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Flashcards in S9 Deck (92):

Pure bond indexing (PBI) adv/dadv

- Returns before expenses track the index (zero or very low tracking error)
- Same risk factor exposures as the index
- Low advisory and administrative fees
- Costly and difficult to implement
- Lower expected return than the index


Enhanced indexing by matching primary risk factors (sampling) adv/dadv

Adv ---------------
- Less costly to implement
- Increased expected return
- Maintains exposure to the index's primary risk factors
Dadv --------------
- Increased management fees
- Reduced ability to track the index (i.e., increased tracking error)
- Lower expected return than the index


Enhanced indexing by small risk factor mismatches adv/dadv

Adv -------------
- Same duration as index
- Increased expected return
- Reduced manager restrictions
Dadv --------------
- Increased risk
- Increased tracking error
- Increased management fees


Active management by larger risk factor
mismatches adv/dadv

Adv ----------
- Increased expected return
- Reduced manager restrictions
- Ability to tune the portfolio duration
Dadv --------------
- Increased risk
- Increased tracking error
- Increased management fees


Full-blown active management adv/dadv

Adv -------------
- Increased expected return
- Few if any manager restrictions
- No limits on duration
Dadv ---------
- Increased risk
- Increased tracking error
- Increased management fees


4 primary considerations when selecting a benchmark

(1) market value risk,
(2) income risk,
(3) credit risk,
(4) liability framework risk.


Market value risk varies directly with

maturity. Greater the risk aversion =>
lower the acceptable market risk => shorter the appropriate maturity of the portfolio and benchmark.


Income risk varies indirectly with

maturity. More dependent client on
reliable income stream = > longer the appropriate maturity of the portfolio and benchmark.


The credit risk of the benchmark should closely match

the credit risk of the portfolio.


Liability framework risk is applicable only to portfolios

managed to meet a liability
structure and should always be minimized.


Risk profiling the index requires measuring

the index's exposure to
- duration,
- key rate duration,
- cash flow distribution,
- sector and quality weights,
- duration contribution


Duration = Effective duration (a.k.a. option-adjusted or adjusted duration), which is

- used to estimate the change in the value of a portfolio given a small parallel shift in the yield curve.
- underestimating the increase and overestimate the decrease in
the value of the portfolio...
... due to convexity


Key rate duration measures

portfolio's sensitivity to twists in the yield curve


Present value distribution of cash flows measures

proportion of the index's total duration attributable
to cash flows (both coupons and redemptions) falling within selected time periods


Bond (non MBS) - 3 primary risk factors, 2 secondary

Interest rate, yield curve, spread / credit, optinality


Interest rate risk - what and how measured

Measures - exposure to yield curve shifts
Using - duration


Yield curve risk - what and how measured

Measures - Exposure to yield curve twists
- PV distribution of CF
- Key rate duration


Spread risk - what and how measured

Measures - exposure to spread changes
Used - spread duration


Credit risk - what and how measured

Measures - exposure to credit changes
Using - duration contribution by credit rating


Optionality risk - what and how measuread

Measures - Exposure to call or put
Using - delta


Tracking error

The standard deviation of alpha across several periods.


Categories of Fixed income portfolio management

(1) pure bond indexing,
(2) enhanced indexing by matching primary risk factors,
(3) enhanced indexing by small risk factor mismatches,
(4) active management by larger risk factor mismatches
(5) foil-blown active management.


Enhanced Indexing by Matching Primary Risk Factors

enhance the portfolio return by utilizing a
sampling approach to replicate the index's primary risk factors while holding only a percentage of the bonds in the index


Enhanced Indexing by Small Risk Factor Mismatches

maintaining the exposure to large risk factors, (e.g. duration), the manager slightly tilts the portfolio towards other, smaller risk factors by pursuing relative value strategies


Active Management by Larger Risk Factor Mismatches

Same as "Enhanced Indexing by Small Risk Factor Mismatches " but mismatches are larger and Duration may differ from benchmark.


Liniar duration under/over estimates

Under estimates increase, overestimate decline of the bond.


MBS primary risk exposures include

sector, prepayment, and convexity risk.


BEY = bond equivalent yield =

semianual x 2


EAR = effective annual return =

(1 + semiannual)^2 -1


goal of classical immunization is to fo rm a portfolio so that:

- If interest rates increase, the gain in reinvestment income = or > loss in portfolio value.
- If interest rates decrease, the gain in portfolio value = or > loss in reinvestment income.


Immunization of a Single Obligation - steps

1 . Select a bond (or bond portfolio) with an effective duration equal to the duration of
the liability.
2 . Set the present value of the bond (or bond portfolio) equal to the present value of the liability.


portfolios cease to be immunized for a single liability when:

- Interest rates fluctuate more than once.
- Time passes.


Bond characteristics that must be
considered with immunization

credit rating, liquidity, embedded options


reinvestment risk (in immuization) is low if

zero coupon bonds are used / cash flows are concentrated around the horizon


duration contribution =

bond weight * bond duration


bond dollar duration =

- (modified or effective duration) * 0.01 * bond price


steps in adjusting portfolio duration

1. Determine new duration
2. Determine rebalancing ratio = Old Dollar Duration / New Dollar Duration
3. Increase/decrease existing bonds using rebalancing ratio OR adjust one (controlling) bond to rebalance... the latter may also minimize needs of cash for rebalancing if it has largest duration.


amount of the spread is a function of

- perceived risk
- market risk aversion


spread duration measures the

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


3 spread duration measures for fixed rate bonds

- nominal spread
- zero volatility spread
- option adjusted spread


Nominal spread is the spread between

the nominal yield on a non-Treasury bond
and a Treasury of the SAME maturity.


Zero-volatility spread (or static spread) is the spread that

must be added to the Treasury spot rate curve to force equality between the:
PV of a bond's CF (discounted at the Treasury spot rates plus the static spread)
= market price of the bond + accrued interest.


Option-adjusted spread (OAS) is determined

using a binomial interest rate tree.


To address the deficiencies in classical immunization, 4 extensions have been offered:

(1) multifunctional duration (using key rate duration)
(2) multiple-liability immunization,
(3) relaxation of the minimum risk requirement, and
(4) contingent immunization.


Contingent immunization is

- combination of active management and passive management techniques (immunization).
- immunization not used as long as the rate of return on the portfolio exceeds a pre-specified safety net return


Contingent immunization strategy :
Period: 3-year
Value: at par $20 million of 15-year bonds
Coupon: 9%, semiannual
Current rate of return for immunized strategies: 9%
Willing to accept a return of 8% (safety net return)

1. Cushion spread = 9%-8% = 1%
2. Required terminal value
= 20Mn * (1 + 8%/2)^(3*2) = 25.3Mn
3. Required assets needed at initial implementation
= 25.3Mn / (1+9%/2)^(3*2) = 19.4Mn
4. Safety margin = 20 - 19.4Mn = 0.6Mn
5. If immunization rate jumps from 9 to 12% after purchase of the bonds then:
- portfolio at new immunization rate of 12% has value of 15.6Mn (PMT 4.5%*20Mn, N 15*2, I 12/2%,
- minimum target value at the current immunization rate: Required TV = 25.3Mn (from #2) and assets required 25.3 / (1+12/2%)^3*2 = 17.8Mn which is more than current portfolio value


Two fa ctors can cause fa ilure to attain the minimum target return in spite of eff ective
monitoring procedures

1. Adverse movements in market yields that occur too quickly for management to trigger the immunization mode soon enough
2. The lack of assurance that the immunization rate will be achieved once the immunization mode is activated.


M2 = 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 3 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.


CF matching steps

- Selects a bond with a maturity date equal to that of the last liability payment date.
- Buys enough in par value of this bond such that its principal and final coupon fully fund the last liability.
- Using a recursive procedure (i.e., working backwards), chooses another bond so that its maturity value and last coupon plus the coupon on the longer bond fully fund the second-to-last liability payment and continues until all liability payments have been addressed.


CF matching vs multiple liability immunization

CF matching is more:
- restrictive
- expensive
- simpler to understand


Combination matching or horizon matching definition / adv / dadv

combination of:
- multiple liability immunization
- cash flow matching (just for initial years)

- provides liquidity in first years
- reduces risk of non-parallel shifts, often happening in first years

dadv - expensive


Interest rate risk - components ?

Reinvestment risk
Price risk


three rebalancing methods

using new funds
changing particular security weight
using derivatives


How and why corporate bonds perform during periods of heavy supply

Perform Best. Valuation of new issues validates the prices of outstanding issues, which relieves pricing uncertainty and
reduces all spreads


Secular CHANGES in bond market and IMPLICATIONS

- Callable issues dominate the high yield market, but less so.
- Intermediate term, bullet maturity bonds (non callable/sinkable/puttable) dominate investment grade
- securities with embedded options trade at premium due to scarcity
- longer duration trade at premium due to scarcity relative to intermediate term
- credit based derivatives increasingly used to take advantage of return/diversification across sectors/structure


Rationale for secondary trade


- new issue swaps - for superior liquidity

- Yield/spread pickup (this is largest secondary trade)
- Yield curve adjustment trades - anticipating shifts in yield curve

- Credit upside trade - identifying issues likely to be upgraded
- Credit defense (opposite of credit upside trade)
- Cash flow reinvestment

- Sector rotation trades - into sectors likely to outperform
- Structure trades - e.g. moving to callable structures in anticipation of smaller volatility


Forms of spread analysis

- mean reversion analysis - comparing current and historical spreads
- quality spread analysis - finding securities with possible change in spread
- percentage yield spread analysis = current vs historical yield ratio = CORPORATE BONDS / TREASURIES of same duration


Duration of Short term bullet structure.

1-5 years.


Duration of Medium term bullet structure.

5-12 years


When and Why 20 year bond structures attractive

Attractive during positively sloped yield curve.
Higher yields than 10-15 year structures but lower duration (i.e. risk)


Duration and Attractiveness of long term bullet structures

30 years.
Attractive: positive convexity at the cost of increased effective duration


Early retirement provision - types

Callable bonds (callable by issuer)
Sinking fund - annually a portion of bonds is retired (repurchased)
Putable bonds


Credit analysis - analytic framework

- CAPACITY TO PAY in corporate credit analysis.
- QUALITY OF COLLATERAL and the servicer are important in the analysis of asset­ backed securities.
- ABILITY TO ASSESS AND COLLECT taxes for municipal bonds.
- An assessment of the COUNTRIES ABILITY to pay (economic risk) and WILLINGNESS to pay (political risk) for sovereign bond issuers.


Relative Valuation Methodologies


Total return analysis
Primary market analysis
Liquidity and trading analysis
Secondary trading rationales
Secondary trading constraints
Spread analysis
Structural analysis
Credit curve analysis
Credit analysis
Asset allocation/sector analysi


Reasons for not trading

Portfolio constraints.
"Story" disagreement.
Buy and hold.


Bond portfolio trading constraings

Quality constraints.
Restrictions on structures and foreign bonds.
High-yield corporate exposure limits for insurance companies.
Structure and quality restrictions for European investors.
Floating rate requirements for commercial banks.


Relative value

Ranking of fixed income investments by sectors structures issuers and issues in terms of their expected performance during some future interval


Credit barbell strategy

Taking credit risk in short/intermediate maturities AND gov securities for long duration portfolio buckets.


Implication of dominance of investment grade market by bullet intermediate structure

- premium for securities with embedded options
- lower duration for the all outstanting credit debt
- increased use of credit derivatives to gain exposure to desired structures


Yield curve placement

positioning of portfolio with respect to:
- duration and
- yield curve risk
also known as curve adjustment trades


Sector / quality allocation

allocations based on relative value analysis of different bond market sectors and quality sectors.


Market segmentation factors

factors affecting supply and demand within sectors of bond market due to impediments or restrictions on investors from reallocating funds across those bond sectors.


what is limitation of yield pickup trade

yield is a poor indication of total return


cross over bond market sector

Ba2/BB - Baa3/BBB ranked bonds , i.e. between investment grade and high yield.


credit defense trade needed when investor is concerned with

widening credit spreads due to political, economy, sector, issuer-specific risks


why high yield issuers will keep issuing callable structures

to have the opportunity to refinance at a lower credit spread should credit quality improve


what is appropriate measure of risk for managers who is evaluated relative to some bond index

Deviation of the portfolio from benchmark in terms of
- yield curve exposure
- sector exposure
- quality exposure
- individual issue exposure


analytical models for valuing bonds iwth embedded put options assume

the issuer will fullfill the obligation to repurchase the issue if bondholder exercises the put option.


sovereign plus

top down approach starts with assessment of economic outlook for emerging market and then basing allocations of funds across differerent countries


US credits plus

bottom up focuses on selection of corporate issuers in emerging countries what are expected to outpeform US credit issuers


market segmentation may create relative value opportunities when

spreads get out of line due to obstructions that prevent investors from allocating funds to certain sectors due to regulatory constraints or asset/liability contraints


spread curves show relationship between

spreads and maturity


forward spread is a

breakeven spread because it is the spread that would make the investor indifferent between two alternative investments with different maturities over a given investment horizon


relative value analysis - comparing the

expected AND forward spread


impact of upgade in a below investment grade security

- outpeform due to narrower spread
- more liquid due to broader class of investors


Specifics of European credit market

The homogeneous character of European market (dominated by high quality intermediate) allowed managers to easily compare securities across fixed/floating markets USING SWAPs FRAMEWORK.

Also, financial institutions were willing to use SWAP METHODOLOGY to capture value discrepancies between fixed and floating rate markets


Specifics of US credit market

US managers embraced swap spreads for MBS CMBS Agency and ABS sectors


it is reasonable to expect spreads to revert to historical mean if there have been

no structural changes in the market that would render historical mean and standard deviation USELESS for analyst


when interest rates fall (convexity)

callable bonds exhibit negative convexity, while noncallable exhibit positive convexity


negative convexity characteristic for low coupon vs high coupon bonds

low coupon issues exhibit LESS negative convexity than high coupon


3 risks associated with managing a portfolio against a liability structure

(1) interest rate risk,
(2) contingent claim risk (i.e., call or prepayment risk), and
(3) cap risk