Week 7 - Fixed Income

Question 1

What impact would a 10% value tilt have had on returns?

Answer 1

A value tilt would have increased compound annualized returns by 0.19% at the AE portfolio level, and 0.05% at the total portfolio level

• This aligns with the well-known fact that value stocks have outperformed on average over time

Question 2

What impact would a 10% value tilt have had on portfolio ‘risk’? (Hint: Consider and contrast the various risk measures and holding periods - there is no single, unambiguous answer.)

Answer 2

Standard deviation for both the AE and total portfolio level reduces over 1-month and 12-month holding periods (by 0.07% to 0.19% and 0.02% to 0.03% pa respectively), but …

• Standard deviation for AE portfolio increases over 36-month holding periods (by 0.17%), a small increase of 0.02% for total portfolio.
• Tracking error (i.e. benchmark relative risk) associated with the tilt is 0.94%-1.02% pa at the AE portfolio level, and 0.28%-0.30% pa at the total portfolio level.

Question 3

−You can think of an AE portfolio with 10% value tilt as comprising

calculation

Answer 3

a 100% long position in the market, a 10% long position in the value index, which is funded by a 10% short position in the growth index.

Thus: Tilted AE Portfolio Return = AE Index Return + 10% * Value Index Return – 10% * Growth Index Return

Question 4

Tilted Total Portfolio Return =

Answer 4

Total Portfolio Return + 30% * 10% * Value Index Return – 30% * 10% * Growth Index Return.

Question 5

What type of investor might take a value tilt?

an investor concerned about benchmark or peer relative risk might still adopt a value tilt if they were sufficiently aggressive

Answer 5

• An investor concerned about benchmark or peer relative risk might still adopt a value tilt if they were sufficiently aggressive. For instance, a 10% value tilt would have added 0.19% pa to AE portfolio returns for tracking error (TE) of 0.94%-1.02%, implying a reasonable Information Ratio (= Alpha/TE) of 0.18-0.20. (IRs above 0.30 are considered very good). However, they might want to control the risk by either limiting the size of the position, or perhaps trying to time the exposure if possible.

Question 6

What type of investor might take a value tilt?

Investors who are primarily focused on overall portfolio performance (AE, or total),

Answer 6

Investors who are primarily focused on overall portfolio performance (AE, or total), and are unconcerned about benchmark or peer relative risk. For these investors, a value tilt provides a meaningful boost to returns, while reducing portfolio standard deviation at shorter horizons (although it adds modesty to standard deviation amount over 36-months).

Question 7

What type of investor might take a value tilt?

Investors with long horizons

Answer 7

Investors with long horizons, who are more concerned about longer-term returns and relatively unconcerned about shorter-term volatility, e.g. some private investors (note: this point is strengthened from analysis in Part B).

Question 8

What type of investor might take a value tilt?

Answer 8

• Investors with long horizons
• Investors who are primarily focused on overall portfolio performance
• An investor concerned about benchmark or peer relative risk might still adopt a value tilt if they were sufficiently aggressive

Question 9

How might you decide how large a tilt is justified?

Answer 9

Depends mainly on tolerance for tracking error risk, given impact on total portfolio risk seems secondary. Investors who expect value to outperform might consider taking a value tilt as big as they can bear

Question 10

How does the episode-based analysis influence your perception the risks of taking a value tilt? Does it make you more or less willing to adopt a style tilt?

Periods of underperformance seem to be

Answer 10

Periods of underperformance seem to be shorter and sharper for value relative to growth, whereas periods of outperformance by value relative to growth are more extended and gradual.

This comparison suggests negative skewness towards underperformance. Suggests that benchmark or peer relative risk less of a concern for investors with longer time horizon

Question 11

How does the episode-based analysis influence your perception the risks of taking a value tilt? Does it make you more or less willing to adopt a style tilt?

The episode-based analysis might encourage

Answer 11

The episode-based analysis might encourage tempering the size of any value tilt. This would particularly be the case for a fund manager who was worried about the implications for their business, bonus or even job from possibly underperforming for around 2 years.

(Note: The historical average suggest 10% value tilt might lead to under performance of 1.71% pa (= 17.1% * 10%) during periods when value underperforms. This would probably be sufficient to put the managers in the lower quartile of the performance league table

Question 12

How does the episode-based analysis influence your perception the risks of taking a value tilt? Does it make you more or less willing to adopt a style tilt?

Answer 12

• The episode-based analysis highlights that value can go through occasional episodes of large and sustained underperformance, averaging -22.3% cumulative (-17.1% pa) over 23 months (range 11 to 33 months).

This kind of underperformance might push a manager to the bottom of the league tables, suggesting the manager would incur meaningful benchmark or peer relative risk for managers with (say) a 1-3 year horizon. Thus a value tilt carries more risk than revealed by analysis of strict holding periods (i.e. 1- or 36-months).

Question 13

List the key ways in which emerging markets differ from developed equity markets.

Currently, many EMs appear to have less structural problems than some of the major developed markets, e.g. US deficit issues; European problems but

Answer 13

Some argue that the Chinese economy is a risk, particular concerns on its mounting debt level

− Some EMs still have chronic structural issues, e.g. corruption in some EM countries

− The earnings cycle has been weaker in EMs more recently, including greater downward EPS revisions, i.e. earnings momentum is weak

Question 14

List the key ways in which emerging markets differ from developed equity markets.

structural problems

Answer 14

Currently, many EMs appear to have less structural problems than some of the major developed markets, e.g. US deficit issues; European problems;

Question 15

List the key ways in which emerging markets differ from developed equity markets.

List 5, 6, 7

Answer 15

5) Less efficient markets, including less information, which implies greater scope for active returns (‘beating the market’, generating alpha)
6) Less regulation
7) Traditionally EMs have traded at a sizable valuation discount - as per chart provided. (However, this has not been so apparent in recent years, raising the question of whether there may have been a permanent ‘revaluation’ due to structural improvements in economies, company management, governance, etc).

Question 16

List the key ways in which emerging markets differ from developed equity markets.

List 4

Answer 16

1) Higher growth potential of underlying economies
2) Higher risk – more volatile; equity beta greater than 1, larger exposure to global economy and cyclical sectors like commodities; country and political risk (albeit possibly idiosyncratic)
3) Returns have been very episodic – as seen in chart provided
4) Lower liquidity

Question 17

three main hazards involved in using bond benchmarks as base-case asset class allocations.

Third

Answer 17

The popular bond benchmarks are not representative of the bond markets

so they do not have anything to do investor objectives but instead cater to issuer objectives

Question 18

three main hazards involved in using bond benchmarks as base-case asset class allocations.

Second

Answer 18

cash bond indexes represent only a fraction of the fixed income markets.

Question 19

three main hazards involved in using bond benchmarks as base-case asset class allocations.

First

Answer 19

there is significant compositional drift in bond indexes due to their capitalization-weighting schemes —> very broad selection of bonds; and most are poor choices for benchmarks –>

past performance and structure used in asset allocation studies is likely not representational of the future

Question 20

FI portfolio risk vs total portfolio risk

Answer 20

interest rate fluctuations. interest rate exposure increases risk for FI income managers

equities

Question 21

credit risk and total portfolio risk

vs FI portfolio level

Answer 21

will increase risk for total portfolio b/c it adds to equity exposure

• returns and yield for lower quality credit are correlated with equity returns (greater credit exposure –)increase risk)

less clear. many cases can reduce risk due to diversification benefits

Question 22

agency problems arising from differing impact of interate rate and credit exposure

Answer 22

FI managers perceive duration as risky and credit as a diversifying asset (incentive to increase credit exposure to the extent that it reduces overall portfolio variability and offers an expected risk premium)

WHILE end investor views credit as adding to equity risk that dominates portfolio + duration between innocautuious and a diversifying exposure

Question 23

Active management

Answer 23

equity portfolio managers are assigned to beat a benchmark market index and to beat similar managers’ portfolio

deliberately deviate from the benchmark to enhance return

manager must watch benchmark or competition otherwise client may conclude it is not worth paying management fees

Question 24

Passive management

Answer 24

equity portfolio managers are assigned to replicate a benchmark market index

Question 25

difference between equity and bond manager

Answer 25

bond =few bond iissue trade actively

Question 26

Fixed income securities helps

Answer 26

diversify the economic risk (interest rate changes) by shift asset allocation from growth assets to fixed income securities

Question 27

FI

Diversifier of risks

equities

Answer 27

correlation between equity and fixed income is not stable. In the past decade or so fixed income can diversify portfolio due to the negative or modest correlation with equity returns

Question 28

FI

Diversifier exposure from equities

example

Answer 28

Real estate investment trust which were heavily leveraged lost 50-60% of market capitalisatoin.

During height of GFC, fixed income securities. The value increased by 6-8%.

Both equities and stocks. They are both driven by fundamental economic development of the country.

Question 29

FI

Diversifier of risks

risk of deflation

Answer 29

growth assets suffer a lot

government bond in countries with good credit rating (High credit rating fixed income securities)

Coupon and principal will be repaid without much default risk which protects investors from deflation risk.

in total portfolio context, FI will diversify risk exposure from equity

Question 30

FI

Diversifier of risks

when economy is weak

Answer 30

equity tends to perform poorly, bond yield is more likely to be lower too, but at least with fixed income you have a positive capital gain to start with.

So fixed income is not affected by economic performance as much as equity, it can partially diversify the economic risk

Question 31

FI: Potential Roles in Total Portfolio

source of alpha generation?

interest rate

Answer 31

If you expect the interest rate is going to drop, you extend the duration of your FI portfolio, or increase the sensitivity of your FI portfolio to interest rate.

When the interest rate does drop, you generate positive capital gains.

Question 32

FI: Potential Roles in Total Portfolio

source of alpha generation?

Credit exposure

Answer 32

If you expect the economy is doing well, default risk is low, you extend your credit exposure, eg, buying corporate high yield bond, EM bond.

There’s higher expected returns with these higher risk FI securities

Question 33

FI: Potential Roles in Total Portfolio

source of alpha generation?

Answer 33

–Mixed evidence that FI managers outperform

Question 34

FI: Potential Roles in Total Portfolio

liability matching

Answer 34

Fixed income is the best matching asset class in liability-driven fund b/c it provides certain cash flow or duration

investor = DB funds with primary objective of matching projected liabilities

Question 35

Exposures within FI Portfolios

I hold a portfolio that includes corporate bonds and gov bonds. Key driver of portfolio variation is

Answer 35

interest rate - most important driver of FI portfolio risk

Question 36

Drivers of interest rate

Answer 36

: economic condition, preference of consumption, government surplus/deficits

Question 37

What do we know about the slightly inverted yield curve?

Answer 37

Yield indicates market expectation of interest rate. Looks like market is expecting interest rate in the US to be reduced to 2.2-2.3% in 2-3 years of time. Currently it is 2.5%.

Market is expecting there is a recession in 2-3 years of time. And expect that federal reserve will reduce interest rate

Expect federal reserve to increase interest rate gradually especially after 5 years. They will increase when economic growth is ositive. Then after 5 years it is going to pick up

Question 38

Managing fixed income portfolio, is this yield curve more relevant or perfromance of stock market more relevant?

Answer 38

The yield curve

Question 39

US economy this year

Answer 39

Given last 4 months of consistent upward rising of stock market, Uprun of US stock market is mainy driven by better than expected corporate earnings but

given uncertainty of presidential election next year and trade conflict btween US and major trading partners, still substantial uncertainties for the US economy. We are not sure if these companies are going to produce such static performance of consistnet growing earnings or profit in the next several quarters

Question 40

interest rate has an inverse relationship with

Answer 40

bond price

Question 41

Fixed income portfolio. Having fixed income securities in my portfolio only. How can I make investment decisions to take advatange of expected interest rate changes?

Answer 41

Increase the duration of fixed income portfolio so I have better capital gain of my fixed income securities.

Question 42

Investors who hld a total portfolio. A balanced portfolio. 40+ years of investment horizon. Holding 90% of asseets in growth assets e.g. equity, hedged funds, properties.

Latest of yield curve, US investor, does it matter for me? (recession 2-3 years (slight decease in IR) and recovery in 5 years)

Answer 42

i do not change asset allocation of portfolio?Leave it as it is.

Question 43

What if US investor and im 65, I decide to retire in 2 years. I hold 70% of my portfolio In equity, 30% of portoflio in US treasuries. What should I do if I retire in 2 years

Answer 43

If I retire, economy is in recession, a mild recession. What happens to total portfolio if thre is recession in 2 years. There is 70% in equity.

My portfolio, there might be some losss in total portfolio b/c equity market tends to perform poorly in recession. Given I have 70% of portfolio in US equity.

Going to take lump sum from pension account.My investment decision right now is to shift some funsd in equity to the fixed income at least when there is reduction in interest rate. Going to have capital gain from my fixed income securities within my total portfolio and limit the loss of my stocks

Question 44

For fixed income securities, _____ movement is the major driver of fixed income portfolio returns and risk

Answer 44

interest rate

e.g. Up to 50% of world fixed income return variation can be explained by US interest rate changes.

Question 45

Aust fixed income. Key driver is the interest rate you can observe from

Answer 45

long term australian gov bond yield

Use australian fixed income index as a proxy of the performance of a fixed incomce portfolio

Question 46

Duration is

Answer 46

particular measure in fixed income portfolio management. It measures sensitivity of fixed income portfolio to interest rate movement.

Question 47

extend duration of FI portfolio

Answer 47

When you have longer duration of fixed income in your portfolio, going to have much higher fixed income volatility b/c you increase sensitivity of portoflio to interest rate

That is why std of FI portfolio increases when you increase duration

Question 48

having higher duration or maturity fixed income securites into your total portfolio

replace short maturity with long maturity

Answer 48

FI portfolio context. adding duration increases volatility

When I replace, I extend interest rate exposure of your total portfolio —> increase the risk of my fixed income securities (make FI securities more sensitive to interest rate movements)

Total portfolio level in Australia: increasing duration of the fixed income securities MAY reduce portfolio volatility. Worst scenario, increase moderately.

negative correlation between A equity and bond returns in last 10-15 years —> introduce more interest rate risk —> but because key driver of balanced portfolio is australian equity market –> diversification benefits —> total portfolio security volatility tends to decrease.

Question 49

In the future next 10-20 years, expect the correlation between australian equity and australian bond returns is close to 0?

Total portfolio volatility if i increase FI duration?

Answer 49

When correlation is expected to be close to 0, have benefits of diversificaiton. Even if correlation might be 0.3, it is moderate. The total portfolio volatility is not going to increase dramatically.

Investors are still going to benefit from diversification of including fixed income securities

Question 50

impact of duration in liability-driven investing

Answer 50

if the duration of projected liabilities is increased e.g. lifespan, salary growth in the future

DB funds managers, have to increase duration of their assets or fixed income portfolio. So they can keep up with changes of the projected liabilites.

Question 51

Increase duration of fixed income securities within a total portfolio?

Answer 51

not necessarily increase total portfolio risk for a tyical austrlaian investor and DB funds manager

Question 52

what happens when correlation is positive between bond returns and equity?

Answer 52

limited diversification benefits of introducing FI in portfolio

Question 53

Another important driver of fixed income risk and return is credit risk

Answer 53

Credit risk that the coupon and principal is not paid

Question 54

Difference between corporate and treasury bond yield

Answer 54

credit spread

Question 55

credit spread of investment grade

Answer 55

very small

Question 56

Credit risk is a particular risk for

Answer 56

high yield bond

Question 57

Companies beta exposure is closely linked to

Answer 57

credit risk. therefore credit is a equity beta exposure esp for high yield bonds

Question 58

Credit risk is highly correlated with

Answer 58

stock risk and beta risk

equity betas rise as credit rating deteriorates

Question 59

Credit as equity beta exposure

Economy / corporate profitability link

Answer 59

poor economy => lower profits + more bankruptcies

May have difficulty paying coupon and repaying principal at maturity. Stock is going to experience negative return

Common driver for equity return and credit: economic condition/profitability of corporations.

Question 60

Impact of adding credit

FI Portfolio level

why are there diversification benefits?

Answer 60

When I have 100% investment grade fixed income securities, key driver of FI portoflio return and risk is interest rate risk.

When 100% in investment grade bonds for australian investors, over 75% of return variation can be explained by intererst rate movment of australian gov bond.

When I have replace with some high yield/speculative corporate bonds, introduce credit risk, the driver of the credit risk is. What am I introducing into fixed income Portfolio? I introduce beta exposure. The returns from high yield bonds are highly related to stock returns of the company

Question 61

Impact of adding credit

FI Portfolio level

Answer 61

To introduce more credit risk in fixed income portfolio, replace some investment grade with high yield bonds.

When I increase the proportion of credit risk in fixed income portfolio, 30-40% of credit exposure I have diversification benefits. Having more credit risk, I may reduce my fixed income volatility

may potentially help generate alpha

Question 62

The returns from high yield bonds are

Answer 62

highly related to stock returns of the company

Question 63

After 40% when you introduce more credit,

Answer 63

going to take over influence of interest rate risk in FI portfolio. Diversiifcation benefits is gone.

Question 64

impact of adding credit

Total Portfolio Context

Answer 64

when i have total portfolio dominated by equity market variations, when I introduce credit risk by replacing investment grade with speculative and high yield bonds bond, no diverisification benefits —> increase total portfolio risk

more credit risk means more beta exposure/risk, because credit risk is equity like, driven by the common fundamental factor as equity returns: economic condition

Question 65

Accessing FI markets

Answer 65

is exclusive for institutional investors

Not for ordinary investor. we are not able to subscribe or buy corporate or gov bond.

it is through specialised fixed income managers or platoform

Question 66

. Credit risk can be considered as

Answer 66

diversification benefit for FI manager but going to increase total portfolio risk for individual investor

Question 67

Issues with managing FI

Risk of FI portfolios and FI index

Answer 67

Risk of FI portfolios and FI index is not properly accounted for at total portfolio level. Credit risk is most obvious example for FI managers. They consider credit risk as diversification benefit, as source of generating alpha.

For total portfolio investors, t increases total portfolio risk

Question 68

Issues with managing FI

Answer 68

Different FI index have different durations; FI index for investors can be underestimating risk exposure for investors

E.g. DB funds for projected libiliates is 5 years. Go find a passive bond index to match the duration of my projected liabilites. Not able to find anyting. DB funds may be changing. Passive bond ind

Question 69

•FI indices have particular shortcomings

direct access

Answer 69

OTC market. Supplied by investment banks (Barclays, Merrills, Citi, UBS)

Replication difficult due to the OTC market, illiquidity issue, index can be replicated by sampling matching the duration.

Question 70

•FI indices have particular shortcomings

Fluctuating exposure:

Answer 70

debt will mature some time, not like equity that’s considered perpetual somehow. It will be replaced with new debt issues depending on the issuer’s situation, market condition.

Question 71

•FI indices have particular shortcomings

Answer 71

Issuer-driven: after GFC when financial market was flooded with cheap money and very low IR, lots of corporations renewed their corporate bondings. Repay corporate bonds earlier so they can issue new coproate bonds at lower interest rate. Even gov bond market is driven by deficit or surplus or gov.