Tactical Management of Credit-Quality Weightings by Bond Funds

George Hoffmann University at Albany

Objective of the Study

To determine if active bond portfolio management outperforms passive management
o Active/Passive management: degree of credit quality weighting changes

Primary Hypothesis
A relation exists between active bond portfolio management and performance. H1: active portfolio management outperforms passive management.
o R(Active Bond Portfolios) > R(Passive Bond Portfolios). o SD(Active Bond Portfolios) < SD(Passive Bond Portfolios).

Motivation for the Study (1)

Question: Are active bond portfolio strategies likely to improve performance? Answer(s):

Altman and Kao (1992)

o The Implications of Corporate Bond Ratings Drift The tendency of BBB rated bonds to be upgraded more often than downgraded.
Reaching for Yield in the Bond Market Gains from Active Bond Portfolio Management Strategies Determinants of portfolio performance II: An update

Becker and Ivashina (2012)

o o o

Boyd and Mercer (2010)

Brinson and Singer and Beebower (1991)

Motivation for the Study (2)

Carty and Fons (1993)
o Measuring Changes in Corporate Credit Quality Short-term ratings have a strong correlation with the business cycle. Concept of ratings momentum. Return Dynamics of Distressed Bonds The Credit Rating Agencies Role of credit ratings in portfolio management and likelihood of the lender to pay back debt.

Sterling and Fridson and Kong (2009)

o o

White (2010)

Data Source
Source: PSN Database Identify bond portfolios and the credit ratings of holdings Years: 1983-2011
o Years of chosen sample: 1995-2011

Nature of data:
o Credit rating weights and their changes by year o Monthly performance: return and return net of benchmark

Characteristics of the Data

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 AAA 40 45 47 50 59 60 59 54 47 45 38 AA 9 9 8 7 7 8 9 10 11 12 16 A 13 12 12 12 11 10 10 13 15 15 16 BBB 4 4 4 5 6 7 7 8 11 12 13 BB 2 2 2 2 4 5 5 5 5 5 6 B 2 2 3 3 4 5 5 5 5 6 6 Under B 0 0 1 1 1 1 1 1 2 2 2 Unrated 33 27 25 20 7 4 3 3 3 3 3

The role of credit rating assignments grew from 2001 to 2011. Displays impact of the credit rating agencies.

14,975 original funds in PSN Database

2,906 with credit weighting data 1,856 for test period 19952011 1,067 testable

627 Actively Managed Funds

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440 Passively Managed Funds

Determining Representative Passive Fund

Method of determination:
o Benchmark: Barclays Aggregate Bond Index o Tracking fund: Hartford Passive Bond Index Fund very similar portfolio composition to the Barclays Aggregate Bond Index, and data available for 1995 to 2011 o Monthly average return 1995 to 2011 for Barclays Index: 0.554% o Monthly average return 1995 to 2011 for Hartford Fund: 0.553%

Determining Active or Passive

From original funds find credit rating weight deviation between years
Credit rating weight data
AAA 1995 20% AAA 1996 25%

Deviation between years

% Change AAA 1995 -1996
5%

Compare to the benchmark by subtracting and taking the absolute value Average the percent deviations from the benchmark Label high deviation as actively managed and low as passively managed Use 5% average deviation as cut off level for active

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Performance Results: Monthly 1995-2011

None of the strategies significantly outperformed. Benchmark adjusted return difference of means: o t-stat: 0.070 Raw return difference of means: o t-stat: -0.377 Actively managed fund returns had notably lower standard deviation. Active managers control return variability through tactical credit quality weighting
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Credit-quality Change vs. Performance

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Conclusion
Fail to reject the null hypothesis
o H0: active portfolio management does not outperform passive management.

Further Observations:
o Regression results: The more actively managed the portfolio, the lower is ROR (to a point) o Although their return is not superior, actively managed funds appear to manage risk comparatively well.

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