Reading 18: Overview of Fixed-Income Portfolio Management

Question 1

Leveraged Portfolio

Answer 1

Asset duration normally exceeds the liability duration. If interest rates increase, the value of the leveraged portfolio and collateral decline.

Question 2

Managing Taxable Accounts

Answer 2

Realise capital losses to offset gains; extend holding periods to realise long-term, rather than short-term capital gains. Consider differentials in income versus gain tax rates when selecting investments. Tax loss harvesting is realising capital losses early and deferring capital gain realisation.

Question 3

Correlation

Answer 3

The more negative a correlation is the more diversification benefits it provides.

Question 4

Inflation Protection

Answer 4

Floating rate bonds adjust only the coupon, not the principle. Inflation-linked bonds directly adjust the principle and therefore indirectly adjusts the coupon payments. Fixed coupon bonds offer no protection against effects of inflation.

Question 5

Securities Lending

Answer 5

Often supports short selling so security must be delivered to borrower. Achieved through bilateral repo, securities borrower specifics securities needed and the lender specifics securities to be received back. Rebate rate (given back to borrower) = collateral earnings rate - securities lending rate. Typically collateralised by cash or high credit quality bonds. Fees can be charged also by lender depending on demand by borrower.

Question 6

Expected Fixed Income Returns

Answer 6

Yield income
\+ Rolldown return
\+ E(Change in price based on investor's views of yields and yield spreads)
− E(Credit losses)
\+ E(Currency gains or losses)

Question 7

Matrix Pricing

Answer 7

Commonly used to price illiquid bonds, may be difficult to identify comparable bonds. Does not require sophisticated modelling of term structure and credit spreads (advantage).

Question 8

Horizon Matching

Answer 8

Uses cash-flow matching in the short-term and duration matching in the long-term. Combines the two.

Question 9

Rolling Yield

Answer 9

Sum of the yield income and the roll down return. Yield income is the sum of bonds current yield and re-investment income.

Question 10

Cash-Flow Matching

Answer 10

Form of immunisation (managed to meet future liability payouts). Has no yield curve or interest rate assumptions, as there is no need to reinvestment of cash since bond cash inflows coincide with liability cash flows. The cash flows include coupon and principle repayments.

Question 11

Contingent Immunisation

Answer 11

Liability based mandate. As long as the surplus is positive the portfolio can be managed in a way to add value.

Question 12

Total Return Mandates

Answer 12

Target an absolute rate of return. Pure indexing replicate the performance of a bond index exactly matching risk factors of the index (duration, credit quality, sectors). With some leeway on individual bonds selected. Low turnover. Enhanced indexing seeks to add modest (20-30bps with active risk below 50bps) active return. Generally duration is matched to index but some risk mismatched occur. Higher turnover expected. Active management involves large deviations of risk factor to generate larger active return.