Reading 23 Fixed-Income Portfolio Management—Part I
com
2. A FRAMEWORK FOR FIXED-INCOME PORTFOLIO MANAGEMENT
The four activities in the investment management process
are as follows:
1. Setting the investment objectives i.e. return, risk and
constraints.
2. Developing a portfolio strategy
3. Implementing the strategy
4. Monitoring and adjusting the portfolio
Source: Exhibit 1, Volume 4, Reading 23, P. 7
Types of investor based on Investment Objectives:
1. Investor whose objective is to replicate the
performance of the chosen index e.g. bond mutual
fund. This approach is also known as “investing on a
benchmark-relative basis”.
• A specific bond market index is usually selected
as a benchmark for the portfolio.
• Portfolio’s objective is to either match or exceed
the rate of return on that index.
• Risk of bond holdings is evaluated both in relation
3. MANAGING FUNDS AGAINST A BOND MARKET INDEX
A passive management strategy assumes that the
market’s expectations are essentially correct and
manager has no reason to disagree with these
expectations because he/she has no superior forecasting
skills.
Characteristics of Passive Management Strategy:
2.
• Portfolio’s risk profile is matched with that of
benchmark’s risk profile.
• Portfolio will have average risk level and average rate
of return.
• Manager is not required to make independent
forecasts.
• Portfolio should very closely track the benchmark
index.
Active management strategy is based on manager’s
forecasting ability i.e. when manager’s forecasts are
more accurate than the market forecast, the portfolio
return increases.
3.1 Classification of Strategies
1. Pure Bond Indexing (or Full Replication Approach):
• In this approach, portfolio will have exactly the same
risk exposures as the benchmark.
• Full replication is done by owning all the bonds in the
index in the same percentage as the index.
• Full replication is inefficient, costly & difficult to
implement due to presence of illiquid & infrequently
traded issues in the bond index i.e. high transaction
costs.
FinQuiz.
to the benchmark index and to the contribution
to the risk of the overall (multi-asset-class)
portfolio.
2. Investor whose objective is to generate sufficient
cash from bond investment to satisfy the liabilities
e.g. money borrowed to leverage the portfolio,
defined-benefit pension plans, quasi-liabilities (i.e.
retirement needs) etc.
• Since meeting a liability is the investment
objective, it also becomes the benchmark for the
portfolio.
• Portfolio’s objective is to ensure that the rate of
return earned in the portfolio satisfies the return
promised to liability holders.
• Full replication generates return less than that of
benchmark e.g. if benchmark earns 10%, the strategy
earns 9.5%.
• This approach fairly closely tracks the index; thus, has
zero tracking error.
Enhanced Indexing by matching primary risk factors:
• In this approach, sampling is done to match the
primary index risk factors. Primary risk factors include
i. Changes in the level of interest rates,
ii. Twists in the yield curve,
iii. Changes in the spread between Treasuries and
non-Treasuries.
• It achieves a higher return as compared to full
replication; however, return is still less than that of
benchmark.
• This approach less closely tracks the index relative to
full replication i.e. tracking risk increases.
• It is less costly to implement but involves higher
management fees.
• It has following two approaches:
A. Construction & maintenance costs of the portfolio
are reduced by investing in a sample of bonds
instead of the whole Index.
Example: Benchmark earns 10%; this strategy earns
9.9%.
B. By matching the primary risk factors, the portfolio
manager may try to enhance the portfolio’s return
by using valuation techniques i.e. investing in
undervalued bonds.
Example: Benchmark earns 10%; this strategy earns
9.95%.
NOTE: Both A & B requires sampling.
1
 Reading 23 Fixed-Income Portfolio Management—Part I
3. Enhanced Indexing by small risk factor Mismatches:
1) Duration must be matched with that of benchmark in
this approach.
2) However, portfolio’s return can be marginally
increased by small mismatches in other risk factors i.e.
twists in the yield curve, changes in the spread.
• It can achieve a higher return as compared to first
two strategies aforementioned i.e. return is equal to
that of benchmark.
Example: Benchmark earns 10%; this strategy earns
10%.
3) It leads to increase in risk & tracking error.
4) This approach is less costly in terms of transaction costs
but involves greater management fees.
5) Objective is to earn return that is enough to overcome
the difference in administrative costs between the
portfolio and the index.
4. Active Management by Larger risk factor
Mismatches:
• In this approach, manager actively pursues
opportunities in the market to increase return i.e. by
opting for large mismatches on the primary risk factors
(including duration).
For example, manager may overweight A rated bonds
relative to AA rated, overweight corporate relative to
treasuries, or adjust portfolio’s duration different from
the benchmark etc.
• Objective is to earn return that is enough to overcome
the higher transaction and risk involved i.e. it can
generate return that is greater than that of
benchmark.
Example: Benchmark earns 10%; this strategy earns
10.1%.
• This approach involves higher tracking error, risk and
increase in management fees.
5. Full-blown Active Management:
• Full-blown active management is based on aggressive
mismatches on duration, sector weights and other
factors.
• It can generate return that is greater than that of
benchmark.
Example: Benchmark earns 10%; this strategy earns
10.2%.
• This approach involves higher tracking error, risk and
increase in management fees.
NOTE:
• Pure Bond Indexing (or Full Replication Approach),
Enhanced Indexing by matching primary risk factors &
Enhanced Indexing by small risk factor Mismatches are
categories of Passive styles with varying degree of
enhancements.
• Active Management by Larger risk factor Mismatches
& Full-blown Active Management are categories of
Active styles.
• Any difference in return is due to strategies employed
by the manager, not structural differences between
the portfolio and the benchmark.
• Each enhancement strategy is intended to increase
the portfolio return, but is not guaranteed to do so.
FinQuiz.com
3.2 Indexing (Pure and Enhanced)
Advantages of Indexing include:
1. Indexed portfolios have lower fees than actively
managed portfolios i.e. both advisory and non-
advisory fees (custodial fees) are lower for indexed
portfolios.
2. It is difficult to outperform a broadly based market
index on a consistent basis.
3. Broadly based bond Index portfolios provide
excellent diversification which results in lower risk for
a given level of return than other less diversified
portfolios.
3.2.1) Selecting of a Benchmark Bond Index: General
Considerations
That Benchmark should be selected whose
characteristics match closely with the desired
characteristics of the portfolio. Benchmark is selected
based on the following four factors:
1. Market value risk: The market risk of the portfolio
and benchmark index should be comparable. For
example, for investors who are risk averse, it is more
preferable to use short-term or intermediate-term
index as a benchmark than the long index because
the market risk is directly related to maturity and
duration of a portfolio.
2. Income risk: The portfolio and benchmark should
have comparable assured income streams. If
investor’s objective is to earn stable and
dependable income (i.e. retirees), then long-term
portfolio is the least risky and short-term portfolio is
the most risky.
3. Credit risk: The average credit risk of the benchmark
index should satisfy any constraints placed on credit
quality in the investor’s IPS. The diversification
among issuers in the benchmark index should also
be satisfactory to the investor.
4. Liability framework risk: In order to reduce risk
associated with liabilities (applicable only to in case
of liability-matching objective), the benchmark
index should be selected that reflects the nature of
the liabilities e.g. investors with long-term liabilities
should select a long index.
• For the taxable investor, returns and risk must be
evaluated on an after-tax basis.
• If a taxable investor can hold the bond portfolio within
a taxable or a tax-deferred account, investors should
select the benchmark index with similar risk-return
characteristics in taxable account and tax-deferred
account as that of his/her portfolio.
Although the bond market index may serve as a realistic
benchmark portfolio, it is not a real portfolio and only
exists on paper or computer software. Therefore, the
bond market index is constructed to mimic the overall
market and the manager’s portfolio is constructed to
mimic the bond market index. Consequently, the
manager’s portfolio will also mimic the overall market.
2
 Reading 23 Fixed-Income Portfolio Management—Part I
NOTE:
Asset allocation and asset location are two different
decisions i.e. asset location is the decision concerning the
accounts in which to hold assets. For example, stocks are
preferred to be held in tax-deferred
deferred accounts because
of higher tax-savings
savings since they have potential to earn
higher returns.
Practice: Example 1
Volume 4, Reading 23, P. 12
3.2.2) Risk in Detail: Risk Profiles
The identification and measurement of risk factors plays a
role in benchmark selection and in a major benchmark
construction.
The Major Source of Risk for most bonds is related to yield
curve (the relationship between interest rates and time to
maturity). Yield Curve changes include:
1) A parallel shift in the yield curve (this accounts for
about 90% of the change in value of a bond).
2) A twist of the yield curve
3) Other curvature changes of the yield curve.
The portfolio must have the same exposures to various
risks as the benchmark index. Therefore, the manager
must examine each index’s risk profile in order to
construct an effective indexed portfolio. A completely
effective indexed portfolio will have the exact same risk
profile as the selected benchmark. Two commonly used
techniques to construct a portfolio that replicates an
index are:
1) A Cell-Matching
Matching Technique (or Stratified Sampling):
The procedure is explained as follows:
• The manager first divides the bonds in the index into
cells according to risk factors, such as sector, quality
rating, duration, callability etc.
• The manager then measures the total value of the
bonds in each of the cells and determines each cell’s
weight in the index.
• Finally, the manager selects a sample of bonds from
each cell and dollar amount selected from this cell is
based on that cell’s weight in the index e.g. if A rated
corporate bonds represent 4% of the entire index, then
A rated bonds will be sampled and added until they
represent 4% of the manager’s portfolio.
2) A Multifactor Model Technique: This technique is
based on the idea of constructing a portfolio with
exactly the same risk factor exposures as benchmark
but with different securities.
Primary Risk Factors needed to be matched are as
follows:
1) Duration:
Effective duration is used to measure
easure the change in the
value of a portfolio given a small parallel shift in interest
rates. The indexed portfolio’s duration should be
matched with the benchmark so that portfolio has same
interest rate risk exposure as that of benchmark index.
FinQuiz.com
However, duration underestimates the increase and
overestimates the decrease in the value of the portfolio;
thus for large parallel shift in interest rates, convexity
adjustment must also be considered.
• If portfolio’s duration > benchmark, portfolio has
greater exposure to parallel changes in interest rates
and portfolio tracking risk (it is explained below)
increases.
2) Key Rate Duration and Present Value Distribution of
Cash flows:
Key rate duration is used to measure the effect of
nonparallel shifts in the yield curve i.e. change in slope or
twist in the curve. In this method, spot rate for particular
key maturity is changed (all other spot rates are kept
constant) to measure a portfolio’s sensitivity
sensitivi to a change
in that maturity. This sensitivity is called the rate duration.
The portfolio and benchmark must have securities with
same maturities, key rate durations and the same overall
effective duration.
• Mismatches in key rate duration increase tracking
trac risk.
Present Value Distribution (PVD) of Cash flows describes
how the total duration of the benchmark index is
distributed across its maturity. In other words, it describes
the fraction of the portfolio’s duration that is attributable
to cash flows falling in that time period. In order to
construct a portfolio
olio to have same exposure to non- non
parallel yield curve shifts and twists, portfolio must have
same present value distribution of cash flows as that of
benchmark index.
Following are the steps to calculate PVD of Cash flows:
i. The present value of the cash flows from the
benchmark index for specific periods i.e. every 6- 6
month period is computed.
ii. Then each present value is divided by the present
value of total cash flows from the benchmark to
determine the percentage of the index’s total
market value attributable
butable to cash flows falling in
each period e.g. 3% of the index cash flows fall in
the first 6-month
month period), 3.8% in the second period
and so on.
iii. Since the cash flows in each 6-month
6 period can
be considered zero-coupon
zero bonds, the time
period is the duration ation of the cash flow. For
example, the very first 6-month
6 time period has a
duration of 0.5. The next time period has duration
of 1.0; the next 1.5, and so forth. The duration of
each period is multiplied by its weight to calculate
the contribution of each ea period’s cash flows to
portfolio duration. For example, the contribution of
the first 6-month
month period is calculated as 0.03(0.5) =
0.015. The contribution of the second period is
0.038(1.0) = 0.038, and so forth.
iv. The duration contribution for each of the th period is
divided by the index duration (i.e., the sum of all
the periods’ duration contributions). The resulting
distribution is the benchmark’s PVD. For example,
suppose total index duration is 3.28. then PVD
distribution is:
Period 1 = 0.015 15 / 3.28 = 0.46%
3
 Reading 23 Fixed-Income Portfolio Management—Part I
Period 2 = 0.038 / 3.28 = 1.16% and so on.
Example:
A benchmark has two Zero-coupon bonds i.e. Bond A & Bond B.
Bond A has maturity of 3-years, FV = $5000, i = 10% (annual)
Bond B has maturity of 5-years, FV = $5000, i = 10% (annual)
PVD is calculated as follows:
Maturity Present Value Duration PV as % of Total PV
FV= 5000,
i=10%,
3 n=3, 3 55%
pmt=0,
comp PV= 3757
FV= 5000,
i=10%,
5 n=5, 5 45%
pmt=0,
comp PV=3105
Total 6,862 100%
3) Sector and Quality Percent: The portfolio must match
the percentage weight in the various sectors and
qualities of the benchmark index in order to have the
same risk exposure.
• Mismatches in sector & quality percent increase
tracking risk i.e. if portfolio contains mortgage-backed
securities but portfolio does not, tracking risk increases
or if a portfolio under-weights AA securities relative to
benchmark, tracking risk will be increased.
4) Sector Duration Contribution: The portfolio must
match the proportion of the index duration that is
contributed by each sector in the index to ensure
that a change in sector spreads has the same
impact on both the portfolio and the index.
• For example, if portfolio’s sector percentages are
similar to that of benchmark but the industrial sector’s
contribution duration is larger for the portfolio than for
the benchmark, a mismatch occurs and tracking risk
increases.
5) Quality spread duration contribution: Spread duration
is a measure used to describe how a non-Treasury
security’s price will change as a result of widening or
narrowing of the spread (spread risk). The portfolio
must, therefore, match the proportion of the index
duration that is contributed by each quality in the
index, (where quality refers to categories of bonds by
rating).
• Spread duration is same as duration for Non-Treasury
securities only i.e. it represents % change in value of a
security due to 100 bps change in spread or risk-free
rate.
• Treasury securities have zero spread duration but
duration is a non-zero number.
• Mismatches in Quality spread duration contribution
increases tracking risk.
FinQuiz.com
Duration Contribution PVD of Cash flows
1.65 1.65 / 3.9 = 42%
2.25 2.25 / 3.9 = 58%
3.9 100%
Spread Duration is further discussed in Topic # 4.1.1.6 on
Page# 8
Example: Suppose that total contribution to spread
duration of a Portfolio is 3.43% and of a benchmark is
2.77%. It indicates that the portfolio has greater spread
risk and is thus more sensitive to changes in the sector
spread than the benchmark. This results in larger tracking
risk. Greater spread duration is the result of the
underweight in the Treasury sector combined with the
longer adjusted duration in spread sectors, specifically
Industrials
Source: Exhibit 5, Volume 4, Reading 23, P. 19
NOTE: The number 3.43% indicates that if spread changes
by 100 bps (1%), the value of a portfolio will change by
3.43%.
In exhibit 5, volume 4, reading 23, page 19, it can be
observed that Industrial sector % is significantly
mismatched from benchmark; also this sector has greater
spread duration and thus greater contribution to spread
duration as compared to benchmark. The reason could
be difference in selection of bonds i.e. bond with high
duration have been selected. Thus, spread duration is
greater either because of selecting:
i. Bonds with high maturity; or
ii. Bonds with Cash flows coming late i.e. zero-coupon
bonds.
Note: That Differences in Quality do not affect differences
in duration.
6) Sector/Coupon/Maturity Cell Weights: Convexity is
difficult to measure for callable bonds as they exhibit
negative convexity. In order to match the convexity
of bonds (call exposure) in the index, the sector,
coupon, and maturity weights of the callable sectors
in the index should be matched instead of matching
the convexity because matching convexity involves
high transaction costs.
4
 Reading 23 Fixed-Income Portfolio Management—Part I
7) Issuer Exposure: The portfolio should consist of a
sufficient number of securities so that the event risk
attributable to any individual issuer is minimized.
NOTE: MBS primary risk exposures include sector,
prepayment, and convexity risk.
Source: Exhibit 3, Volume 4, Reading 23, P. 15
Practice: Example 3
Volume 4, Reading 23, P. 20
4.
3.2.3) Tracking Risk
Tracking risk (tracking error) is a measure of the variability
with which a portfolio’s return tracks the return of a
benchmark index i.e. the closer the portfolio tracks the
benchmark index, the lower is the tracking error. When
there are mismatches between a portfolio’s risk profile
and the benchmark’s risk profile, tracking risk arises (as
explained above in Topic# 3.2.2). An actively managed
portfolio that has a different risk profile from those
thos of the
benchmark index would likely have large observed
excess returns, both positive and negative, and thus
would have a large observed tracking error.
Active Return = Portfolio’s Return – Benchmark Index’s
Return
And
Tracking Risk = Standard deviation
n of the Active Returns
i.e.
/
∑Active Return  Mean Active Return
FinQuiz.com
negative slope between 25 & 30 years. The portfolio’s
net return can be increased by overweighting the
undervalued
ndervalued areas on the curve and underweighting
the overvalued areas.
• Overall duration must be matched at any point in
time.
• Note that in yield curve positioning if, e.g. long-term
long
bonds are over-weighted,
weighted, then these include all long-
term bonds regardless
ess of sector or quality.
Sector and Quality Positioning: It has two forms:
a. Maintaining a yield tilt towards a specific sector
and/or quality e.g. maintaining a yield tilt toward
short duration Corporate issues because, historically
corporate securities with less than 5 years maturity
have provided the best yield spread per unit of
duration risk. However, note that this strategy
involves risks (e.g. default risk is higher for corporate
securities); although these are manageable.
Example: Consistently overweighting long-term
Municipal Bonds (Here municipal bond refers to a
specific sector).
b. Periodic over-or-under
under weighting of sectors (e.g. (
Treasuries vs. Corporates) or qualities. For example,
when spreads are expected to widen (narrow), (narro
portfolio’s net return can be enhanced by
overweighting (underweighting) Treasuries.
NOTE: Unlike active management strategy, the
objective of this strategy is not to outperform the
benchmark by a large margin.
Tracking Risk 

n1
Interpretation of Tracking Risk: For example a tracking risk
of 20 bps indicates that in approximately two-thirds
two of the
time periods, the portfolio return will be within a band of
the benchmark index’s return + / - 20 bps.
Practice: Example 2
Volume 4, Reading 23, P. 18
3.2.4) Enhanced Indexing Strategies
Perfectly indexed portfolio underperforms the benchmark
because of the transaction costs associated with
constructing and rebalancing an indexed portfolio.
Therefore, index enhancement strategies are used by
managers to enhance the portfolio’s return. There are
five index enhancement strategies:
1. Lower Cost Enhancements: The portfolio’s net return
can be increased by maintaining tight controls on
trading costs and management fees.
2. Issue Selection Enhancements: The manager can
identify and select issues that are undervalued
relative to a theoretical value or can select issues
which according to his/her credit analysis will soon
be upgraded to enhance portfolio returns.
3. Yield Curve Positioning: Some maturities along the
yield curve tend to remain consistently undervalued
or overvalued e.g. yield curve frequently have a
5. Call Exposure Positioning: For example, when interest
rates decrease, callable bonds underperform as
compared to non-callable
callable issues. Therefore, in case
of declining interest rates, portfolio’s net return can
be enhanced by underweighting these issues.
Practice: Example 4
Volume 4, Reading 23, P. 22
3.3 Active Strategies
In contrast to pure indexing and enhanced indexing,
active management involves large tracking risk and a
large positive active return. If a manager has superior
forecasting or analytical skills, he/she can generate a
portfolio return that is considerably higher
h than the
benchmark return. After selecting the type of active
strategy to pursue, active managers are required to
implement the following four extra activities.
1. Identify which index mismatches are to be exploited:
The choice of mismatches to be exploited is based
on the expertise of the manager e.g. if manager has
superior interest rate forecasting skill, mismatches in
duration is appropriate to be exploited.
2. Extrapolate the market’s expectations (or inputs) from
the market data: Current market prices reflect
market’s expectations. By analyzing these prices and
yields, additional data can be obtained e.g. forward
5
 Reading 23 Fixed-Income Portfolio Management—Part I
rates can be estimated which can provide insight
into the direction and level of expected future
interest rates.
3. Independently forecast the necessary inputs and
compare these with the market’s expectations: For
example, if manager believes that forward rates
expected by the market are too high as compared
to his/her forecasts, he/she can increase the
portfolio’s duration to gain profit from resulting drop
in yield curve.
4. Estimate the relative values of securities in order to
identify areas of under-or-overvaluation: It also
depends on the skill of managers e.g. some
managers will make duration mismatches while
others will focus on undervalued securities.
3.3.2) Total Return Analysis and Scenario Analysis
Total return analysis and scenario analysis are two primary
tools used by active managers to assess the risk-return
characteristics of a trade.
Total Return Analysis: It allows managers to assess the
expected effect of a trade on the portfolio’s total return
(i.e. coupon income, reinvestment income and change
in price) given an interest rate forecast. Total return
analysis is helpful for only one assumed change in interest
rates. Given an investment horizon, expected
reinvestment rate for coupon income and expected
price of the bond at the end of the time horizon, the
semi-annual total return on the trade is calculated as
follows:
Semi-annual Total Return = (Total Future Dollars / Full Price
of the Bond) 1/n – 1
Where, n is the number of periods in the investment
horizon.
FinQuiz.com
Example: Consider a 8-year, 8% semiannual, $100 par
corporate bond. The bond is priced to yield 7% ($106.05),
and it is assumed that coupons can be reinvested at 6%
over the 1-year investment horizon.
1. Horizon price (in one year the bond will have a 6-
year maturity):
N = 7 × 2 = 14; FV = 100; I/Y = 7/2 = 3.5%; PMT = 4;
CPT → PV = 105.46
2. Semiannual return i.e. Horizon value of reinvested
coupons:
N = 1× 2 = 2; PV = 0; I/Y = 6/2 = 3.0%; PMT = 4; CPT →
FV = 8.12
Total horizon value = 105.46 + 8.12 = $113.580
PV = –106.05; FV = 113.580; N = 2; CPT → I/Y = 3.489%
3. BEY = 3.489% × 2 = 6.978%
4. EAR = (1.03489)2 – 1 = 7.10%
Scenario Analysis: It is an excellent risk assessment and
planning tool. It is used to evaluate the impact of trade
on expected total return under varying set of
assumptions. It is helpful in variety of ways i.e.
1. By conducting a risk analysis on the portfolio’s trades,
manager is able to assess the distribution of possible
outcomes.
2. The analysis can be reversed by calculating the
range of interest rate movements (inputs) and their
probabilities of occurrence that would result in a
desirable outcome.
3. The contribution of the individual components of
inputs to total return can be evaluated i.e. when
analyzing amortizing bonds, impact of different
reinvestment rates is also considered.
4. The relative merits of entire trading strategies can
also be evaluated.
6
 Reading 23 Fixed-Income Portfolio Management—Part I FinQuiz.com

4. MANAGING FUNDS AGAINST LIABILITIES

Managing funds against a liability or a set of liabilities has In other words, price risk will exactly offset reinvestment
two types of Passive style strategies. rate risk.

1. Dedication Strategies Classical immunization theory is based on following

2. Derivative Enabled Strategies assumptions:

1. Any changes in yield curve are parallel changes. (It is

the most critical assumption because in case of non-
non
4.1 Dedication Strategies parallel changes, matching duration to the
investment horizon no longer assures immunization).
Dedication strategies are fixed-income strategies used to 2. The portfolio is valued at a fixed horizon date.
meet specific funding needs of the investor. They are 3. The target value of investment is equal to t the
generally passive in nature but some active portfolio value at the horizon date if the interest rate
r
management elements can be added as well. They are structure does not change.
further classified as follows:
When these assumptions hold, immunization provides a
1) Immunization: Immunization is a strategy used to minimum-risk
risk strategy i.e. target value of the investment is
minimize
ze interest rate risk, and it can be used to fund the lower limit of the value of the portfolio at the horizon if
either single or multiple liabilities. It has following three there are parallel interest rate changes.
types:
Immunization is based on two important conditions:
i. Single Period Immunization
ii. Multiple Period Immunization 1) Duration of the portfolio must be set equal to the
iii. Immunization for General Cash Flows Investment horizon (time horizon of a liability that
needs to be funded). Note that Duration-matching
Duration is
2) Cash flow Matching:: It is a strategy which provides the a minimum condition for immunization.
future funding of liability stream from the coupon and 2) The initial present value of the projected cash flows
matured principal payments of the portfolio. from the bond (or bond portfolio) equals the present
value of the future liability.
Types (or Classes) of Liabilities:
Example: $100 million liability is due in 10 years. PV of
Amount of Timing of liability is $34,360,700. In order to immunize this single
Example
Liability Liability period liability, invest in a bond (or portfolio) with 10-year
10
Known Known A principal repayment duration and PV of $34,360,700.
Known Unknown A life insurance payout
A floating rate annuity NOTE: Investing in a coupon bond with YTM equal to the
Unknown Known
payout target yield and maturity equal to the investment horizon
Post-retirement
retirement health does not ensure that the target value will be achieved
Unknown Unknown
care benefits because when:

The more uncertain the liabilities the more difficult it
becomes to use a passive dedication strategy to
achieve the portfolio’s goals. In such cases, managers
prefer to use some elements of active management.
These aggressive strategies include active/passive
active/pas
combinations, active/immunization combinations, and
contingent immunization.
• Market yields rise, total return higher than the target
value (target yield) will be achieved because coupon
payments can be reinvested at a higher rate.
• Market yields fall, total return lower than the target
value (target yield) will be achieved because coupon
payments have to be reinvested at a lower rate.

4.1.1) Immunization Strategies & Classical Single-period

Single Practice: Example 5
Immunization Volume 4, Reading 23, P. 27

Immunization is based on the objective of constructing a

portfolio that over a fixed horizon will earn a
predetermined return to meet a liability regardless of
interest rate changes i.e.

• If interest rates increase, the gain in reinvestment

income ≥ loss in portfolio value.
• If interest rates decrease, the gain in portfolio value ≥
loss in reinvestment income.

7
 Reading 23 Fixed-Income Portfolio Management—Part I
4.1.1.2 Rebalancing an Immunized Portfolio
• Duration of a portfolio changes when market yield
changes and/or with passage of time. For example,
when market yield decreases, there is a need to invest
more in short-term
term bonds because duration is higher
at lower yields.
• Also, duration of a portfolio changes
hanges at a different
rate from time when the term structure is not flat e.g. if
yield curve is upward sloping, and if one year of
maturity is decreased, then duration of coupon bonds
will be decreased by less than 1.
This implies that portfolios are no longer immunized for a
single liability when:
• Interest rates fluctuate more than once.
• Time passes.
Thus, immunization is not a buy-and-hold
hold strategy. To
keep a portfolio immunized, it must be rebalanced
periodically. Rebalancing an immunized portfolio involves
cost-benefit trade-off
off i.e. more frequent rebalancing
increases transaction costs while less frequent f
rebalancing causes the duration to stray away from
target duration.
Effect of mismatch in the duration of the portfolio and the
duration of the liability:
• If portfolio duration is less than liability duration, the
stment risk. If interest
portfolio is exposed to reinvestment
rates are decreasing, the losses from reinvested
coupon and principal payments would be > any
gains from appreciation in the value of outstanding
bonds. Under this scenario, the cash flows generated
from assets would be insufficientt to meet the targeted
obligation.
• If portfolio duration is greater than liability duration,
the portfolio is exposed to price risk. If interest rates
are increasing, this would indicate that the losses from
the market value of outstanding bonds would be >
any gains from the reinvestment income. Under this
scenario, the cash flows generated from assets would
be insufficient to meet the targeted obligation
4.1.1.3 Determining the Target Return
The immunization target rate of return is defined as the
total return of the portfolio assuming no change in the
term structure.
• For a flat yield curve, the yield to maturity (YTM) is
approximately equal to the assured target return.
• For an upward sloping ng yield curve, the yield to
maturity (YTM) of a portfolio can be quite different
from its immunization target rate of return i.e. the
immunization target rate of return < YTM because of
the lower reinvestment return.
• For a negative or downward sloping yield
yi curve, the
immunization target rate of return > YTM because of
the higher reinvestment return.
FinQuiz.com
Approaches of determining the Target Return:
1) Using a yield implied by a zero coupon bond with
quality and duration comparable with that of the
bond portfolio.
2) The most conservative method is to use the lowest
rate i.e. Treasury spot rates in order to have the
largest present value of liabilities.
3) A more realistic approach is to use yield curve
(converted to spot rates) implied by the securities
held in the portfolio.
4.1.1.4 Time Horizon
The immunized time horizon is equal to the portfolio
duration. Portfolio duration is equal to a weighted
average of the individual security durations where the
weights are the relative amounts or percentages
invested in each.
NOTE: A typical immunized time ti horizon under
Guaranteed Investment Contracts (GICs) is five years.
Practice: Example 8
Volume 4, Reading 23, P. 32
4.1.1.5 Dollar Duration and Controlling Positions
Dollar duration is a measure of the change in portfolio
value for a 100bps (1%) change in market interest rates.
Dollar Duration = Duration × Portfolio Value × 0.01
Portfolio’s Dollar Duration = Sum of dollar durations of the
individual securities in the
portfolio
Rebalancing Ratio = Original or Old Dollar Duration / New
Dollar Duration
Cash required for the rebalancing = (Rebalancing ratio –
1) × (total new
market value of
portfolio)
Controlling Position = Target (Original) Dollar Duration –
Current (new) Dollar Duration
Needed change in exposure can be obtained from
changing the proportion of one or more bonds in the
portfolio.
Practice: Example 6 & 7
Volume 4, Reading 23, P. 30 & 31
4.1.1.6 Spread Duration
The contribution of an individual bond or sector to the
duration of the portfolio is the weight of the bond or
sector in the portfolio multiplied by its duration i.e.
Contribution of bond or sector i to the portfolio duration =
wi × D i
8
 Reading 23 Fixed-Income Portfolio Management—Part I
Where,
wi= the weight of bond or sector in the portfolio = market
value of bond or sector in the portfolio / total
portfolio value
Di = the effective duration of bond or sector i
Spread duration of a Portfolio = Market weighted average
of the sector spread
durations of the individual
securities
• For a portfolio of Non-Treasury securities, spread
duration = portfolio duration.
• For a portfolio of both Non-treasury and Treasury
securities, spread duration < portfolio duration since
spread duration of Treasury securities is zero.
Duration v/s Spread Duration:
• In duration, the parallel shift in the yield curve could
be caused by a change in inflation expectations,
which causes the yields on all bonds, including
Treasuries, to increase/decrease the same amount.
Duration is an Absolute measure of portfolio interest
rate sensitivity.
• In the spread duration, the shift is in the spread only,
which indicates an overall increase in risk aversion (risk
premium) for all bonds in a given class. Spread
Duration is a Relative measure of portfolio interest rate
sensitivity.
There are three spread duration measures used for fixed-
rate bonds:
1) Nominal spread is the spread between the nominal
yield on a non-Treasury bond and a Treasury of the
same maturity. When spread duration is based on
the nominal spread, it represents the approximate
percentage price change for a 100 basis point
change in the nominal spread.
2) Zero-volatility spread (or static spread) is the spread
that, when added to the
Treasury spot rate curve makes the present value of
the cash flows (when discounted at the spot rates
plus the spread) equal to the price of the bond plus
accrued interest. In this case, Spread duration is the
approximate percentage change in price for a 100
basis point change in the zero-volatility spread,
holding the Treasury spot rate curve constant.
3) The option-adjusted spread (OAS) is another spread
measure that can be interpreted as the
approximate percentage change in price of a
spread product for a 100 basis point change in the
OAS, holding Treasury rates constant. So, for
example, if a corporate bond has a spread
duration of 5, this means that, if the OAS changes
by 30 basis points, then the price of this corporate
bond will change by approximately 1.5% (0.05 ×
0.003 × 100).
FinQuiz.com
4.1.2) Extensions of Classical Immunization Theory
1. A natural extension of classical immunization theory is
to deal with non-parallel shifts in interest rates. It
involves two approaches:
a) Modifying the definition of duration so as to
incorporate effects of nonparallel yield curve shifts
i.e. use of multifunctional duration (functional or key
rate duration).
b) Establishing a measure of immunization risk against
any arbitrary interest rate change i.e. the
immunization risk can be minimized subject to the
constraint that the duration of the portfolio equals
the investment horizon.
2. Multiple-liability Immunization: A second extension of
classical immunization theory is used to deal with the
limitations of a fixed horizon assumption (e.g.
multiple-period liability like defined benefit plan’s
promised payouts). Unlike single period liability, there
can be numerous certain or even uncertain liabilities
with accompanying numerous horizon dates. In such
cases, the liability at a single horizon date cannot be
considered as the minimum target value of the
portfolio.
3. Return Maximization Approach: It is a third extension
of classical immunization theory. As long as the
liability can be easily satisfied, this strategy allows
managers to pursue increased risk strategies that
could lead to excess portfolio value (i.e., a terminal
portfolio value greater than the liability).
4. Contingent Immunization: It is a fourth extension of
classical immunization theory. It combines
immunization strategies with elements of active
management. Contingent immunization ensures a
certain minimum return in case of parallel shift and
also provides a degree of flexibility to use active
strategies. In contingent immunization, immunization
serves as a fall-back strategy if the actively managed
portfolio does not grow at a certain rate.
• Contingent immunization only possible when the
prevailing available immunized rate of return >
required rate of return.
Cushion Spread = Immunized Rate – Minimum
acceptable return (Safety net rate of return)
• As long as the rate of return on the portfolio exceeds
a pre-specified safety net return, the portfolio is
managed actively. If the portfolio’s return declines to
the safety net return, the immunization mode is
activated. The safety net return is the minimum
acceptable return as designated by the client.
Example:
A portfolio manager has decided to pursue a contingent
immunization strategy over a three-year time horizon. He
just purchased at par $93 million worth of 10.0%
semiannual coupon, 12-year bonds. Current rates of
return for immunized strategies are 10.0% and the
portfolio manager is willing to accept a return of 8.5%. If
interest rates rise to 11% immediately, the dollar safety
margin is calculated as follows:
9
 Reading 23 Fixed-Income Portfolio Management—Part I
We must first compute the required terminal value:
PV=$93,000,000, N=6, I/Y=8.5/2=4.25%, PMT=0, compute
FV=$119,382,132.
Next, we calculate the current value of the bond
portfolio: PMT= ($93,000,000) (.05) =$4,650,000, N=24,
I/Y=11/2=5.5%, and FV=$93,000,000, CPT → interest rates, changing interest rates are a major
PV=$86,884,460.
Next, compute the present value of the required terminal
value at the new interest rate: FV=$119,382,132, PMT=0,
N=6, I/Y=11/2=5.5%, CPT → PV=$86,581,394.
The dollar safety margin is positive ($86,884,460 −
$86,581,394 = $303,066) and the manager can continue
to use contingent immunization. When dollar safety
margin is negative, the portfolio must be immunized
immediately.
• The yield level at which the immunization mode
becomes necessary is called the trigger point.
Factors which affect Rebalancing in Contingent
Immunization:
The frequency of rebalancing the portfolio is determined
by the relationship between the safety net return and
current market interest rates (and immunized rates).
If safety net rate of return is close to market returns:
• Less flexibility for active management
• Probably funds are not sufficient
If safety net rate of return << market returns
• High flexibility for active management
• Sufficient funds are being invested (may be too
much)
NOTE: Rapid adverse large movement in market yields
and the uncertainty that the immunization rate will be
achieved once the immunization mode is activated
leads to failure to attain the minimum target return in
spite of effective monitoring procedures.
4.1.2.1 Duration and Convexity of Assets and Liabilities
Economic Surplus = Market value of assets – present
value of liabilities
To determine the true impact on the value of the
economic surplus, both the duration & convexity of the
assets and the liabilities must be considered i.e. both must
be matched. If liabilities and assets are duration
matched but not convexity matched, economic surplus
will be exposed to variation in value from interest rate
changes.
Source: Exhibit 15 & 16, Volume 4, Reading 23, P. 37 & 38
FinQuiz.com
4.1.2.2 Types of Risk
Risks in managing Against Liability Structures:
1. Interest rate risk: Since the values of most fixed
income securities move opposite to changes in
source of risk. To help avoid interest rate risk, the
manager will match the duration and convexity of
the liability and the portfolio.
2. Contingent claim risk (call risk or prepayment risk):
Callable bonds are typically called when interest
rates decrease. This means that the portfolio not only
loses the higher stream of coupons that were
originally incorporated into the immunization
strategy, but it is also faced with reinvesting the
principal at a reduced rate of return.
3. Cap risk: Funded investors might invest in a floating-
rate bond that has a cap (i.e., a maximum interest
rate). To fund the investment in the floater, the
investor might borrow funds on a short-term basis.
There is no cap on the borrowing cost. Thus, if rates
rise above the cap specified for the floater and there
is no cap on the liabilities, then, at some point the
funding cost will exceed the rate earned on the
floater. This risk is called cap risk.
4.1.2.3 Risk Minimization for Immunized Portfolios
Reinvestment risk determines the immunization risk
because reinvestment rate only has impact on asset
returns not liability i.e. when interest rates decline, only
assets face lower reinvestment income. Price risk is not
relevant because when e.g. interest rates decline, values
of both assets and liabilities increases.
The portfolio that has the least reinvestment risk will have
the least immunization risk.
• When both Barbell Portfolio and Bullet Portfolio have
durations equal to the horizon length, both portfolios
are immune to parallel rate changes.
• In case of non-parallel rate changes, barbell portfolio
is riskier than the bullet portfolio because it has greater
exposure to changes in interest rate structure than the
bullet portfolio.
• Barbell portfolio has high dispersion of cash flows
around the horizon date; therefore, it is exposed to
higher reinvestment risk.
For example, when short rates decline while long rates
rise:
o Both the barbell and bullet portfolios would
experience a capital loss and lower reinvestment
rates at the end of investment horizon.
o However, barbell portfolio would experience a
higher decline in value relative to bullet portfolio
due to the following two reasons:
i. The barbell portfolio experiences the lower
reinvestment rates longer than the bullet
portfolio.
ii. More of the barbell portfolio is still outstanding at
the end of investment horizon which results in
higher capital loss.
• When there are no interim cash flows, reinvestment
risk is absent and thus, immunization risk is zero e.g. a
pure discount instrument maturing at the investment
horizon.
10
 Reading 23 Fixed-Income Portfolio Management—Part I
• For non-parallel interest rate changes, the target
value is not necessarily the lower bound on the
investment value.
Relative change in the portfolio value depends on two
terms.
1) M 2 known as maturity variance: 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. For example, if all the
bonds have the same maturity date as the liability,
M2 is zero. As the dispersion of the maturity dates
increases, M2 increases. It depends only on the
composition of portfolio and therefore, it is under the
control of manager.
• It can be used as a measure of immunization risk
i.e. when it is small, the exposure of the portfolio to
any interest rate change is small.
2) Interest rate movements i.e. ∆y: It is an uncertain
quantity and therefore, outside the control of the
manager.
NOTE: Linear programming can be used to find the
optimal immunized portfolio because the risk measure is
linear in portfolio payments.
Confidence interval represents an uncertainty band
around the target return within which the realized return
can be expected with a given probability.
Confidence Interval = Target Return +/- (k) × (Standard
Deviation of Target Return)
Where,
k = number of S.D around the expected target return
• The higher the desired confidence level, the larger k
and the wider the band around the expected target
return.
S.D of expected target return is approximately the
product of three terms:
i. Immunization risk measure
ii. S.D of variance of 1-period change in the slope of
the yield curve
iii. An expression that is a function of the horizon length
only
4.1.3) Multiple-Liability Immunization
The basic idea behind multiple liabilities immunization is to
decompose the portfolio payment streams in such a way
that the component streams separately immunize each
of the multiple liabilities. There are three conditions that
must be satisfied to assure multiple-liability immunization
in case of parallel rate shifts:
i. The PV of assets must equal the PV of liabilities.
ii. The composite (multiple) duration of the portfolio
must equal the composite (multiple) duration of the
liabilities. It implies that if there are liabilities beyond
30 years, it is not necessary to have a duration for the
portfolio that is 30 years in order to immunize the
entire liability stream i.e. the second condition
FinQuiz.com
requires that portfolio duration must equal the
weighted average duration of liabilities.
iii. The distribution of durations of individual portfolio
assets must have a wider range than the distribution
of the liabilities i.e.
• The portfolio must have an asset with a duration ≤
duration of the Shortest-duration liability in order to
have funds to pay the liability when it is due (i.e. to
avoid price risk).
• The portfolio must have an asset with a duration ≥
longest-duration liability in order to avoid
reinvestment rate risk.
It is important to note that satisfying these three
conditions will assure immunization only against parallel
rate shifts. In the case of nonparallel rate changes, linear
programming models can be used to construct
minimum-risk immunized portfolios for multiple liabilities.
NOTE:
• In case of multiple-liability immunization, matching
duration of portfolio to the average duration of
liabilities is not a sufficient condition for immunization.
• Relative change in portfolio depends on structure of
portfolio and interest rate movement (as explained
above).
• Linear programming can be used to find the optimal
immunized portfolio.
4.1.4) Immunization for General Cash Flows
In both single investment horizon and multiple liability
cases, it is assumed that the investment funds are initially
available in full. However, when investment funds are not
available in full at the time the portfolio is constructed,
immunization for General Cash Flows strategy is used. In
this case, the expected cash contributions are
considered the payments on hypothetical securities that
are part of the initial holdings. The actual initial
investment can then be invested in such a way that the
real and hypothetical holdings taken together represent
an immunized portfolio.
• The actual initial investment must have a duration >
investment horizon.
Example: The investment horizon is 2-years. If only half
of funds are available initially then, actual initial
investment must be constructed with a duration of > 2
e.g. 3. Then, the remaining funds must have a
duration of 1 in this case so that weighted average
duration of total investment becomes 2 (matching the
horizon length).
• The rate of return on future contributions is not the
current spot rate; rather it will be the forward rate for
the date of contribution i.e. in the example above, if
current spot rate is 10%, actual initial investment will
be invested at 10% but remaining half funds will be
invested at 1f1 rate.
NOTE:
• Linear programming can be used to find the optimal
immunized portfolio.
• Immunization for general cash flows can also be
extended to multiple contributions and liabilities.
11
 Reading 23 Fixed-Income Portfolio Management—Part I
4.1.5) Return Maximization for Immunized Portfolios
According to return maximization for immunized portfolios
strategy, if expected return can be increased
substantially with little effect on immunization risk, then
high-yielding portfolio will be preferred in spite of its high
risk.
• In this strategy, duration of portfolio at all times equal
to the horizon length. Thus, portfolio remains fully
immunized in the classical sense.
• This strategy focuses on risk-return trade-off instead of
dealing with non-parallel rate shifts.
• This strategy maximizes the lower bound on the
portfolio return.
Example:
• Optimally immunized portfolio A has expected return
= 8% & S.D = 20bps (with 95% confidence interval).
• Optimally immunized portfolio B has expected return =
8.3% & S.D = 30bps (with 95% confidence interval).
o Out of these two, portfolio B is more risky due to its
higher S.D
o However, if target return is 7.8%, then portfolio B will
be preferred to portfolio A because, portfolio B has
1 out of 40 chances of realized return > 8%
compared to 7.8% on minimum-risk portfolio.
NOTE:
• The greater the cushion spread, the more scope the
manager has for an active management policy.
• Linear programming can be used to find the optimal
immunized portfolio with the objective of return
maximization.
• The amount of assets required for the immunization will
vary inversely with the expected return on the
portfolio e.g. manager could commit fewer assets by
constructing an actively-managed, higher expected
return portfolio.
4.2 Cash Flow Matching Strategies
Cash flow matching is an alternative to multiple liability
immunization in asset/liability management. In this
strategy, there is a need to select securities to match the
timing and amount of liabilities i.e. a
i. Bond is selected with a maturity equal to last liability
maturity; and
ii. Amount of principal = Amount of last liability – final
coupon payment
Or
Amount of Principal + Final Coupon payment = Amount of
Liability
Similarly, remaining liability streams are then reduced by
the coupon payment on this bond and another bond is
selected for the next-to-last (second last) liability i.e. with
an
FinQuiz.com
Amount of principal = amount of next-to-last liability –
coupon on first bond selected (for
last liability) – coupon on bond
selected (for next-to-last liability)
Or
Amount of principal - coupon on first bond selected (for
last liability) – coupon on bond selected (for next-to-last
liability) = Amount of next-to-last liability
This process continues until all liabilities have been
matched by payments on the securities selected for the
portfolio.
NOTE: The more excess cash is available at each period,
the greater the risk of the strategy because of the
reinvestment risk. Therefore, it is more appropriate to use
conservative interest rate assumption i.e. 0%.
Source: Exhibit 18 & 19, Volume 4, Reading 23, P. 45 & 46
4.2.1) Cash Flow Matching versus Multiple Liability
Immunization
• When liability flows are perfectly matched by the
asset flows of the portfolio, there is no reinvestment risk
and thus, no immunization or cash flow match risk.
• When perfect matching is not possible, an
immunization strategy is preferred because it requires
less money to fund liabilities. Immunization is superior
to cash flow matching due to two reasons i.e.
1) Cash flow matching requires a relatively
conservative rate of return assumption for short-
term cash & cash balances; in contrast, an
immunized portfolio is fully invested at the remaining
horizon duration.
2) Funds from cash flow matching must be available
when ( usually before) each liability is due; in
contrast, an immunized portfolio is required to meet
the target value only on the date of each liability
because funding is achieved by a rebalancing of
the portfolio.
4.2.2) Extensions of Basic Cash Flow Matching:
In basic cash flow matching, only asset cash flows
available before a liability date can be used to satisfy the
liability. There are two extensions of basic cash flow
matching.
1) Symmetric Cash Flow Matching: It is an extension of
basic cash flow matching that allows cash flows
occurring both before and after the liability date to
be used to meet a liability. In this technique, short-
term borrowing of funds is allowed to meet a liability
prior to the liability due date. This results in reduction
in the cost of funding a liability. However, it also
introduces price risk.
2) Combination Matching or Horizon Matching: In this
strategy, a portfolio is created that is duration
matched but with an additional constraint that it is
cash-flow-matched in the first few years (usually 5
years).
12
 Reading 23 Fixed-Income Portfolio Management—Part I
Combination Matching Strategy v/s Multiple-liability
Multiple
Immunization:
• In combination matching strategy, liquidity needs are
provided for in the initial cash flow matched period.
• Cash flow matching for the initial portion of the liability
stream reduces the risk associated with non-parallel
non
shifts of the yield curve.
• The cost st to fund liabilities is greater in Cash flow
matching strategy as compared to multiple-liability
multiple
immunization because more funds are required at
time 0. However, in basic cash flow matching, more
funds are required relative to combination matching
strategy.
4.2.3) Application Considerations for Dedication
Strategies
1) Universe Considerations: Selection of the universe of
securities for construction of a single period
immunized portfolio or a dedicated portfolio is
extremely important. Securities in the portfolio should
be limited to high-quality,
quality, very liquid instruments
because illiquid securities
ties involve high transaction
costs and make portfolio rebalancing costly.
NOTE: Immunization theory assumes no default risk.
FinQuiz.com
2) Optimization: For example, for an immunized
portfolio, optimization means to minimize the
immunization risk (maturity variance) subject to
constraints of matching weighted average duration
and necessary duration dispersion. For cash flow
matching, optimization means to minimize the initial
portfolio cost subject to constraint of having sufficient
cash to satisfy a liability when it is due.
3) Monitoring: Monitoring requires periodic performance
measurement e.g. the performance of a multiple
liability immunization can be monitored by
comparing the current market value of the assets
with the present value of remaining liabilities.
4) Transaction Costs: These must be considered both
when the immunized portfolio is first created and
when periodic rebalancing is performed to match
ma
duration.
Practice: End of Chapter Practice
Problems For Reading 23
Practice:
set ID# 12087
FinQuiz Item-set
13