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Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

FIXED INCOME
PORTFOLIO
MANAGEMENT

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Copyright McGraw-Hill Ryerson Limited, 2003

Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Sources of Bond Risk


Primary:

Default: Will the borrower honor its promise to


repay?
Interest Rate: How will changing market
conditions affect the value of the bond?
Price risk component
Reinvestment risk component

Secondary:

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Call: Will the borrower refinance the loan under


conditions that are disadvantageous to investor?
Liquidity: How easily can bond be bought or
sold?
Tax: Will changes in the tax code affect bond
values?

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Copyright McGraw-Hill Ryerson Limited, 2003

Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Bond Yields, Pricing, and Volatility

Theorem #1: Bond prices are inversely related to bond yields.


Implication: When market rates fall, bond prices rise, and vice versa.

Theorem #2: Generally, for a given coupon rate, the longer is the term to
maturity, the greater is the percentage price change for a given shift in yields. (The
maturity effect)
Implication: Long-term bonds are riskier than short-term bonds for a given shift in
yields, but also have more potential for gain if rates fall.

Theorem #3: For a given maturity, the lower is the coupon rate, the greater is the
percentage price change for a given shift in yields. (The coupon effect)
Implication: Low-coupon bonds are riskier than high-coupon bonds given the same
maturity, but also have more potential for gain if rates fall.

Theorem #4: For a given coupon rate and maturity, the price increase from a
given reduction in yield will always exceed the price decrease from an equivalent
increase in yield. (The convexity effect)

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Copyright McGraw-Hill Ryerson Limited, 2003

Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Overview of Bond Portfolio Strategies


Generally speaking, bond portfolio management strategies can be broken down into
four groups:

I. Passive portfolio strategies

a. Buy and Hold: This involves selecting securities with the desired
characteristics (e.g., credit quality, coupon, maturity) and then not trading
them again until they mature.

b. Indexing: This is an attempt to design a portfolio of bonds that mimics a


certain index (e.g., Lehman Brothers Index). There are two approaches to
indexing: (1) full replication, in which all of the securities represented in the
index are held in their exact proportions, and (2) stratified sampling, which
divides the index into cells based upon parameters such as coupon, maturity,
country, etc. and concentrates on indexing within certain cells.
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Copyright McGraw-Hill Ryerson Limited, 2003

Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Overview of Bond Portfolio Strategies (cont.)


II. Active management strategies

The active approach to bond portfolio management involves altering the portfolio
so that the characteristics of the securities held provide the best chance of taking
advantage of the managers view of anticipated conditions in the macro economy or
with the specific security. Generally, the following types of views are employed in
practice:

a. Interest Rate Anticipation: This involves trading in and out of existing


securities based on uncertain forecasts of future interest rate conditions; for
this reason it is considered to be a risky strategy.

b. Valuation Analysis: An attempt to select bonds based on their intrinsic value


by accurately gauging the cost of the relevant characteristics (e.g., credit
quality) of the bond.

c. Credit Analysis: This involves assessing the default risk of an issuer and
trading the bond when your perception differs from that of the market.
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Copyright McGraw-Hill Ryerson Limited, 2003

Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Overview of Bond Portfolio Strategies


(cont.)
II. Active management strategies (cont.)

d. Yield Spread Analysis: A variation of interest rate anticipation, this strategy


attempts to predict when the credit spread for a certain credit class will
widen or narrow in anticipation of changing economic conditions.

e. Bond Swaps: This involves liquidating a current position and


simultaneously buying a different issue in its place with similar attributes,
but a chance for improved return. Notable examples of this approach
include pure yield pickup swaps, substitution swaps, and tax swaps.

While these transactions can involve anything from little risk (yield pickup
swaps) to great risk (rate anticipation swaps), they all are based on the
premise that it is possible to improve portfolio performance as a result of
changing market conditions.
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Copyright McGraw-Hill Ryerson Limited, 2003

Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Bond Swaps
Another type of active trade is a bond
swap. This involves liquidating a current
position and simultaneously buying a
different issue in its place with similar
attributes, but a chance of improved
returns.
Notable examples of bond swaps include:

Pure Yield Pickup Swaps: Swapping out of a


low-coupon bond into a comparable highercoupon bond to realize an automatic and
instantaneous increase in current yield and
yield to maturity.
Substitution Swaps: Swapping comparable
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Slide 13-7

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Bond Swap Example


Evaluate the following pure yield pickup
swap: You are currently holding a 20year, Aa-rated, 9.0 percent coupon bond
priced to yield 11.0 percent.
As a swap candidate, you are considering
a 20-year, Aa-rated, 11.0 percent coupon
bond priced to yield 11.5 percent
You can assume that all cash flows are
3 -Ryerson
8 Limited, 2003
reinvested
at 11.5 percent. Copyright McGraw-Hill
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Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Overview of Bond Portfolio Strategies (cont.)


III. Matched Funding Techniques

Generally, matched funding techniques are asset/liability management procedures,


whereby the bond portfolio is managed with respect to a specific set of future
liabilities.

a. Cash Matching/Dedicated: This approach designing a bond portfolio so that


it delivers cash in the exact amount and timing as it is needed to pay off a set
of liabilities. This can be done strictly or with reinvestment of excess cash
flows from prior periods to enhance returns.

b. Duration Matching/Classical Immunization: This strategy involves holding a


portfolio whose duration is equivalent to the duration of the underlying
liabilities. In this manner, it is possible to eliminate interest rate risk as that
exposures two componentsprice and reinvestment riskwill offset each
other. More detailed notes on this process are given on the following pages.

c. Horizon Matching: This is a combination of cash-matching dedication and


immunization, based on a division of the liability cash flows into two
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segments involve short- and long-term time horizons.

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Copyright McGraw-Hill Ryerson Limited, 2003

Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Overview of Bond Portfolio Strategies (cont.)


IV. Derivative-Linked & Contingent Procedures

Contingent management procedures are hybrid strategies that attempt to marry the
best practices from both passive and active strategies with the risk control
mechanisms implied by dedicated strategies.

a. Contingent Immunization: This approach combines classical immunization and


active management by accepting a lower lock in yield than prevails in the market on
the immunized portion of the portfolio in exchange for some potential upside through
active strategies.
b. Enhanced Indexing: Also called indexing plus, this strategy supplements an
indexed position with enough active position bets. An enhanced indexing strategy
hopes to exceed the total return performance of the managers designated benchmark
on a enough consistent basis to cover the costs of active management. Under this
strategy, the total return on the index becomes the minimum objective rather than the
target itself.

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Copyright McGraw-Hill Ryerson Limited, 2003

Bodie

Kane Marcus Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Overview of Bond Portfolio Strategies (cont.)


IV. Derivative-Linked & Contingent Procedures (cont.)
c. Core-Plus Management: Similar to enhanced indexing, a core-plus mandate
attempts to add performance alpha by supplementing a fairly passive approach to
managing the main fixed-income assets (i.e., the core) relative to the designated
benchmark with plus investing in sectors not covered in the benchmark. A typical
core portfolio might include government, agency, and investment-grade sectors, with
the plus sectors then including high-yield and emerging market bonds.

d.

Derivative-Linked Investing:

Derivativessuch as futures contracts, swap

agreements, or optionsare used to transform the cash flows and/or risk profile of a
plain vanilla bond offering it something other than the original structure. Although
derivatives represent a cost-effective way of implement this sort of financial reengineering, the point using derivatives in the fixed-income portfolio is usually to
create something synthetically that: (i) the manager cannot do directly, or (ii) does not
exist otherwise.

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Copyright McGraw-Hill Ryerson Limited, 2003

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