CFA III SS 9 Fixed Income

  1. 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
  2. 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
  3. 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
  4. 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
  5. 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
  6. 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
  7. 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
  8. 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
  9. 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
  10. 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
  11. 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
  12. 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
  13. multifunctional duration
    same as key rate duration
  14. 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
  15. 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
  16. 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
  17. 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
  18. cyclical market analysis
    • aka primary market analysis
    • new bonds have narrower spreads and stronger returns
    • bond returns have declined when the supply drops
  19. secular market analysis
    • bullets and intermediate term bonds dominate market
    • ex. option securities may command premium due to scarcity
  20. 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
  21. 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
  22. 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.
  23. 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
Card Set
CFA III SS 9 Fixed Income