Fixed Income Portfolio Management Flashcards
(46 cards)
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
trade.
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
scenarios.
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
risk.
(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).”