Cfa Level Iii - Study Session 9

Front 1

Management of Passive and Active Fixed Income PFs

Liabilities or Bond index as a benchmark?
(SS9)

Back 1

Two types of investors
1. Those with no liability to manage (i.e. use a bond index as a benchmark)
You want your return to exceed the return on the index.
2. Those WITH a liability.
Success here is the ability to make enough cash to cover these payouts (meeting the liability objective)

Front 2

Management of Passive and Active Fixed Income PFs

Active or Passive bond management
(SS9)

Back 2

1. Passive strategy
i. Good for when the manager has no experience in forecasting
ii. it sets the pf risk profile to that of the index
iii. gets an average rate of return that should closely track the benchmark index.

2. Active
i. relies on management's forecasting ability
ii. return should increase if manager forecasts a future path that is more accurate than current prices show.
iii. small mismatches found? You are on an enhanced management
iv. large mismatches? You are on full-blown active management

Front 3

Management of Passive and Active Fixed Income PFs

Fixed-income Strategies
(5 of them)
(SS9)

Back 3

1. Pure bond indexing - owning all bonds in the index. Rarely attempted because of the difficulty, inefficiency and cost of implementation
2. Enhanced indexing - matches primary risk factors and tries to get a little bit higher return. Matches on interest rates, twists and changes in spread
Less closely matched, but greatly reduced costs means overall returns are better.
3. Enhanced indexing by .
small risk factor mismatches - Matches duration, but tilts in favor of finding relative value in sectors, quality or term structure.
4. Active management by larger risk factor mismatches (on the primary risk factors) - Stronger choices than tilt. Relative value driven
5. Full-blown active management - Deliberate positioning, aggressive mismatches on duration, sector weights.

Front 4

Management of Passive and Active Fixed Income PFs

How do you select a benchmark bond market index?
(SS9)

Back 4

1. Market value risk - If the investor is risk averse choose a benchmark with a SHORTER duration.
2. Income risk - portfolio and benchmark should provide comparable assured income streams.
3. Credit risk - the benchmark should be diversified in issues and issuers in roughly the same way as the portfolio.
4. Liability framework risk - This risk should be minimised. Duration match assets and liabilities if liabilities have any role. Investors with long term liabilities should choose a long index. Bond holders with NO liabilities have much more flexibility to choose a benchmark.

Front 5

Fixed Income Portfolio Management

Example - What benchmark to choose
(SS9)

Back 5

A highly risk-averse investor who is sensitive to fluctuations in portfolio value
1. CHOOSE short to intermediate duration
2. NOT high yield bond benchmark, even if it has a short duration

Educational endowment with a long investment horizon
1. Match long to long horizon duration

Life insurer who wants to meet short-term claims
1. Life insurers generally have unknown times when they are going to have to meet claims, but since this one wants to meet short term, then choose a shorter duration

Front 6

Fixed Income Portfolio Management

Is the bond market index a real portfolio?
(SS9)

Back 6

NO
The bond market index is NOT investable
i. Indexes are good benchmarks, but you have to find another way to invest in them.
ii. Manager has to make their own portfolio that mimics, closely tracks the characteristics of the benchmark index.

Front 7

Fixed Income Portfolio Management

How do you match risk exposures to your bond benchmarks risk exposures?
(SS9)

Back 7

Cell-matching technique
(stratified sampling)
i. select a bond to represent the risk of that cell e.g. A rated company chosen to represent 4% of the pf.

Multi-factor technique
1. Duration match with effective duration (designed for parallel shifts in yield curve)
2i. Key rate duration (designed for twists) - if you expect shifts in key points along the curve.
Good for bullet strategies
ii. PV cash flows of benchmark = PV cash flows of your portfolio
3. Sector and quality percent
4. Sector duration contribution - match on sector duration spreads
5. Quality spread duration contribution - SPREAD DURATION weight all except the treasury bond. How a NON-treasury bond changes in price.
6. Sector/coupon/maturity cell weights - this tries to convexity match, which is an impossible ask, so it fakes it by sector/coupon and maturity weights.
7. Issuer exposure - To control event risk if one guy goes bust.

Front 8

Fixed Income Portfolio Management

Tracking Risk
(SS9)

Back 8

Active Return =
Portfolio's return - Benchmark index's return
= (10 -8) squared = 4

Tracking Risk = Standard deviation of the active returns
s.d = square root 4 = 2 tracking risk

If your tracking risk is 2, then one standard deviation either side of the mean catures 67% of returns.

SMALL tracking risk, means that the portfolio matches the benchmark.

Front 9

Fixed Income Portfolio Management

What cause tracking risk
(SS9)

Back 9

1. Mismatch on portfolio duration
2. Mismatch on key rate duration
3. Mismatch on sector and quality percent - if the benchmark has MBS and your pf does not, the tracking risk increases
4. Mismatch on sector duration contribution - benchmarks industrials have a duration of 6 and your industrials have a duration of 5
5. Mismatch on quality spread duration contribution

Front 10

Fixed-Income Portfolio Management

Enhanced Indexing Strategies
(SS9)

Back 10

Enhanced is all about indexing with a little boost to cover transactions costs
i. Lower cost enhancements - reduce your costs
ii. Issue selection enhancements - select before an upgrade
iii. Yield curve positioning - mispricing can persist because demand for those types of bonds will always be strong.
iv. Sector and quality positioning -
yield tilt toward short duration. History has show that short duration under 5 yr corps have the best yield spread
Periodic over-underweighting but on a much smaller scale than active management, just to cover trading costs.

Front 11

Fixed-Income Portfolio Management

Total Return on a Bond
and then scenario analysis on that
(SS9)

Back 11

Three sources of potential return
1. Coupon income
2. Reinvestment income
3. Changes in price

Then run a scenario analysis
i. looking at the range of your outcomes
ii. reverse engineer starting with a range of your outcomes trying to figure out inputs that you need.
iii. scenario can point out what happens if the manager is wrong
iv. puts the range of outcomes out in the open in front of the manager
v. good planning tool
vi. good risk assessment tool

Front 12

Fixed-Income Portfolio Management

Managing Funds against Liabilities
(SS9)

Back 12

Managing funds against liabilities
Dedication strategies (mostly passive)
1. Immunization (single liability or multiple as for a defined-benefit plan's payouts) - locks in a guaranteed rate of return over a particular horizon.
2. Cash flow matching

Types of liabilities
i. Amount of liability (known or unknown)
ii. Timing of liability (known or unknown)
Example: Principal payout (known amount, known timing)
Post retirement health care benefits (unknown amount and unknown timing)

Front 13

Fixed-Income Portfolio Management

Immunization
(SS9)

Back 13

Immunization requires
1. Offsetting reinvestment risk and price risk
Any price changes from ir going up/down should be offset by increases/decreases in investment income.
2. Duration match to time horizon. This is a minimum condition for immunization.
3. Investing in a coupon bond with a yield to maturity equal to the target yield and a maturity equal to the investment horizon does not assure that the target value will be achieved. Because the ir could drop right after you set it up and your reinvested coupons will be at a lower rate.

Front 14

Fixed-Income Portfolio Management

Dollar Duration Formula
(SS9)

Back 14

Dollar duration is a measure of the change in portfolio value for a 100 bps change in market yields

Dollar duration = Duration x Portfolio value x 0.01

Portfolio dollar duration equals the sum of the dollar durations of the component securities.

nb: remember to multiply it by 0.01

Front 15

Fixed-Income Portfolio Management

Rebalancing Ratio for Dollar Duration
(SS9)

Back 15

1. Establish your initial dollar duration
= $111,945
2. Move forward in time one year and calc. your new dollar duration
= $82,579
3. Calc. the rebalancing ratio old/new
$111,945
-------------- = 1.356
$82,579

4. Rebalancing requires each position to be increased by 35.6%. The cash required for this rebalancing is calculated from the new market values
= 0.356 x ($1,023,704 + $1,004,770 + $1,002,458)
= $1,079,012

Front 16

Fixed-Income Portfolio Management

Spread duration types (nominal, static and OAS)
(SS9)

Back 16

1. Nominal spread - spread above the yield of a certain maturity Treasury
2. Static spread - zero volatility spread which is the constant spread above the Treasury spot curve that equates the calculated price of the security to the market price.
3. Option-adjusted spread (OAS) - takes out the spread that compensates for the option

i. Spread duration of Treasuries is zero
ii. If the portfolio has no Treasuries, then spread duration of pf equals portfolio duration.

Front 17

Fixed-Income Portfolio Management

Portfolio Immunisation
(SS9)

Back 17

1. Set and forget? - NO you need to rebalance whenever interest rates change and time elapses
2. Immunization target rate of return is less than yield to maturity
3. If duration matched the portfolio faces no risk except for default risk? - NO it is also exposed to the risk that the ir curve twists as duration only matches parallel move.
4. Liquidity is irrelevant - NO immunized pfs need to be rebalanced. Illiquid securities have high transaction costs and make rebalancing costly.
5. In general the entire pf doesn't have to be turned over to rebalance an immunized portfolio - TRUE you don't have to sell/buy everything every day, just a small set of securities from one maturity range to another is enough

Front 18

Fixed-Income Portfolio Management

Assumptions of Classical Immunization Theory
(SS9)

Back 18

1. Any yield curve changes are parallel changes. (ir moves up/down by same amount for all maturities)
2. Portfolio is valued at a fixed horizon date, no interim cash inflows/outflows before the horizon date
3. Interest rate structure can't change (no change in forward rates)

Assumption that breaks down the most is the parallel shift in ir's.

Front 19

Fixed-Income Portfolio Management

Contingent Immunization
(SS9)

Back 19

Contingent Immunization is only possible when the available immunized rate of return is greater than the required rate of return.
i. Example if you must earn 3% and it can immunize its asset portfolio at 4.75%, the manager can actively manage part or all of the pf until it reaches the safety net rate of return of 3%.
ii. If pf drops below safety net, the pf is IMMUNIZED and the active management is dropped.
iii. Difference between 4.75% and 3% is called the cushion spread

Front 20

Fixed-Income Portfolio Management

Types of risk for immunization
(SS9)

Back 20

When the market changes, you risk not being able to pay liabilities when they come due.
1. Interest rate risk - MAIN ONE
2. Contingent claims risk - those with a call like callable securities or MBS with prepayments. When ir falls people prepay, coupons stop and worst case principal is repaid.
3. Cap risk - for floating rate securities. The manager is at risk when the market rates rise when the asset returns are capped.

Front 21

Fixed-Income Portfolio Management

Where is there high reinvestment risk?
(SS9)

Back 21

REINVESTMENT RISK determines IMMUNIZATION RISK
The portfolio that has the least reinvestment risk will have the least immunization risk.
i. When there is a high DISPERSION of cash flows around the horizon date (barbell) the pf has higher reinvestment risk
ii. When the cash flows are concentrated around the horizon date (bullet) the pf has minimal reinvestment risk.
iii. If pure discount security matches horizon then there is NO reinvestment risk and immunization risk is zero.

Front 22

Fixed-Income Portfolio Management

Multiple Liability Immunization
(SS9)

Back 22

Matching duration of the pf to the average duration of the liabilities isn't a good condition for immunizing when you have multiple liabilities.
i. Split out your portfolio payment streams
ii. If there is a parallel rate shift then (composite) duration of pf must equal the (composite) duration of liabiltiies
iii. Hard to get duration assets over 15. Just because you have a liability in 30 yrs, you don't have to set up a pf with duration 30 because you take a weighted average of the liability durations.
iv. Asset portfolio income should be more dispersed in time than liabilities. So, there must be an asset with a duration less than the smallest duration liability and an asset with a longer duration than the longest duration liability to avoid reinvestment risk that might jeopardise payment of the longest duration.

Front 23

Fixed-Income Portfolio Management

Cash Flow matching vs Immunization
(SS9)

Back 23

1. Cash flow matching is easier to understand and sometimes used
2. Cash flow returns are lower than immunized
3. Cash flow matching keeps a higher cash balance to match liabilities than immunized.
4. Immunized can get higher returns and it stays more fully invested.

Front 24

Relative Value for Global Credit Bonds

Relative value of bond markets
(SS9)

Back 24

In the bond market, relative value refers to ranking of fixed income sectors by:
i. structures
ii. issuers
iii. issues in terms of their expected performance during some future period of time.

Classic Relative Value
i. Top-down - allocate at credit asset classes
ii. Bottom-up - allocate to individual issues

Relative Value Methodologies
i. total return analysis
ii. primary market analysis
iii. liquidity and trading analysis
iv. secondary trading rationales and constraints analysis
v. spread analysis
vi. structure analysis
vii. credit curve analysis
viii. credit analysis
ix. asset allocation/sector analysis

Front 25

Relative Value for Global Credit Bonds

Primary Market Analysis
(SS9)

Back 25

1. New primary valuations validate and enhance secondary valuations.
When primary issues decline sharply, secondary traders lose reinforcement from the primary market and tend to reduce their bid spreads.

NB: This is contrary to the normal supply-demand pricing relationship where more supply means prices go down.

2. Product Structure:
i. Bullets with intermediate terms are most common
ii. except in high-yield market where callables are the structure of choice, so co's can refinance at a lower rate if things improve.
iii. structures with embedded options are rare, because everything is a bullet - this creates a 'scarcity effect' for these option bonds.
iv. since there are so many intermediates and no long term maturities, this reduced the pf durations and reduced everyones sensitivity to ir risk.

Front 26

Relative Value for Global Credit Bonds

Liquidity and Trading Analysis
(SS9)

Back 26

1. Liquidity means some people won't buy
i. Issues less than $1.0 billion
ii. private placements
iii. non-local corp issuers
2. Liquidity changes over time varying with
i. economy
ii. supply
iii. season
iv. shape of yield curve
v. credit cycle
3. With technology and competition, the bond market is more liquid than it used to be.

Front 27

Relative Value for Global Credit Bonds

Secondary Trade Rationales (why bother trading in the secondary market? long list)
(SS9)

Back 27

1. Yield/Spread Pickup trades (most common) - Sell your Ford and buy a GM bond for 10bps
2. Credit upside - manager foresees an upgrade before it is announced. Most popular in the 'cross-over' sector from non-investment grade to investment grade.
3. Credit-defense trades - global pick
4. New Issue swaps - current issues are better because they'll have more liquidity ('on-the-run')
5. Sector-Rotation trades - these are intra asset class trades out of utilities into telecom
6. Curve-Adjustment trades - to reposition a pf's duration
7. Structure trades - swaps into structures like callable, bullet and putable structures that are expected to have better performance
8. Cash flow reinvestment - forces people into the secondary market as a place to invest their capital.

Front 28

Relative Value for Global Credit Bonds

Trading Constraints
(SS9)

Back 28

1. Portfolio constraints
i. investment grade only securities
ii. pension funds can't buy non A due to legislative and administrative guidelines
iii. regulators limited insurance companies' investments in high-yield corporates
iv. many investors are restricted to investing in their local currency market
v. commercial banks have to buy floating rate securities
2. 'Story' disagreement - buying Asian debt after the crisis
3. Buy-and-Hold - e.g. cannot sell at a loss, can't sell if the capital gain will be too high
4. Seasonality - trading slows at month end and quarter end

Front 29

Relative Value for Global Credit Bonds

Spread Analysis
(SS9)

Back 29

Over time people have switched from
option adjusted spread (OAS)
to
interest rate swap spreads
to
credit default swaps
(use the Treasury yield as the benchmark)

because the number of OAS products went down so it was less useful.

Front 30

Relative Value for Global Credit Bonds

Spread Tools
(SS9)

Back 30

1. Mean-Reversion Analysis - the mean is highly dependent on the interval selected. Added to that "persistence" persists and cheapies remain cheap, while rich securities remain rich.
2. Quality spread analysis - is a big spread going to get bigger (deteriorate) or is it going to get smaller (overreaction).
Good to overweight lower-quality debt at the outset of an upward turn in the economic cycle.
3. Percent yield spread analysis - (ratio of credit yields to gov yields) pretty basic analysis, doesn't add much.