-
Spectrum of Bond Portfolio Management
- 1. full replication
- 2. enhanced indexing - match primary risk factors
- 3. enhanced indexing - mismatch primary risk factors
- 4. active management - large mismatches
- 5. active management - full blown
-
Full Replication: Adv and Disadv
- Adv: zero or very low tacking error, same exposure as index, low advisory and administrative fees
- Disadv: costly and difficult to implement (need huge portfolio), lower return than index due to cost
-
Enhanced indexing, matched primary factors: adv and disadv
- compared to full replication
- adv: less costly to implement; increased expected return; maintains exposure to index's primary factors
- disadv: increased management fees; increased tracking error; lower expected return than index due to cost
-
Enhanced indexing, mismatch primary factors: adv and disadv
- compared to EI with matched primary risk factors
- adv: same duration as index; higher return; reduced manager restrictions
- disadv: higher risk, tracking error, and mgmt fees
-
Active management: adv and disadv
- compared to enhanced indexing
- adv: ability to tune duration; higher return; reduced mgmt restrictions
- disadv: higher risk, tracking error, management fees
-
Cell matching and tracking error minimization
- enhanced indexing strategies
- cell matching: place index securities into a matrix based on risk factors, such as duration and credit; choose best securities in each cell while maintaining proportional cell weight
- tracking error minimization: optimization with multifactor model
-
Four risk factor exposures
- Market (value): sensitivity of value to change in interest rates
- Income: uncertainty in the amount of payment to be paid/received (ex. prop/cas liability)
- Credit: default
- Liability framework: mismatches in risk exposures of assets vs liabilities
-
Methods for aligning risk exposures
- cell matching: place index securities into a matrix based on risk factors, such as duration and credit; choose best securities in each cell while maintaining proportional cell weight
- tracking error minimization: optimization with multifactor model
- duration: accounts for parallel shifts in curve with duration and convexity; inadequate due to not accounting for non-parallel shifts
- key rate duration: sensitivity to changes in interest rates at certain key maturities
- pv distribution of cash flows: duration contribution per time period over the portfolio maturity; usually 6 month blocks; pv of cash flows in a time period divided by total market value of bond; weight of period * that period's duration (ex. duration of 12-18 block would be 1.5) / total duration = duration contribution
-
Immunization
- Match duration and pv of liability with asset
- fails if rates change more than once or non-parallel and as time passes so must frequently rebalance
- to minimize immunization risk use zeros; bullets with maturities closely bracketing liability
-
Rebalancing Ratio and Controlling Position
- rebalance portfolio using dollar duration
- Ratio = desired (usually old) / current
- multiply mv of each bond by rebalancing ratio to determine necessary changes
- Controlling position: can save money by rebalancing using only bonds with longer duration as this will have the most impact
-
Contingent immunization
- Active mgmt as long as return exceeds required return, and if not switch to passive
- Identify safety net return, immunized return, and dollar safety margin
- Dollar safety margin = portfolio value - value needed to invest passively and meet liability; if positive, can invest actively until (if) value falls to safety margin, then must switch to passive
-
1. contingent claim risk
2. cap risk
- 1. call or prepayment risk - assets called as rates fall, reduced cash flows for reinvestment
- 2. floating rate assets capped in rising rate environment
-
multifunctional duration
same as key rate duration
-
multiple liability immunization
- Bond maturities and coupons used to meet multiple liab
- PV assets = PV liab
- Duration assets = duration liab
- at least one asset duration less than lowest liab duration, and one asset duration more than greatest liab duration
-
cash flow matching
- buy bond with maturity date and value equal to final liab maturity date and value
- work backwards to see how bond coupons can pay other liabilities, and for any shortfall, buy another bond for the shortfall amount
- cash flow must occur at or before maturity date
- Cons: difficult to accomplish and expensive
-
combination matching
- duration and cash flow matching in first few years, only duration matched after
- due to short term rates moving more than long term rates, so benefits of cash flow matching are greatest in short term
-
symmetric cash flow matching
- cash flows can occur before or after liab date
- if after, borrow at liab date to meet liab, then use cf from bond to repay borrowed money later
-
cyclical market analysis
- aka primary market analysis
- new bonds have narrower spreads and stronger returns
- bond returns have declined when the supply drops
-
secular market analysis
- bullets and intermediate term bonds dominate market
- ex. option securities may command premium due to scarcity
-
8 reasons to trade bonds
- relative yield pickup: pick up additional yield using lower rated bonds, con is when spreads change, lower rated bond will be less favorably affected
- credit-upside trades: identify bonds likely to be upgraded and buy
- credit-defense trades: sell bonds likely to be downgraded
- new issue swaps: move to on-the-run for perceived higher liquidity
- sector-rotation trades: shift to sectors expected to outperform
- yield curve-adjustment trades: preemptively shift portfolio to match anticipated changes in yield curve
- structure trades: choose which structures will out-perform, such as callables in a high volatility environment (increases call option value); decreasing in value due to market move to homogenous bullet structures
- cash flow investment: need to reinvest cash flows
-
4 reasons not to trade bonds
- portfolio constraints: constraints on the portfolio, such as credit quality, structures, regulatory high-yield limits; considered a major contributor to inefficiencies in global market
- story disagreement: lack of consensus between buy-side and sell-side analysts leads to uncertainty about optimal trading strategy
- buy and hold: unwillingness to recognize accounting loss, keep turnover low, or lack of liquidity
- seasonality: slowing of trading at the end of months, quarters, and years when mgrs are preoccupied with reports and filing
-
Three methods for analyzing spread
- mean-reversion: if current spread is significantly greater than historic, buy
- quality spread: analyze spread differential between low and high quality credits, and if appears unjustified, trade accordingly
- percentage yield spread: divide yields on corporate by yields on treasuries with same maturity; if ratio higher than justified, buy; flawed bc treasuries (denominator) are missing many factors such as supply, demand, profitability, default, liquidity that can contribute to difference.
-
call option
sinking fund
put option
- call: issuer can call, usu at par; outperform in rising rate environment
- sinking funds: issuer is required to repurchase a portion of issuance each year; issued at discount, retain upside potential as long as don't rise to par
- putable: very rare, difficult to conclude on performance
|
|
