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Fin431x (Ch 19&20) 1
Bond Portfolio Management
1. Five steps in investment management process
2. Tracking Errors
3. Active Portfolio Strategies
4. Use of Leverage
5. Indexing
Fin431x (Ch 19&20) 2
Five Steps in Investment Management
Setting investment objectives
Establishing Investment Policy
(in cash equivalent, equities, fixed-income, real estate)
Select a portfolio strategy
(active, structured, or indexing)
Select assets
Measuring and evaluating performance (ch22)
Fin431x (Ch 19&20) 3
Tracking Error
The standard deviation of the return of the portfolio relative to the return of the benchmark index.
(example on pages 416-417)
• Calculate monthly or weekly tracking error
• Annualize it
Fin431x (Ch 19&20) 4
Two Types of Tracking ErrorBackward-looking (ex-post) tracking error:
tracking error calculated from observed active returns for a portfolio
Forward-looking (ex-ante) tracking error: tracking errors associated with bond market index based on multi-factor models – setting an appropriate benchmark
Fin431x (Ch 19&20) 5
Risk Factors
Systematic risk factors
• Term structure risk factors
• Non-term structure risk factors
Non-systematic risk factors
• Issuer specific
• Issue specific
Fin431x (Ch 19&20) 6
Active Portfolio Strategies
Interest-rate expectations strategies
Yield Curve Strategies
Yield Spread Strategies
Individual Security Selection Strategies
Strategies for Asset Allocation within Bond Sectors
Fin431x (Ch 19&20) 7
Interest-rate Expectations Strategies
Increase or decrease duration
increase duration when expected interest goes down
decrease duration when expected interest goes up
Approach: Rate anticipation swaps
Gambling incentive – make an interest bet to cover inferior performance relative to a benchmark index.
Fin431x (Ch 19&20) 8
Yield Curve Strategy
Seek to capitalize on expectations based on short-term movements in yields; make profit from the change of yield curve in the portfolio
Key: if your investment horizon is 1 year, what strategy you want to take, put all your money in 1-year bonds or 30-year bonds
Fin431x (Ch 19&20) 9
Strategies
• Bullet strategy (see page 428)• Barbell strategy• Ladder strategy
To see which strategy to implement, investors need look at the impact of the strategy on the total return of the portfolio
Exhibit 19-8 on page 431 compares the relative performance of a bullet portfolio and a barbell portfolio
• One factor driving the difference in portfolio performance is the difference in their convexity.
Fin431x (Ch 19&20) 10
Yield Spread Strategies
Involve positioning a portfolio to capitalize on expected changes in yield spreads between sectors of the bond market.
Swapping one bond for another when manager believes that the prevailing yield spread between the two bonds in the market is out of line with their historical yield spread.
Fin431x (Ch 19&20) 11
Yield Spread Strategies
Credit spread
Spreads between callable and noncallable securities
Fin431x (Ch 19&20) 12
Individual Security Selection Strategy
Identify mis-priced securities
(1) Its yield is higher than that of comparably rated issues
(2) Its yield is expected to decline because credit analysis indicates that its rating will improve
To implement this strategy: swap.
Fin431x (Ch 19&20) 13
Use of Leverage
A portfolio in which a manager has created leverage.
If return from investing the amount borrowed exceed cost of funding.
Leveraging trades will generate a return needed to make the investment attractive to traders.
Fin431x (Ch 19&20) 14
Create Leverage with Repo
Repurchase agreement: sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date.
Repurchase price
Repurchase date
Repo rate
Overnight repo versus term repo
Fin431x (Ch 19&20) 15
Example
A dealer delivers (sells) $10 million of treasury security to a customer and buy it back in to the next day. Repo rate is 6.5%. (dealer is financing a long position) (page 441)
What is amount borrowed by the dealer?What is the dollar interest
Jargons: (1) reversing out securities, (2) reversing in securities – page 442
Fin431x (Ch 19&20) 16
Indexing
Designing a portfolio so that its performance will match the performance of some bond index
Benefits and costs• Low management fee and expenses• Straightforward and easy to evaluate• Basis risk between indexing and matching to
liabilities
Fin431x (Ch 19&20) 17
Factors Affecting Index Selection
Level of Risk Tolerance
Investor’s objective• Difference in variability
• Nonsymmetry in rising and falling markets
Fin431x (Ch 19&20) 18
Alternative Indexes
1. Lehman Brothers U.S. Aggregate Bond Index
2. Salomon Smith Barney (SSB) Broad Investment-grade Bond Index (BIG)
3. Merrill Lynch Domestic Market Index
Exhibit 20-2, sector breakdown of Lehman Brother index
Fin431x (Ch 19&20) 19
How to Create an Indexed Portfolio
Tracking error: the discrepancy between the performance of the indexed portfolio and the index
The tradeoff between transaction costs and mismatching of the characteristics of the indexed portfolio and the index.
Have logistic problem (see pages 457, 458)
Fin431x (Ch 19&20) 20
Specific Approaches
Stratified sampling approach • Based on characteristics (page 456)
Optimization approach• Jointly consider characteristics and fund
objectives
Tracking error minimization using multifactor model
Enhanced indexing: adding active portfolio management in indexing
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