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

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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

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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

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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.

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Yield Spread Strategies

Credit spread

Spreads between callable and noncallable securities

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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

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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)

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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

Fin431x (Ch 19&20) 21

Exercises – Ch19 and 20

1. Problem 7, ch19 – (a) 288.74, (b) backward-looking, (c) enhanced indexing

2. Problem 15, ch19 – (a) II, (b) I, (c) the one having greater convexity, (d) don’t worry about it.

3. Problem 7, ch20