Chap 12 & 13 - Stratégie de PF: Titres à revenu fixe

Question 1

What are the 3 main segments of public debt based on a issue’s original maturity ?

Answer 1

1. Short-term issues with maturities of 1 year or less. The market for these instruments is commonly known as the money market.
2. Intermediate-term issues with maturities in excess of 1 year but less than 10 years. These instruments are known as notes.
3. Long-term obligations with maturities in excess of 10 years, called bonds.

Question 2

A bond can be characterized by its (1) intrinsic features, (2) type, (3) indenture provisions, or (4) features that affect its cash flows or its maturity.

Answer 2

1- Intrinsic Features: The coupon, maturity, principal value, and the type of ownership are important intrinsic features of a bond. The principal, or par value, of an issue represents the original value of the obligation. This is generally stated in $1,000 increments from $1,000 to $25,000 or more.

2- Types of Issues In contrast to common stock, companies can have many different bond issues outstanding at the same time. Secured (senior) bonds are backed by a legal claim on some specified property of the issuer in the case of default. Unsecured bonds (debentures) are backed only by the promise of the issuer to pay interest and principal on a timely basis. As such, they are secured by the general credit of the issuer. Subordinate (junior) debentures possess a claim on income and assets that is subordinated to other debentures.

3- Indenture Provisions: The indenture is the contract between the issuer and the bondholder specifying the issuer’s legal requirements. A trustee (usually a bank) acting on behalf of the bondholders ensures that all the indenture provisions are met, including the timely payment of interest and principal.

4- Features Affecting a Bond’s Maturity :

Question 3

What is A serial obligation bond ?

Answer 3

A serial obligation bond issue has a series of maturity dates, perhaps 20 or 25. Each maturity, although a subset of the total issue, is really a small bond issue with generally a different coupon. Municipalities issue most serial bonds.

Question 4

What is the difference between bearer bonds and registered bonds ?

Answer 4

With a bearer bond, the person physically holding the security is the owner, so the issuer keeps no record of ownership. Interest from a bearer bond is obtained by clipping coupons attached to the bonds and sending them to the issuer for payment. In contrast, the issuers of registered bonds maintain ownership records and pay the interest directly to the current owner of record.

Question 5

What is the call premium of callable bonds ?

Answer 5

Callable bonds have a call premium, which is the amount above par value that the issuer must pay to the bondholder for prematurely retiring the bond.

Question 6

What are some of the most important bonds provisions ?

Answer 6

1- A freely callable provision that allows the issuer to retire the bond at any time with a typical notification period of 30 to 60 days.

2- A noncallable provision wherein the issuer cannot retire the bond prior to its maturity.

3- Adeferred call provision, in which the issue cannot be called for a certain period of time after its issue (for example, 5 to 10 years and then becomes freely callable).

4- A nonrefunding provision prohibits a call and premature retirement of an issue from the proceeds of a lower-coupon refunding bond. An issue with a nonrefunding provision can be called and retired prior to maturity using other sources of funds, such as excess cash from operations, the sale of assets, or proceeds from a sale of common stock.

5- The sinking fund, which specifies that a bond must be paid off systematically over its life rather than only at maturity. The size of the sinking fund can be a percentage of a given issue, a percentage of the total debt outstanding, or a fixed sum stated on a dollar basis.

Question 7

What are the 5 different categories of bonds for each currency ?

Answer 7

(1) Sovereign bonds (for example, the U.S. Treasury)

(2) Quasi- and foreign governments (including agency bonds): 2 type of Subdivisions of gouv. : government-sponsored enterprises and federal agen cies. Foreign government issues are typically not denominated in its own currency (for example, a Japanese government issue denominated in dollars and sold in the United States).

(3) Securitized and collateralized bonds from governments or corporations: These can be either government agencies or corporate issues that are backed by cash flow from a portfolio of other assets, such as mortgages or car loans.

(4) Directly issued corporate bonds

(5) High-yield and emerging market bonds: Noninvestment grade from corporations in developed countries, and government or corporate issues from emerging market countries such as China and India, where the bonds can be either investment grade or high yield (noninvestment grade).

Question 8

What is a split rating ?

Answer 8

This happens when one of the three main rating agencies for bonds have a different opinion on a certain credit rating and therefore differs from the conclusions of the other ratings.

Question 9

The agencies modify the ratings with and signs for Fitch and S&P or with numbers (1-2-3) for Moody’s. As an example, an A (A1) bond is at the top of the A-rated group, while A (A3) is at the bottom of the A category. The top four ratings—AAA (or Aaa), AA (or Aa), A, and BBB (or Baa)—are generally considered to be investment-grade securities. The next level of securities, known as speculative bonds, includes the BB- and B-rated obligations. The C categories are generally either income obligations or revenue bonds. In the case of D-rated obligations, the issues are in outright default, and the ratings indicate the bonds’ relative salvage values. Bonds rated below investment grade are also referred to as high-yield, or “junk,” bonds.

Question 10

Short-term T-bills differ from notes and bonds in that they are sold at a discount from par to provide the desired yield. The return is the difference between the purchase price and the face value at maturity. In contrast, government notes and bonds pay semiannual coupons through their maturity dates.

Question 11

How does gouv. bonds, notes and bills pricing differs from short-term bills ?

Answer 11

1- Ex: The ask price is actually 102-28/32, or 102.875 percent of par. These quotes also are notable in terms of the bid–ask spread, which typically is one 32nd or less. This small spread reflects the outstanding liquidity and low transaction costs for Treasury securities.

2- Short-term bills: Quoted on a discount yield basis rather than on a price basis. So, for the bill that matures on June 21, 2018 (a one-year bill shown as the fourth entry), the ask discount rate of 1.205 percent would be the basis for the amount the investor would subtract from the bill’s face value of 100 (as a percentage of par) to determine the current price.

Question 12

How does Treasury Inflation-Protected Securities (TIPS) work ?

Answer 12

Because the actual level of inflation is generally not known immediately, the index value used has a built-in three-month lag. For example, for a bond issued on June 30, 2011, the beginning base index value used would be the CPI value as of March 30, 2011. Following the issuance of a TIPS bond, its principal value is adjusted every six months to reflect the inflation since the base period. In turn, the interest payment is computed based on this adjusted principal—that is, the interest payments equal the original coupon times the adjusted principal.

Question 13

TIPS can mathematically help to calculate the implied inflation rate: For example, if we assume that when this bond was issued on July 15, 2008, it sells at par for a yield of 3.50 percent, while a nominal Treasury note of equal maturity is sold at a yield of 5.75 percent. This differential in promised yields (5.75 3.50) implies that investors expect an average annual rate of inflation of 2.25 percent during this five-year period. If, a year later, the spread increased to 2.45 percent, it would indicate that investors expect a higher inflation rate during the subsequent four years.

Question 14

Municipalities in the United States issue two distinct types of bonds: general obligation bonds and revenue issues. General obligation bonds (GOs) are essentially backed by the full faith and credit of the issuer and its entire taxing power. Revenue bonds, in turn, are serviced by the income generated from specific revenue producing projects of the municipality, such as bridges, toll roads, hospitals, municipal coliseums, and waterworks. Revenue bonds generally provide higher returns than GOs because of the higher default risk that occurs if a municipality fails to generate sufficient income from a project designated to service its obligations.

Answer 14

As Feldstein, Fabozzi, Grant, and Ratner (2012) note, the most important feature of municipal obligations is that the interest payments are exempt from federal income tax and from taxes for some states in which the bond was issued.

Question 15

A significant feature of the U.S. municipal bond market is municipal bond insurance, wherein an insurance company will guarantee to make principal and interest payments in the event that the issuer of a bond defaults. The insurance is placed on the bond at date of issue and is irrevocable over the life of the issue. (Increase in credit rating and more liquidity)

Question 16

What is an asset-backed security ?

Answer 16

This is an important concept because it substantially increases the liquidity of these individual debt instruments, whether they be car loans, credit card debt, student loans, or home equity loans.

Question 17

What are Certificates for automobile receivables (CARs) ?

Answer 17

Certificates for automobile receivables (CARs) are securities collateralized by loans made to individuals to finance the purchase of cars. These auto loans can either be direct loans from a lending institution or indirect loans that are originated by an auto dealer and sold to the ultimate lender.

Question 18

What are Credit card–backed securities ?

Answer 18

Credit card–backed securities are the fastest-growing segment of the ABS market and differ from mortgage-backed and car loan-backed securities in that the principal payments from credit card receivables are not paid to the investor but are retained by the trustee to reinvest in additional receivables.

Question 19

What are Original issue discount (OID) bonds ?

Answer 19

Original issue discount (OID) bond, where the coupon is set substantially below the prevailing market rate—for example, a 3 percent coupon on a bond when market yields are 8 percent. As a result, the bond is issued at a deep discount from par value.

Question 20

What is the difference of foreign bonds and Eurobonds ?

Answer 20

Foreign bonds are issues sold primarily in one country and currency by a borrower of a different nationality. An example would be U.S. dollar–denominated bonds sold in the United States by a Japanese firm. (These are called Yankee bonds.) Eurobonds are bonds underwritten by international bond syndicates and sold in several national markets. An example would be Eurodollar bonds, which are securities denominated in U.S. dollars and sold to investors outside the United States.

Question 21

Bulldog bonds are sterling-denominated bonds issued by non-English firms and sold in London.

Samurai bonds are yen-denominated bonds sold by non-Japanese issuers and mainly sold in Japan.

Question 22

What are the 4 components that Bond investors separate the risk premium into ?

Answer 22

1. The quality of the issue as determined by its risk of default relative to other bonds
2. The term to maturity of the issue, which can affect price volatility
3. Indenture provisions, including collateral, call features, and sinking-fund provisions
4. Foreign bond risk, including exchange rate risk and country risk

Question 23

The value of call protection increases during periods of high interest rates. Marshall and Yawitz (1980) and Booth, Gounopoulos, and Skinner (2014) note that when you buy a bond with a high coupon, you want protection from having it called away when rates decline.

Question 24

The term structure of interest rates (or the yield curve, as it is more popularly known)
relates the term to maturity to the yield to maturity for a sample of bonds at a given point in time. Thus, it represents a cross section of yields for a category of bonds that are comparable in all respects but maturity. Specifically, the quality of the issues should be constant, and ideally you should have issues with similar coupons and call features within a single industry category. You can construct different yield curves for Treasuries, government agencies, prime-grade municipals, utilities and corporates with different ratings, and so on. The accuracy of the yield curve will depend on the comparability of the bonds in the sample.

Question 25

What are the main 3 theories attempting to explain the different shapes of the term structure ?

Answer 25

1- Expectations Hypothesis: According to this theory, the shape of the yield curve results from the interest rate expectations of market participants. More specifically, it holds that any long-term interest rate simply represents the geometric mean of current and future one-year interest rates expected to prevail over the life of the issue. Under such conditions, the equilibrium long-term yield is the rate the long-term bond investor would expect to earn through successive investments in short-term bonds over the term to maturity of the longterm bond.

2- Liquidity Preference (Term Premium) Hypothesis: The theory of liquidity preference holds that long-term securities should provide higher returns than short-term obligations because investors are willing to accept lower yields for short-maturity obligations to avoid the higher price volatility of long-maturity bonds. Lenders prefer short-term, more liquid loans, and to induce them to invest in more volatile long-term bonds, it is necessary to offer higher yields. Taken in isolation, this theory argues that the yield curve should generally slope upward and that any other shape should be viewed as a temporary aberration.

3- Segmented Market Hypothesis: Also known as the preferred habitat theory, it asserts that different institutional investors have different maturity needs that lead them to confine their security selections to specific maturity segments. That is, investors supposedly focus on either short-, intermediate-, or long-term securities. This theory contends that the shape of the yield curve ultimately is a function of these unique investment preferences of major financial institutions.

Question 26

The liquidity preference theory has been found to possess some strong empirical support by Cagan (1969) and McCulloch (1975). As a matter of historical fact, the yield curve does show an upward bias, which implies that some combination of the expectations theory and the liquidity preference (term premium) theory will more accurately explain the shape of the yield curve than either of them alone.

Question 27

1. When the yield to maturity is less than the coupon rate, the bond will be priced at a
   premium to its par value.
2. When the yield to maturity is greater than the coupon rate, the bond will be priced at a discount to its par value.
3. The price–yield relationship is not a straight line; rather, it is convex. As yields decline, the price increases at an increasing rate; and, as yields increase, the price declines at a declining rate.
4. For two bonds with the same maturity, the one with the lower coupon rate will experience the greater percentage price change for a given shift in yields.
5. Generally, for two bonds with the same coupon rate, the one with the longer maturity will experience the greater percentage price change for a given shift in yields.

Question 28

The practical significance of this is that when an investor acquires a bond from an existing owner between coupon dates, she will actually have to pay an amount that represents two things: (1) the actual value of the bond itself, which is the discounted value of the remaining future cash flows, and (2) the interest that has accrued since the last coupon date.

Question 29

Macaulay duration, as the most basic form of the statistic is called, calculates a weighted average of the payment dates associated with an N-period bond.

Answer 29

Modified duration approximates how the bond’s price will change as interest rates changes, while convexity (the second derivative) approximates how modified duration (the first derivative) will change with yield curve shifts.

Question 30

A callable bond is different because it provides the issuer with an option to refinance the bond by paying it off with funds from a new issue sold at a lower yield. Alternatively, a putable bond gives the investor the option to sell the bond back to the issuer at a fixed price, which is likely to occur when market yields rise. These are examples of bonds containing an embedded option feature.

Question 31

Starting from yield y (which is close to the par value yield), if interest rates increase, the value of the call option declines because it is unlikely the issuer will want to call the issue. Therefore, the call option has very little value, and the price of the callable bond will be similar to the price of a noncallable bond. In contrast, when interest rates decline below y , there is an increase in the probability that the issuer will exercise the call option and so the value of the call option increases. As a result, the value of the callable bond will deviate from the value of the noncallable bond in that its price will initially not increase as fast as that of the noncallable bond and eventually will not increase at all.

Question 32

The noncallable bond is said to have positive convexity because as yields declined, the price of the bond increased at a faster rate. With the callable bond, however, when rates decline, the price increases at a slower rate and ultimately does not change at all. This pattern of price– yield change for a callable bond when yields decline is referred to as negative convexity. Of course, this negative convexity price pattern is one of the risks of owning a callable bond.

Question 33

As with stock index funds, when designing a bond portfolio to mimic a hypothetical index, managers can follow two different paths: full replication or stratified sampling.

Answer 33

Stratified sampling : The bond index fund manager often follows a sampling approach because a bond indexes often contain several thousand specific issues and are adjusted frequently, making them both impractical and expensive to replicate precisely in practice. The goal of the stratified sampling approach is to create a bond portfolio that matches the important characteristics of the underlying index— such as credit quality, maturity/duration, or average yield—while maintaining a portfolio that is more cost effective to manage.

Question 34

Fixed-income portfolio managers often address this concern by forming a bond ladder, in which they divide their investment funds evenly into instruments that mature at regular intervals. The idea would then be to hold each bond to maturity, but to reinvest the proceeds from a maturing bond into a new instrument with a maturity at the far end of the ladder. In this way, the desired duration target for the portfolio can be maintained over time without having to continually adjust the investment weights for the remaining positions.

Question 35

Of course, to beat a benchmark, the active manager must form a portfolio that differs from the index in a meaningful way. Thus, active bond management strategies are closely tied to the manager’s view of what factors or market conditions will be the source of the incremental alpha returns she seeks.

Question 36

Interest rate anticipation is perhaps the riskiest active management strategy because it involves relying on uncertain forecasts of future interest rates. The idea is to preserve capital when an increase in interest rates is anticipated and achieve attractive capital gains when yields are expected to decline. Such objectives are usually achieved by altering portfolio duration (reducing duration when interest rates are expected to increase and increasing duration when a decline in yields is anticipated).

Question 37

When portfolio duration is shortened, substantial income could be sacrificed and
the opportunity for capital gains could be lost if interest rates decline rather than rise. Similarly, an investor sacrifices current income by shifting from high-coupon short bonds to longer duration bonds in anticipation of a rate decline. Further, the portfolio is purposely exposed to greater price volatility that could work against the portfolio if an unexpected increase in yields occurs. Note that the portfolio djustments prompted by an anticipated rate increase involve less risk of an absolute capital loss. When you reduce portfolio maturity, the worst that can happen is that interest income is reduced or capital gains are forgone (opportunity cost).

Question 38

To use credit analysis as a bond management strategy, it is necessary to predict rating changes prior to the announcement by the rating agencies. This can be quite challenging because the market adjusts rather quickly to bond rating changes. You want to acquire bond issues expected to experience a rating upgrade and sell or avoid those bond issues expected to be downgraded.

Question 39

Bond swaps: which entail liquidating a current position and simultaneously buying a different issue with similar attributes but better return potential. These trades can be executed to increase current yield, to increase yield to maturity, to take advantage of shifts in interest rates or yield spreads, to improve the quality of a portfolio, or for tax purposes. All swaps have one basic purpose: portfolio improvement.

Question 40

Core-plus bond portfolio management places a significant part (70 to 80 percent) of the available funds in a passively managed portfolio of highgrade securities that broadly reflects the overall bond market; this is the “core” of the strategy.
The remainder of the funds are managed actively in the “plus” portion of the portfolio, using the manager’s selection skills to offer a higher probability of achieving positive abnormal returns.

Question 41

Matched-funding strategies are a form of asset-liability management whereby the characteristics of the bonds held in the portfolio are coordinated with those of the liabilities the investor is obligated to pay. These matching techniques can range from an attempt to exactly match the levels and timing of the required cash payments to more general approaches that focus on other investment characteristics, such as setting the average duration or investment horizon of the bond portfolio equal to that of the underlying liabilities.

Question 42

What is Dedication ?

Answer 42

Dedication refers to bond portfolio management techniques that are used to service a prescribed set of liabilities.

Question 43

How does a pure cash-matched dedicated portfolio work ?

Answer 43

Using a pure cash-matched dedicated portfolio is the most conservative strategy. The objective of pure cash matching is to develop a portfolio of bonds that will provide a stream of payments from coupons and principal payments that exactly match the specified liability schedules.

Question 44

How does a Dedication with reinvestment portfolio works ?

Answer 44

Dedication with reinvestment is similar to the pure cash-matched technique except that it allows that the bond cash flows do not have to exactly match the liability stream. Any inflows that precede liability claims can be reinvested at some reasonably conservative rate. This assumption lets the portfolio manager consider a wider set of bonds that may have higher return characteristics. In addition, the assumption of reinvestment within each period and between periods also will generate a higher return for the asset portfolio.

Question 45

Instead of using a dedicated portfolio technique, a portfolio manager may decide that the optimal strategy is to immunize a portfolio against interest rate changes. Immunization techniques attempt to derive a specified rate of return (generally quite close to the current market yield) during a given investment horizon, regardless of what happens to the future level of interest rates.

Question 46

What is Interest rate risk ?

Answer 46

Interest rate risk is the uncertainty regarding the ending-wealth value of the portfolio due to changes in market interest rates between the time of purchase and the investor’s horizon date.

Question 47

Price risk occurs because if interest rates change before the horizon date and the bond is sold before maturity, the realized market price for the bond will differ from the expected price, assuming no change in rates. If rates increased after the time of purchase, the realized price for the bond in the secondary market would be below expectations, whereas if rates declined, the realized price for the bond would be above expectations.

Question 48

Coupon reinvestment risk arises because the yield to maturity computation implicitly assumes that all coupon cash flows are reinvested at the promised yield to maturity. If, after the purchase of the bond, interest rates decline, the coupon cash flows will be reinvested at rates below the initial promised yield, and the ending wealth will be below expectations. If interest rates increase, the coupon cash flows will be reinvested at higher rates and the ending wealth will be above expectations.

Question 49

Fisher and Weil (1971) and Bierwag and Kaufman (1977) show that (1) price risk and reinvestment risk are affected inversely by a change in market rates, and (2) duration is the point in time when these two risks are of equal magnitude and offset each other. An increase in interest rates will cause an ending price below expectations, but the reinvestment rate for interim cash flows will be above expectations. A decline in market interest rates will cause the reverse situation.

Question 50

They showed that it is possible to immunize a bond portfolio if you can assume that any change in interest rates will be the same for all maturities (that is, there is a parallel shift of the yield curve). Given this assumption, Fisher and Weil proved that a portfolio of bonds is immunized from interest rate risk if the duration of the portfolio is always equal to the desired investment horizon.

Answer 50

Put another way, by investing in a bond that pays out the “average” cash flow at precisely the time it is desired, it is possible to completely offset interest rate risk. If yields fall (rise) after purchase, the bond price will rise (fall) by exactly enough to offset the decline (increase) in income from reinvested coupons. Once again, this is immunization.

If duration > investment horizon, the investor faces net price risk
If duration < investment horizon, the investor faces net reinvestment risk
If duration = investment horizon, the investor is immunized

Question 51

Horizon matching is a combination of two of the techniques just discussed: cash-matching dedication and immunization. The liability stream is divided into two segments. In the first segment, the portfolio is constructed to provide a cash match for the liabilities during this horizon period (for example, the first 5 years). The second segment is the remaining liability stream following the end of the horizon period—example; 25 years . During this second time period, the liabilities are covered by a duration-matched strategy based on immunization principles. As a result, Leibowitz (1986) contends that the client receives the certainty of cash matching during the early years and the cost saving and flexibility of duration-matched flows thereafter.