Lecture 14

Fixed Income Portfolio Strategies

JOTD (joke of the day)

A mathematician, an accountant and an economist apply for the same job. The interviewer calls in the mathematician and asks "What do two plus two equal?" The mathematician replies "Four." The interviewer asks "Four, exactly?" The mathematician looks at the interviewer incredulously and says "Yes, four, exactly." Then the interviewer calls in the accountant and asks the same question "What do two plus two equal?" The accountant says "On average, four - give or take ten percent, but on average, four." Then the interviewer calls in the economist and poses the same question "What do two plus two equal?" The economist gets up, locks the door, closes the shade, sits down next to the interviewer and says "What do you want it to equal?"

VSE Assignment 1
Reading about earnings announcements and economic announcements. Earnings = specific to stock Econ = applies to whole economy but may effect stocks differently

Alternative Bond Portfolio Strategies

1. Passive portfolio strategies 2. Active management strategies 3. Matched-funding techniques

Passive Portfolio Strategies

Buy and hold
Buy a portfolio of bonds and hold them to maturity Can by modified by trading into more desirable positions

Indexing
Match performance of a selected bond index Performance analysis involves examining tracking error for differences between portfolio performance and index performance

Active Management Strategies

Active management strategies attempt to beat the market Mostly the success or failure is going to come from the ability to accurately forecast future interest rates

Active Management Strategies

Interest-rate anticipation
Risky strategy relying on uncertain forecasts of future interest rates, adjusting portfolio duration Ladder strategy staggers maturities Barbell strategy splits funds between short duration and long duration securities

Credit analysis
Detailed analysis of the bond issuer Determines expected changes in default risk Try to predict rating changes and trade accordingly
Buy bonds with expected upgrades Sell bonds with expected downgrades

Yield-spread analysis
Monitor spreads within and across sectors, bond ratings, or industries Trade in anticipation of changing spreads

Bond swaps
Selling one bond (S) and purchasing another (P) simultaneously Swaps to increase current yield or YTM, take advantage of shifts in interest rates or realignment of yield spreads, improve quality of portfolio, or for tax purposes

Active Management Strategies

Bond Swaps
Pure yield pickup swap
Swapping low-coupon bonds into higher coupon bonds

Substitution swap
Swapping a seemingly identical bond for one that is currently thought to be undervalued

Tax swap
Swap in order to manage tax liability (taxable & munis)

Swap strategies and market-efficiency

Bond swaps by their nature suggest market inefficiency

Bond/Interest rate Strategies

Ladders: Bonds mature at different times and you continually reinvest them.

Ladders, Barbells, and Bullets Bullets: Bonds, invested Barbells: Sets of bonds
mature in the long term and short term, but not the mid term. at different times, have the same target maturity date.

Ladders and Barbells

Income - The periodic return of principal provides the investor with additional income beyond the set interest payments Flexibility - The income derived from principal and interest payments can either be directed back into the fund if interest rates are relatively high or invested elsewhere if they are relatively low Interest rate volatility is reduced because the investor now determines the best investment option every few years, as each bond matures Investors should be aware that laddering can require commitment of assets over time, and return of principal at time of redemption is not guaranteed

Benefits
Ladder Increases and declines in interest rates average over the business cycle Barbell For when short term interest rates are rising and long term steady or falling. ST bonds can be reinvested else where if conditions change. Bullet matching a liability or horizon

Matched-Funding Strategies
Many immunization strategies are designed to take the sting out of rising interest rates for a bond portfolio!

Matched-Funding Techniques
Classical (pure) immunization strategies attempt to earn a specified rate of return regardless of changes in interest rates
Must balance the components of interest rate risk
Price risk: problem with rising interest rates Reinvestment risk: problem with falling interest rates

Set Duration equal to investment horizon

Growth of Invested Funds

Example
Fund a $1M liability 4 years from now using a 2 year zero and a perpetuity (perp)

Matched-Funding Techniques
Dedicated portfolios to service liabilities Different types:
Exact cash match Dedication with reinvestment

Exact Cash Match

Matched-Funding Techniques
Horizon matching
Combination of cash-matching and immunization With multiple cash needs over specified time periods, can duration-match for the time periods, while cash-matching within each time period

Contingent Immunization
Allow the managers to actively manage until the bond portfolio falls to a threshold level Once the threshold value is hit the manager must then immunize the portfolio Active with a floor loss level

Figure 10-8 Contingent Immunization

Term Structure of Interest Rates

Relationship between yields to maturity and maturity Yield curve - a graph of the yields on bonds relative to the number of years to maturity
Usually Measured with Treasury Bonds Have to be similar risk or other factors would be influencing yields

Theories of Term Structure

Expectations
Long term rates are a function of expected future short term rates Upward slope means that the market is expecting higher future short term rates Downward slope means that the market is expecting lower future short term rates

Liquidity Preference
Upward bias over expectations The observed long-term rate includes a risk premium

Figure 9.12 Returns to Two 2-year Investment Strategies

Forward Rates Implied in the Yield Curve

(1+ y n )
(1 . 12 )
2
n

= (1+

y n -1) (1+ f n )
n -1

= (1 . 11 )

(1 . 1301 )

For example, using a 1-yr and 2-yr rates

Longer term rate, y(n) = 12% Shorter term rate, y(n-1) = 11%

Forward rate, a one-year rate in one year = 13.01%

Figure 9.13 Illustrative Yield Curves

Figure 9-11 Yield Curves

Figure 9.14 Term Spread

Thank You..