Fixed Income Portfolio Management Flashcards Preview

CFA Level 3 > Fixed Income Portfolio Management > Flashcards

Flashcards in Fixed Income Portfolio Management Deck (46)
Loading flashcards...

Classification of Strategies ( Manage Funds against bond market index benchmark)


Pure Bond Indexing

Enhanced Indexing

Enhanced Indexing by small risk factors

Active Management

Full Blown Active Management


Enhanced Indexing by Small risk factors Mismatches


While matching duration ( intrest rate sensitivity ) manager may try to marginally increase the return by pursuing relative value in certain sectors , quality , term structure.


Active Management by larger risk factor mismatches


larger mismatches on primary risk factors-


Enhanced Indexing by Matching Primary risk factors


Uses sampling approach in an attempt to match the primary index risk factors Primary risk factors are - typically major influences on the pricing of bonds such as change in level of interest rates, twists in the yield curve and changes in the spread between treasuries and non - treasuries.


LOS 21.c: Discuss the criteria for selecting a benchmark bond index and justify the selection of a specific index when given a description of an investor’s risk
aversion, income needs, and liabilities


Among others, there are four primary considerations when selecting a benchmark:

(1) market value risk, -
(2) income risk -

(3) credit risk - The benchmark’s credit risk exposure should be consistent with the client’s objectives and constraints. If the client seeks higher return and will accept higher credit
risk, select a benchmark with greater credit risk exposure.

(4) liability framework risk. -If there are definable liabilities, then ALM is the preferred
approach. The benchmark that most closely matches the liabilities should be selected


Market value risk


The market value risk of the portfolio and benchmark index should be comparable.

Risking yield curve means that investors believe interest rates will likely increase in the future.

Long duration portfolio is more sensitive to interest rate changes The maturity and duration of portfolio increase the market risk increase Risk averse - Short term or Intermediate term index may be more appropriate as Bench Mark index


Income risk


If the client is dependent upon cash flows from the portfolio, those cash flows should be consistent and low-risk. Longer term fixed-rate bonds will lock in an
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.


21.d: Critique the use of bond market indexes as benchmarks


bond market securities are more heterogeneous and illiqud. many issues do not trade regularly and pricing data is frequently based on appraisals and trades are often not
publicly reported.

These characteristics lead index providers to make choices regarding what to include in an index and full index replication is less common than for equities

the resulting indexes from various vendors can appear similar but be quite different in characteristics.

Third, the risk characteristics can change quickly over time as new issues of bonds are
added and those approaching maturity are deleted from the index.

Lastly, it can be difficult for investors to find an index that matches their risk profile. For


21.e: Describe and evaluate techniques, such as duration matching and the use of key rate durations, by which an enhanced indexer may seek to align the risk exposures of the portfolio with those of the benchmark bond index.


Enhanced indexing generally allows no deviation from the benchmark’s duration but allows smaller deviations in other risk factors in an effort to add value

Cell matching (i.e., stratified sampling) adds precision by matching individual cell exposure within the risk factor.

multifactor is regression of past data to find a portfolio allocation by risk factors that would have most closely tracked past benchmark returns.

The primary risk factors considered in any of the approaches previously mentioned typically include-

Duration (i.e., effective duration)

Key rate duration or present value distribution of cash flow matching achieves the same result as cell matching of duration.

Sector and quality percent

Quality spread duration contribution

Sector duration contributions.

Sector/coupon/maturity cell weights.

Issuer exposure. After matching all of the risk factors previously mentioned, there is
still event risk, and an individual security could underperform for reasons unrelated
to market circumstances


21.f: Contrast and demonstrate the use of total return analysis and scenario analysis to assess the risk and return characteristics of a proposed


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

Scenario analysis can be broken down into the return due to price change, coupons
received, and interest on the coupons.


21.g: Formulate a bond immunization strategy to ensure funding of a
predetermined liability and evaluate the strategy under various interest rate


Immunization is a strategy used to minimize interest rate risk, and it can be employed to
fund either single or multiple liabilities. Interest rate risk has two components: price risk and reinvestment rate risk.

Price risk, also referred to as market value risk, refers to the
decrease (increase) in bond prices as interest rates rise (fall).

An important assumption of classical immunization theory is that any changes in the yield curve are parallel.

Immunization risk can -terminal value of an immunized portfolio falls short of its target value as a result of
arbitrary (nonparallel) changes in interest rates.

Duration measures percent change in value. Dollar duration is related and measures
dollar change in value.


21.i: Explain the importance of spread duration.


Duration measures the sensitivity of a bond to a one-time parallel shift in the yield curve.

Spread duration measures the sensitivity of non-Treasury issues to a change in
their spread above Treasuries of the same maturity.


factors increase tracking risk


Portfollio duration

key rate duration

sector and quality percent ****

sector duration contribution ****

quality spread duration contribution ***


Enhanced Indexing stratageis


Lower cost enhancements issue selection enhancements yield curve positioning sector and quality positioning *** cell exposure positioning ***


Sector and Quality positioning


need to add


Cell expsoure positiong


need to add


3,3.1 extra activities required for active manager


Identify which index mismatches are to be exploited extrapolate the market’s expectations from teh market data independently forecast the necessary inputs and comparet hese with the market’s expectations extimate the relative values of securities


dedication stratagies


passive in nature can add active management immnization single period immunization multiple liability immuniztion immunization for general cash flows Cash flow matching


Classical single period immunization


Can be defined as the creation of fixed income portfolio that produces an assured return for specific horizon , irrespective of any paralledl shifts in the yield curve 1. Specified time horizon. 2 Assured rate of return during the holding period to a fixed horizon date. 3 Insulation from the effects of interest rate changes on the portfolio value at the horizon date.” Duration matching is the minimum condition for immunization ( immunization does offsetting price and reinvestment risks)


A explain classic relative-value analysis, based on top-down and bottom-up
approaches to credit bond portfolio management;


is dialectical process comnining the best of top down and bottom up approcahes.

the methodolgy combines many sources of information from proftfolio managers, quatitave analyst, economist, Chif investment officers, stratagiests


21.j: Discuss the extensions that have been made to classical
immunization theory, including the introduction of contingent immunization.


(1) multifunctional duration,
(2) multiple-liability immunization,

(3) relaxation of the minimum risk requirement, and
( 4) contingent immunization.

multifunctional duration (a.k.a. key rate duration). the manager focuses on certain key interest rate maturities.

multiple-liability immunization. is ensuring that the portfolio contains sufficient liquid assets to meet all the liabilities as they come due.


LOS 21.k: Explain the risks associated with managing a portfolio against a liability structure including interest rate risk, contingent claim risk, and cap


(1) interest rate risk - most fixedincome securities move opposite to changes in interest rates, changing interest rates
are a continual source of risk

(2) contingent claim risk (i.e., call or prepayment risk) - Callable bonds are typically called only after interest rates have fallen
(3) cap risk -If any of the bonds in the portfolio have floating rates, they may be subject to cap risk.


LOS 21.l: Compare immunization strategies for a single liability, multiple
liabilities, and general cash flows.


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.

Concentrating the maturities of the bonds around the liability date is known as a bullet strategy

barbell strategy where the first bond matures several years before the liability date and the other several years after the liability date.

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

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.


“Classical immunization theory is based on several assumptions:”


“1 Any changes in the yield curve are parallel changes, that is, interest rates move either up or down by the same amount for all maturities. 2 The portfolio is valued at a fixed horizon date, and there are no interim cash inflows or outflows before the horizon date. 3 The target value of the investment is defined as the portfolio value at the hori- zon date if the interest rate structure does not change (i.e., there is no change in forward rates).”


Determining the target rate of return.


Determining the target return: in upward slopping yield curve, the target rate for immunzation is less than YTM because of lower re investment rate


LOS 21.m: Compare risk minimization with return maximization in
immunized portfolios.


One standard condition for classical immunization is risk minimization

Return maximization is the concept behind contingent immunization.


LOS 21.n: Demonstrate the use of cash flow matching to fund a fixed set of future liabilities and compare the advantages and disadvantages of cash flow
matching to those of immunization strategies.


The timing and amounts of asset cash flows must also correspond to the liabilities. Because of this, the durations will stay matched as time passes and rebalancing
should not be needed.

cash flow matching is more restrictive,
simpler to understand, and safer (though both are very safe when done correctly)

Combination matching, also known as horizon matching

the portfolio would also be cash flow matched in
order to make sure that assets were properly dispersed to meet the near-term obligations.

Provides liquidity in the initial period.
Reduces the risk associated with nonparallel shifts in the yield curve. The initial
cash needs are met with asset cash flows. There is no rebalancing needed to meet the
initial cash requirements


“Relative-ValueMethodologies The main methodologies for credit relative-value maximization are:


■ total return analysis;

■ primary market analysis;

■ liquidity and trading analysis;

■ secondary trading rationales and constraints analysis; ■ spread analysis;

■ structure analysis;

■ credit curve analysis;

■ credit analysis;

■ asset allocation/sector analysis”


B. discuss the implications of cyclical supply and demand changes in the primary
corporate bond market and the impact of secular changes in the market’s dominant
product structures;


Cyclical changes –Increases in the number of
new corporate bond issues are sometimes associated with narrower spreads and relatively strong returns

Securities with embeded option trade at premium prices due to their scarcity

Credit manager seeking long term secuties pay premium price for long term securities becuase they are scarcely available.

Credit based derivates will be increasingly used to take advantage of ( understand


c explain the influence of investors’ short- and long-term liquidity needs on portfolio
management decisions;


With liquidty decreases investors pay less ( Increasing Yields) with liquidty increase investory pay more ( Decreasing yields)


discuss common rationales for secondary market trading;

Imortant for the exam


1 Yield spread pick up trades

  1. credit upside treades -In credit-upside trades, the bond portfolio manager attempts to identify issues that are likely to be upgraded in credit rating before the upgrade is incorporated into their prices.

Credit defense trades

  1. New Issue swaps
  2. sectror - rotation trades
  3. Yield Curve Adjustment Trades -Yield curve-adjustment trades attempt to align the portfolio’s duration with anticipated changes/shifts in the yield curve
  4. Structure Trades - Yield curve-adjustment trades attempt to align the portfolio’s duration with anticipated changes/shifts in the yield curve
  5. Cash Flow Reinvestment trades

**If interest rates are expected to rise, buy short-duration bonds and sell long-duration bonds.
If interest rates are expected to fall, buy long-duration bonds and sell short-duration bonds. **

If the yield spread for the sector is expected to narrow, choose longer-duration bonds in the sector, as they will gain the most from decreased rates.
If the yield spread for the sector is expected to widen, choose shorter-duration bonds in the sector.


E. discuss corporate bond portfolio strategies that are based on relative value


Spread tools -

Mean reversion analysis - it is based on asumption that the spread between two sectors and two issuers will revert back to its histroical average

Quality Spread analysis- Quality spread analysis is bases spread differential between low and high quailty credits **( based on the anlaysis the manger will by spread wider than what is justified by its internsic analysis) **

Ask this question - how much we need to write

Percentage yeid spread analysis - divides the yield on corporate bond by yield on truesary with same duration . If the ratio is higher than historical the yield is expected to fall.


Structural Analysis - Bond structures


Bullet bonds

Callable bonds

Sinkable bonds

Putable bonds


Credit Curve analysis

Credit analysis


Credit analysis involves studying issuers financial statements and accounting techniques, Interviewing issuers managments, evaluating industry issues reading indentures and charters and developing an awareness ( not necissarily agreeing ) withe views of the rating agencies and various indsutries and issuers


Asset allocation / Sector analysi


Need to review quick


23.c: Critique the use of standard deviation, target semivariance, shortfall
risk, and value at risk as measures of fixed-income portfolio risk.


semivariance measures the dispersion of returns. it measures only the dispersion of returns below a target return

there is no easy way of doing so for semivariance.
If investment returns are symmetric, the semivariance yields the same rankings as the variance and the variance is better understood.

If investment returns are not symmetric, it can be quite difficult to forecast downside risk and the semi variance may not be a good indicator of future risk.

Because the semivariance is estimated with only half the distribution, it uses a
smaller sample size and is generally less accurate statistically.

shortfall risk measures the probability that the actual return will be less than the target return.

The value at risk (VAR) provides the probability of a return less than a given amount over specified time.

As in the shortfall risk measure, VAR does not provide the magnitude of losses that exceed that specified by VAR.

VAR - depends on symentric - check if shortfall are the same


23.d: Demonstrate the advantages of using futures instead of cash market
instruments to alter portfolio risk.


The dollar duration is the dollar change in the price of a bond, portfolio, or futures
contract resulting from a 100 bps change in yield.

Are more liquid.
2. Are less expensive.
3. Make short positions more readily obtainable, because the contracts can be more
easily shorted than an actual bond.


23.e: Formulate and evaluate an immunization strategy based on interest
rate futures.


DDT = DDP + DDFurures

DDT = the target dollar duration of the portfolio plus futures
DDP = the dollar duration of the portfolio before adding futures
DD Futures = the total dollar duration of the added futures contracts

The difference between the cash price and the futures price is called the basis. The risk that the basis will change in an unpredictable way is called basis risk.

There are three basic sources of hedging error. There can be an error in the:

  1. Forecast of the basis at the time the hedge is lifted.
  2. Estimated durations.
  3. Estimated yield beta.

23.f: Explain the use of interest rate swaps and options to alter portfolio
cash flows and exposure to interest rate risk.


Interest rate swaps =

Bond options - duration of an option depends on the duration of the underlying contract, the option delta, and the leverage.

the duration of a bond option is computed as:

option delta x duration of the underlymg x .( price of underlying /pnce of option ) .

The delta and duration of a call will be positive (it provides the right to go long), and the delta and duration of a put will be negative )

interest rate caps and floors. A call on price pays the call owner if the underlying price rises above the strike price.


23.g: Compare default risk, credit spread risk, and downgrade risk and
demonstrate the use of credit derivative instruments to address each risk in the
context of a fixed-income portfolio


Types of Credit Risk

Default risk is the risk that the issuer will not meet the obligations of the issue (i.e., pay interest and/or principal when due).

  • *Credit spread risk** is the risk of an increase in the yield spread on an asset. Yield spread is the asset’s yield minus the relevant risk-free benchmark.
  • *Downgrade risk** is the possibility that the credit rating of an asset/issuer is downgraded by a major credit-rating organization,

They fall into three broad categories: (1) credit options, (2) credit forwards, and (3) credit swaps.

They fall into three broad categories: (1) credit options,

OV = max [(strike - value), O]

Credit spread options

OV =max [(actual spread - strike spread) x notional x risk factor, O]

(2) credit forwards - FV = (spread at maturity - contract spread) x notional x risk factor

and (3) credit swaps.


23.h: Explain the potential sources of excess return for an international
bond portfolio


excess return on international bonds: (1) market
selection, (2) currency selection,

(3) duration management,

(4) sector selection,
(5) credit analysis, and

(6) markets outside the benchmark.


23.i: Evaluate 1) the change in value for a foreign bond when domestic
interest rates change and 2) the bond’s contribution to duration in a domestic
portfolio, given the duration of the foreign bond and the country beta


Yield beta measures the relationship between change in one set of rates (foreign) and another set (domestic). The change in value of the foreign bond will depend on its duration and change in foreign rates. ( study again)

duration contribution = weight x duration


23.j: Recommend and justify whether to hedge or not hedge currency risk in an international bond investment.


If the foreign rate is higher than the investor’s domestic rate, the foreign currency will trade at a forward discount and selling the foreign currency forward to hedge the currency risk will earn a negative currency return

investor’s precise return is (1 + LCR) (1 + LMR) - 1

Invest in a foreign asset and (forward) hedge the currency. This means invest in the foreign asset and sell the foreign currency forward. Earn the LMR + the investor’s domestic interest rate - the foreign currency interest rate because the LCR hedged will equal investor’s domestic interest rate - the foreign currency
interest rate.

The approaches to hedging the currency risk in an international bond investment are:
(1) the forward hedge, (2) the proxy hedge, and (3) the cross hedge.

The cross hedge. In a currency cross hedge, the manager enters into a contract to deliver the original foreign currency (i.e., the currency of the bond) for a third currency.

Rb = RI+ RC
Rb = the domestic return on the foreign bond
R1 = the local return on the foreign bond (i.e., in its local currency)
Rc = the expected (by the market) currency return; the forward premium or discount


23.k: Describe how breakeven spread analysis can be used to evaluate the risk in seeking yield advantages across international bond markets.


Breakeven spread is the change in spread that would make the return on two bonds equal. For any other change in spread, one of the bonds will have superior return.

( study and understand)


23.l: Discuss the advantages and risks of investing in emerging market debt.


Generally provides a diversification benefit.
Increased quality in emerging market sovereign bonds.

EMD returns can be highly volatile with negatively skewed distributions.

A lack of standardized covenants, which forces managers to carefully study each issue. 
Political risk (a.k.a. geopolitical risk).

23.m: Discuss the criteria for selecting a fixed-income manager.


style analysis,

selection bets,

investment processes,

and alpha correlations.