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Bond Portfolio Management StrategiesBond Portfolio Management Strategies
–Performance, Style, and Strategy–Passive Management Strategies–Active Management Strategies–Core-Plus Management Strategies–Matched-Funding Strategies–Contingent and Structured Strategies
19-2
Bond Portfolio PerformanceStyle and Strategy
Bond Portfolio PerformanceStyle and Strategy
• Bond Portfolio Performance– Fixed-income portfolios generally produce both less
return and less volatility than found in other asset classes (e.g., domestic equity, foreign equity)
– shows this in the examination of the investment performance of different long-term securities over the 21-year time horizon
– The low historical correlation between fixed-income and equity securities—Reilly and Wright (2004) calculated this to be 0.27—has made bond portfolios an excellent tool for diversifying risk
19-3
Bond Portfolio PerformanceStyle and Strategy
Bond Portfolio PerformanceStyle and Strategy
• Bond Portfolio Style– The investment style of a bond portfolio can be
summarized by its two most important characteristics: credit quality and interest rate sensitivity
– The average credit quality of the portfolio can be classified as high, medium, and low grades
– The interest rate sensitivity of the bond portfolio can be separated as short-term, intermediate-term, and long-term
19-5
Bond Portfolio PerformanceStyle and Strategy
Bond Portfolio PerformanceStyle and Strategy
• Bond Portfolio Strategies
– Passive Portfolio Strategies
– Active Management Strategies
– Core-plus Management Strategy
– Matched-funding Techniques
– Contingent Procedure (Structured Active Management)
19-7
Passive Portfolio StrategiesPassive Portfolio Strategies
• Buy and hold– A manager selects a portfolio of bonds based on
the objectives and constraints of the client with the intent of holding these bonds to maturity
– Can by modified by trading into more desirable positions
• Indexing– The objective is to construct a portfolio of bonds
that will track the performance of a bond index – Performance analysis involves examining tracking
error for differences between portfolio performance and index performance
19-8
Active Management StrategiesActive Management Strategies
• Active management strategies attempt to beat the market
• Mostly the success or failure is going to come from the ability to accurately forecast future interest rates
• Active Strategy Attributes – Scalability – Sustainability – Risk-adjusted performance– Extreme values
19-10
Active Management StrategiesActive Management Strategies
• Interest-rate anticipation– Risky strategy relying on uncertain forecasts– Ladder strategy staggers maturities– Barbell strategy splits funds between short duration
and long duration securities
• Valuation analysis– The portfolio manager attempts to select bonds
based on their intrinsic value
• Credit analysis– Involves detailed analysis of the bond issuer to
determine expected changes in its default risk – See Exhibit 19.6
19-12
Active Management StrategiesActive Management Strategies
• High-Yield Bond Research– Several investment houses such as Merrill Lynch,
First Boston, Lehman Brothers, etc., have developed specialized high-yield groups that examine high-yield bond issues and monitor high-yield bond spreads
• Yield spread analysis– Assumes normal relationships exist between the
yields for bonds in alternative sectors
• Bond swaps– Involve liquidating a current position and
simultaneously buying a different issue in its place with similar attributes but having a chance for improved return
19-13
• Bond Swaps Types– Pure yield pickup swap
• Swapping low-coupon bonds into higher coupon bonds
– Substitution swap• Swapping a seemingly identical bond for one that is
currently thought to be undervalued
– Tax swap• Swap in order to manage tax liability (taxable & munis)
– Swap strategies and market-efficiency• Bond swaps by their nature suggest market
inefficiency
Active Management StrategiesActive Management Strategies
19-14
Active Global Bond InvestingActive Global Bond Investing
• An active approach to global fixed-income management must consider the following three interrelated factors
– The local economy in each country including the effects of domestic and international demand
– The impact of total demand and domestic monetary policy on inflation and interest rates
– The effect of the economy, inflation, and interest rates on the exchange rates among countries
19-15
Core-Plus Management StrategiesCore-Plus Management Strategies
• A combination of passive and active styles ( a form of enhanced indexing)
• A large, significant part of the portfolio is passively managed in one of two sectors:
– The U.S. aggregate sector, which includes mortgage-backed and asset-backed securities
– The U.S. Government/Corporate sector alone
• The rest of the portfolio is actively managed– Often focused on high yield bonds, foreign bonds,
emerging market debt– Diversification effects help to manage risks
19-16
Matched-Funding StrategiesMatched-Funding Strategies
• Dedicated Portfolios– Designing portfolios that will service liabilities– Exact cash match
• Conservative strategy, matching portfolio cash flows to needs for cash
• Useful for sinking funds and maturing principal payments
– Dedication with reinvestment• Does not require exact cash flow match with liability
stream
• Great choices, flexibility can aid in generating higher returns with lower costs
19-17
Matched-Funding TechniquesMatched-Funding Techniques
• Immunization Strategies– The process is intended to eliminate interest rate
risk that includes:• Price Risk
• Coupon Reinvestment Risk
– A portfolio manager (after client consultation) may decide that the optimal strategy is to immunize the portfolio from interest rate changes
– The immunization techniques attempt to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates
19-18
Matched-Funding TechniquesMatched-Funding Techniques
• Classical Immunization – Immunize a portfolio from interest rate risk by
keeping the portfolio duration equal to the investment horizon
– Duration strategy superior to a strategy based only a maturity since duration considers both sources of interest rate risk
– An immunized portfolio requires frequent rebalancing because the modified duration of the portfolio always should be equal to the remaining time horizon
19-19
Matched-Funding TechniquesMatched-Funding Techniques
• Difficulties in Maintaining Immunization Strategy
– Rebalancing required as duration declines more slowly than term to maturity
– Modified duration changes with a change in market interest rates
– Yield curves shift
19-20
Matched-Funding TechniquesMatched-Funding Techniques
• Horizon matching – Combination of cash-matching dedication and
immunization
– Important decision is the length of the horizon period
– With multiple cash needs over specified time periods, can duration-match for the time periods, while cash-matching within each time period
– See Exhibit 19.17
19-22
Contingent and Structured StrategiesContingent and Structured Strategies
• Contingent procedures for managing bond portfolios are a form of what has come to be called structured active management
• Contingent Immunization – Duration of portfolio must be maintained at the
horizon value– Cushion spread is potential return below the
current market return– Safety margin is a portfolio value above the
required value– Trigger point refers to the minimum return that will
stop active portfolio management