T5 Managing a Fixed Income Portfolio Flashcards
What are the main arguments for including FI in a pf?
- beats R obtainable from ST money market
- a low-risk means to fund LT liab (altho earnings generated may be insufficient to meet the liab)
- separate low-risk asset class providing protection against falling interest rates
- can use inflation-indexed FI securities to hedge against inflation
Overall, has the govt yld been rising or declining? Why?
Overall, govt bond ylds have been declining. Reasons being:
- Govt stimulus has been in place since GFC i.e. reducing interest rates which lead to bond yld falls
- Increasing demand for bonds from pension funds and pensioners due to ageing population in Aus and other economies such as the US, Japan, Germany etc.
- prior to 2008 GFC, supply of private debt securities were on the rise, esp. supply of mortgage and asset-backed securities were increased, driven by competition between mortgage providers, and govt debts were increasingly retired as govt favoured small deficits and there was a trend of govt enterprises being privatised in the 90s.
- trend in credit spread (corp bond yld as additional spread over govt bond yld) : has been tightening, investors increasingly switching over to lower-rated corp bonds (BBB) due to lower volatility, moderate growth and lower default expectation in spite of deteriorating credit quality among the corporate debt issuers.
Can interest rate market can divided? How?
Interest rate market can be divided into 2 kinds:
- ST mkt (<1yr, focused on 3-6 mth maturity)
- LT mkt (>1yr, focused on maturity up to 10 yrs; note though some issuers offer longer term of maturity)
Name a few examples of FI instruments traded in the LT interest rate mkt?
FRN, commonwealth govt bonds, semi-govt bonds, corp bonds, hybrids, index-linked/inflation-linked securities, bank transferrable CDs
Overall, in the LT interest rate mkt, what sets retail and wholesale apart?
Retail mkts lack liquidity and technical expertise with little 2ndary mkt activities.
(Note recent emergence/development aka mezzanine level where retail investors have semi-commercial amount to invest but lack professional investment knowledge);
development of inv trust i.e. pooled vehicle enables investors to access benefits of wholesale mkt
Who are the dominating/major issuers of non-govt bonds?
- supranationals ‘non-residents’ (have become increasingly active)
- banks ‘financials’ (have become increasingly active)
- high-grade corporate issuers (high credity quality, no junk bonds min: A-)
- asset-back securities
What are the reasons why non-residents and financials have become increasingly active in issuing non-govt bonds?
- govt no longer has as much need to borrow (decline in the outstanding, running budget surpluses)
- pf manager’s need for diversification
- (for the ‘non-residents’) - need to hedge exchange rate exposure hence development of cross-currency basis swap mkt
Name the 6 types of risk associated with FI securities?
Generally, as pf migrates down the credit curve (e.g. switching from govt bond to BBB-rated bond), the impact of interest rate falls and the security-specific risks become more important. credit risk is the main concern if holding a bond of a low rate, but holding a commonwelath govt bond, main risk is interest rate risk. The 6 types of risks associated with investing in FI securities are:
- market/interest rate risk - generally shorter maturity or high coupon rates shorten duration thus result in lower interest risk. note that duration measures a bond’s. interst rate risk, considering the bond’s maturity, yld, coupon and call features, and gauges how sensitive a bond’s value is to interest rate changes. Interest rates are under the influence of govt’s monetary policy, inflation, global demand for capital, supply and emand of credit avail to the economy.
- credit risk - when borrower defaults on debt repayments. Note though, defaulting coys are not necessarily bond issuers. and bondholders are paid before other creditors like trade creditors and equity holders.
- event risk - usually refering to events beyond the issuer’s control like 911 attack and gulf war, accidents, regulatory changes, corp restructuring. disrupting P/I repayments that are otherwise timely.
- reinvestment risk - variability of prevailing interest rate at the time interest is reinvested for earning interest on interest
- sector risk - (know the 5 sectors are: commonwealth govt bonds, semi-govt bonds, bonds guaranteed by the commonwealth, corporate bonds, mortgage and asset-backed securities ) if actual sector allocation diff from that of a benchmark, then manager runs the risk pf underperforms the benchmark. but active manager may try diff sector allocation delibrately to generate excess return relative to bench.
- liquidity risk - ease with which investor/creditor convert inv to cash without neg impact on capital and R. Typically adding non-govt (esp. lower rated bonds) into pf increases liquidity risk.
Why is duration not a complete measure of bond risk? How can an active manager manage duration?
Duration is not a complete measure if bond risk as other aspects like credit quality, bond strategy esp. when dealing with a low-rated bond with high ylds need to be assessed. Also, as bonds within a pf mature and interest rate changes, the AVERAGE duration changes vs duration at purchase. So average duration should be checked regularly to avoid surprises.
An actively managed portfolio may maintain a set average duration range. Which can be done if the pf manager adjusts the holdings within the pf to adjust the average duration such that it aligns with the forecast/outlook on interest rate.
When estimating the credit risk of a borrower, the ability and willingness of the issuer to make timely payment of P&I must be assessed. Much like equity analysis, this is a research-intensive exercise. What are the factors that affect the afore-mentioned ability and willingness?
Management considerations, ownership considerations, financial analysis, documentation/financial covenant considerations, sharemarket performance considerations etc.
What is the highest and lowest credit rating that can be assigned to an FI product? Name a couple of well known credit rating aencies. What is an investment grade rating? What is a speculative grade rating?
Highest: AAA
Lowest: D
Credit rating agencies well known in the industry: S&P’s or Moody’s investor service (or credit rating can be done via an institutional investor’s own due dilligence for more reliability.
BBB-/BAA2 and above = investment grade, otherwise = speculative grade (i.e. junk bonds where investors require higher ylds as compensation for taking on higher credit risk)
How does an FI portforlio manager set performance objective(s)?
Much like managing an equity portfolio, an FI pf manager may also set up an objective in the format of: bond index (benchmark) R + 1.5% p.a.
Note that Bloomberg bond indices are commonluy selected as benchmark. However, choice of benchmark depends on risk parameters e.g. a bond pf with longer average duration capable of tolerating high price volatility may choose 5-10 yr maturity bond index as its benchmark.
Describe in general terms passive FI pf mgmt.
Track bond indices/benchmark, seeks to provid Rs that approximate relevant benchmark performance with low probability of underperforming benchmark When using a passive management approach to manage an FI pf, it is important to ensure pf’s sensitivities to factors (changes in interest rate, yld curve shape, sector spread) are the same as the benchmark’s).
Describe in general terms active management for an FI pf.
Actively managing an FI pf involves managing 3 types of risks i.e. interest, credit and sector risks.
- Managing interest rate risk involves the use of either duration strategy or yield curve strategy.
- Managing credit risk = {micro-economic research, issuer-specific research, issue-specific research}
- Manage sector risk involves active sector tilt which provides a low-risk means to add value to pf with no change in the underlying interest rates structure. (e.g. yield margin b/w govt and semi govt bonds contract -> capital gains). mgr can underweight the underperforming sectors and overweight the outperforming sectors to add value to the FI pf.
What is event risk?
It usually refers to events beyond the debt issuer’s control like 911 attack and gulf war, accidents, regulatory changes, corp restructuring. disrupting P/I repayments that are otherwise timely.
In general terms, describe how interest rate risk can be actively managed?
- duration strategy (i.e. decide pf duration) - can modify portfolio average duration to manage price volatility induced by interest rate changes e.g. make it 3 yrs when benchmark duration is 4 yrs, that way if interest rate rises by 1%, benchmark performance falls by 4% whilst your pf falls by 3% i.e. outperforming the benchmark by 1%
- yield-curve strategy (i.e. decide yield-curve position of pf) - this is based on the view of how the yld curve shapes might change and position the pf to benefit e.g. construct pf as cash and longer duration bonds if anticipate an inverse yld curve change and longer duration bonds outperform the shorter duration bonds; or if parallel shift upwards in rising interest rate environment, long bonds underperform short bonds.
