analysis

Back 119

assets are compared along readily identifiable characteristics and value measures.

In comparing firms, for example, we can use measures such as P/E ratios for ranking. With bonds, some of the characteristics used include sector, issue, and structure, which are used to rank the bonds across and within categories by expected performance.

Front 120

Top-down approach to relative value

Back 120

the manager uses economy-wide projections to first allocate funds to different countries or currencies. The analyst then determines what industries or sectors are expected to outperform, and selects individual securities within those industries.

Front 121

Bottom-up approach to relative value

Back 121

starts at the "bottom." The analyst selects undervalued issues

Front 122

Any bond analysis should focus on what type of return?

Back 122

Total return

Front 123

Cyclical changes

Back 123

Increases in the number of new bond issues are sometimes associated with narrower spreads and relatively strong returns. Even though this seems counter-intuitive, relative corporate returns often perform best during periods of heavy supply. A possible explanation is that the valuation of new issues validates the prices of outstanding issues, which relieves pricing uncertainty and reduces spreads.

Corporate bond returns have even declined, in both relative and absolute terms, when the supply of new issues unexpectedly drops off. An explanation for this occurrence is the loss of the validation provided by the primary markets, which causes uncertainty and accompanying higher spreads.

Front 124

Why is there more price uncertainty in bond markets than stock markets?

Back 124

Unlike the fast-moving equity markets, bond markets can be very thinly traded, meaning there isn’t an on-going mechanism for the reassessment of prices. This can make investors uncertain that prices reflect all current information.

Front 125

Secular changes

Back 125

refer to the characteristics of the bonds themselves. Bullets are not callable, putable, or sinkable. Callable issues still dominate the high-yield segment, but this situation is expected to change as credit quality improves with lower interest financing and refinancing.

Front 126

What are three implications of the current secular bond market?

Back 126

1. Securities with embedded options will trade at premium prices due to their scarcity value.
2. Because of the tendency toward intermediate maturities, credit managers seeking longer durations will pay a premium for longer duration securities.
3. Credit-based derivatives will be increasingly used to take advantage of return and/or diversification benefits across sectors, structures, etc.

Front 127

What is the relationship between liquidity and bond prices?

And what is the implication of this on portfolio management decisions?

Back 127

Generally positive;

As liquidity decreases, investors are willing to pay less (increasing yields), and as liquidity increases, investors will pay more (decreasing yields).

The corporate debt market has shown variable liquidity over time, influenced to a great extent by macro shocks (i.e., a variety of economic conditions). And while some investors are willing to give up additional return by investing in issues that possess great liquidity (e.g., larger-sized issues and government issues), other investors are willing to risk liquidity for those issues which offer a greater yield (e.g., smaller-sized issues and private placements).

Front 128

There has been a general move in debt markets toward increased liquidity mainly due to what factors?

Back 128

1. Trading innovation
2. Competition among portfolio managers

Front 129

List the reasons for active trading in the secondary bond markets by mangers (as opposed to simply holding their portfolios).

Back 129

1. Yield/spread pickup trades
2. Credit-upside trades
3. Credit-defense trades
4. New issue swaps
5. Sector rotation trades
6. Yield Curve adjustment trades
7. Structure trades
8. Cash flow reinvestment

In all cases, the manager must determine whether trading will produce returns greater than the associated costs

Front 130

What are the most cited reason for secondary trading in bond markets?

Back 130

Yield/spread pickup trades

Front 131

Yield/spread pickup trades

Back 131

Pickup of additional yield which is possible within specified duration and credit-quality bounds.

Flaw: Does not based within a total return framework

Front 132

Credit upside trades

Back 132

The bond portfolio manager attempts to identify issues that are upgradeable before the upgrade is incorporated into their prices.

When the upgrade is officially announced, the prices of the affected bonds will increase as their spreads narrow.

Front 133

Where do credit upside trades most often occur?

Back 133

at the juncture of the highest speculative rating and the lowest investment rating.

Front 134

Credit defense trades

Back 134

Managers reduce exposure to sectors where they expect a credit downgrade

Front 135

New issue swaps

Back 135

Trades into large, new issues, particularly on-the-run Treasuries that are often perceived to have superior liquidity.

Front 136

Sector-rotation trades

Back 136

Undertaken to take advantage of sectors that are expected to outperform on a total return basis.

Front 137

Yield curve-adjustment trades

Back 137

Occur because of the desire to alter the duration of a portfolio to be favorably positioned with respect to anticipated yield curve changes.

If long-term interest rates are expected to fall, the manager may want to shift into longer durations to maximize the positive effect of the change in interest rates

Front 138

Structure trades

Back 138

refers to swaps into structures (callable, bullet, and put) that will have strong performance given an expected movement in volatility and yield curve shape.

Ex: higher volatility tends to result in decreased prices for callable securities because of the increased value to the issuer of the embedded option

Put structures tend to fare better in environements where interest rates are not expected to decrease

Front 139

Do call or put structures tend to fare better in environments where interset rates are not expected to decrease?

Back 139

Puts

Front 140

Is higher volatility good for the prices of callable securities or bad?

Back 140

Bad because of the increased value to the issuer of the embedded option

Front 141

If interest rates decline, do putable bonds under or out perform nonputable issues?

Back 141

Underperform

Front 142

Cash flow reinvestment trades

Back 142

Common reason for portfolio managerse to trade in the secondary market.

Particularly true when portfolio cash flows do not coincide with new issues in the primary market for corporate bonds.

Front 143

If interest rates are expected to rise, buy _____ duration bonds and sell _____ duration bonds

Back 143

buy short duration bonds

Sell long-duration bonds

Front 144

If interest rates are expected to fall, buy _____ duration bonds and sell _____ duration bonds

Back 144

buy long duration bonds

Sell short-duration bonds

Front 145

If the yield spread for a bond sector is expected to narrow, choose _______ duration bonds in the sector. Why?

Back 145

longer-duration bonds. They will gain most from decreased rates

Front 146

If the yield spread for a bond sector is expected to widen, choose _______ duration bonds in the sector.

Back 146

Shorter-duration bonds.

Front 147

Name four reasons why a bond portfolio manager would not trade in the secondary market?

Back 147

1. Trading constraints
2. Story disagreement
3. Buy and hold
4. Seasonality

Front 148

Trading constraints

Back 148

considered to be a major contributor to inefficiencies in the global corporate bond market

Front 149

List several example of bond trading constraints

Back 149

1. State employee pension funds are limited to investing only in investment grade bonds

2.Restrictions on structures and foreign bonds

3. High yield corporate exposure limits for insurance companies

4. Structure and quality restrictions for European investors

5. Floating rate requirements for commercial banks.

Front 150

Story disagreement

Back 150

the lack of consensus between buy-side and sell-side analysts and strategists -

Can lead to conflicting recommendations and uncertainty about optimal trading strategies

Can be similar to anchoring and adjustment

Front 151

Buy and hold

Back 151

an unwillingness to sell and recognize an accounting loss or the desire to keep turnover low. Or lack of liquidity

Front 152

Seasonality

Back 152

refers to the slowing of trading at the ends of months, quarters, and calendar years when portfolio managers are preoccupied with various reports and filings

Front 153

Nominal spread

Back 153

the yield difference between corporate and government bonds of similar maturity

Currently the basic unit of both price and relative value analysis for most of the global corporate bond market

Front 154

Swap spreads

Back 154

The spread paid by the fixed rate payer over the rate on the on-the-run Treasury with the same maturity as the swap.

Widely used in Europe as an indication of credit spreads

Front 155

Option-adjusted spread

Back 155

Often used when comparing investment-grade corporate securities with mortgage-backed and US agency issues.

It is the effective spread for the class after removing any embedded options.

The use of the OAS is declining due to the reduction in corporate structures that contain embedded options

Front 156

Name three types of spread analysis

Back 156

1. Mean-reversion analysis
2. Quality spread analysis
3. Percentage yield spread analysis

Front 157

Mean-reversion analysis

Back 157

Simple.

Used expensively for analyzing spreads

Presumption: spreads between sectors tend to revert toward their historical means

Can use statistical analysis (standard deviations and t-scores) to determine if the current spread is significantly different from the mean.

Front 158

In mean reversion analysis, if the current spread is significantly greater than than the historic mean, should you buy or sell the issue?

Back 158

Buy. If yield is high on a relative basis, price is low

Front 159

In mean reversion analysis, if the current spread is significantly less than the historic mean, should you buy or sell the issue?

Back 159

Sell. If yield is low, price is high

Front 160

Quality spread analysis

Back 160

Based on the spread differential between low and high quality credits

A manager may buy an issue with a spread wider than that which is justified by its intrinsic quality. But the risk is that the spread will not narrow or will become even greater

Front 161

Percentage yield spread analysis

Back 161

Divides the yields on corporate bonds by the yields on treasuries with the same duration.

Front 162

In percentage yield spread analysis, if the ratio is higher than justified by the historical ratio, the spread is expected to _________, making corporate bond prices _________.

Back 162

Spread - fall
Corporate bond prices - rise

Front 163

What is an argument against using percentage yield spread analysis?

Back 163

The denominator in the ratio (government yields) is just one of many factors that contribute to corporate yields.

Front 164

Structural analysis

Back 164

The analysis of the performance of structures (bullet, callable, putable, sinking fund) on a relative value basis.

Becoming more useful as US and global bond marekts move toward the homogenous bullet structure of the European corporate bond market.

Front 165

Short-term bullets

Back 165

Have maturities of one to five years and are used on the short-end of a barbell strategy.

Front 166

Barbell

Back 166

a portfolio that contains short and long term bonds.

Corporate securities are used on the frong end of the yield curve with long-term Treasuries at the long end of th eyield curve

Front 167

Medium-term bullets

Back 167

Maturities of 5-12 years. Most popular sector in the US and Europe.

Front 168

When the yield curve is positively sloped, what structures are often the most attractive? Why?

Back 168

20 year structures.

Because they offer higher yields than 10 or 15 year structures but lower duration than 30-year securities

Front 169

Long-term bullets

Back 169

30-year maturities. Most commonly used long-term security in the global corporate bond market.

They offer managers and investors additional positive convexity at the cost of increased effective duration

Front 170

The price and return differentials of callable and noncallable bonds are driven by the value of ________

Back 170

the embedded option

Front 171

Callable bonds have _______ convexity

Back 171

Negative

Front 172

Do callable bonds underperform or outperform noncallables when interest rate fall (Relative to the coupon rate)?

Back 172

Underperform due to their negative convexity. They don't realize the gains from a bond market rally because their prices do not rise as much of those of similar noncallables due to the embedded option

Front 173

Do callable bonds underperform or outperform noncallables when interest rate rise (Relative to the coupon rate)?

Back 173

Outperform. When the current rate is lower than the coupon rate, their negative convexity makes callables respond less to increasing rates.

Front 174

Do callable bonds underperform or outperform noncallables when interest rate are very high (Relative to the coupon rate)?

Back 174

They perform similarly since the call option has little or no vallue.

Front 175

Sinking funds

Back 175

Provide for the early retirement of a portion of an issue of bonds.

Front 176

Sinking fund structures priced at a discount to par, have historically retained upside price potential during interest rate declines as long as the bonds remained priced how?

Back 176

at a discount to par - that is, the firm can call the bonds back at par.

Front 177

Do the price of sinking fund structures fall more or less than callable and bullets when interest rates rise?

Back 177

Less because the issuer is usually required to repurchase part of the issue each year.

Front 178

Putable bonds

Back 178

Due to the relative scarcity of bonds with put options, difficult to reach a conclusion about their performance and valuation.

Should only consider putable bonds when there is a strong belief that interest rates will rise

Increases in interest rates increase the value of the embedded put option

It may be that the creditworthiness of the high-yield issuer is a more relevant indicator of the vlaue of the bond than that calculated using a valuation model

Front 179

Credit analysis

Back 179

Involves examinging financial statements, bond documents, and trends in credit ratings.

Provides an analytic framework in assessing key information in sector selection

Front 180

What is the key factor in corporate credit analysis?

Back 180

Capacity to pay

Front 181

What are the most important considerations in credit analyis of asset-backed securities?

Back 181

Quality of the collateral and the servicer

Front 182

What is the key factor in municipal bond credit analysis?

Back 182

Ability to assess and collect taxes

Front 183

What are the key factors in sovereign credit analysis?

Back 183

Ability to pay (economic risk)
Willingness to pay (political risk)

Front 184

What is the main disadvantage to credit analysis?

Back 184

The need to continually search out and interpret information - this is becoming more arduous with the expansion in the universe of global bonds.

To be effective, managers must establish and support an effective credit analysis sytem within their managerial domains to assure that appropriate information is available to make the best possible choices.