fixed income portfolio strategies

7/27/2019 Fixed Income Portfolio Strategies

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Lecture 14

Fixed Income Portfolio Strategies


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JOTD (joke of the day)

A mathematician, an accountant and an economist applyfor the same job.

The interviewer calls in the mathematician and asks "Whatdo two plus two equal?" The mathematician replies "Four."The interviewer asks "Four, exactly?" The mathematicianlooks at the interviewer incredulously and says "Yes,four, exactly."

Then the interviewer calls in the accountant and asks thesame question "What do two plus two equal?" The accountantsays "On average, four - give or take ten percent, but onaverage, four."

Then the interviewer calls in the economist and poses thesame question "What do two plus two equal?" The economistgets up, locks the door, closes the shade, sits down nextto the interviewer and says "What do you want it toequal?"


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VSE Assignment 1

Reading about earnings announcementsand economic announcements.

Earnings = specific to stock

Econ = applies to whole economy but mayeffect stocks differently


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Alternative Bond PortfolioStrategies

1. Passive portfolio strategies

2. Active management strategies

3. Matched-funding techniques


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Passive Portfolio Strategies

Buy and hold

Buy a portfolio of bonds and hold them to maturity

Can by modified by trading into more desirable

positions Indexing

Match performance of a selected bond index

Performance analysis involves examining tracking

error for differences between portfolio performanceand index performance


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Active Management Strategies

Active managementstrategies attempt tobeat the market

Mostly the success orfailure is going tocome from the abilityto accurately forecast

future interest rates


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Interest-rate anticipation Risky strategy relying on uncertain forecasts of future interest rates,

adjusting portfolio duration Ladder strategy staggers maturities Barbell strategy splits funds between short duration and long duration

securities

Credit analysis Detailed analysis of the bond issuer Determines expected changes in default risk Try to predict rating changes and trade accordingly

Buy bonds with expected upgrades Sell bonds with expected downgrades

Yield-spread analysis

Monitor spreads within and across sectors, bond ratings, or industries Trade in anticipation of changing spreads

Bond swaps Selling one bond (S) and purchasing another (P) simultaneously Swaps to increase current yield or YTM, take advantage of shifts in interest

rates or realignment of yield spreads, improve quality of portfolio, or for taxpurposes


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Bond Swaps

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


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Bond/Interest rate Strategies

Ladders, Barbells, and BulletsLadders: Bonds matureat different times andyou continually reinvestthem.

Barbells: Sets of bondsmature in the long termand short term, but notthe mid term.

Bullets: Bonds, investedat different times, havethe same target maturitydate.


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Ladders and Barbells

Income - The periodic return of principal provides theinvestor with additional income beyond the set interestpayments

Flexibility - The income derived from principal andinterest payments can either be directed back into thefund if interest rates are relatively high or investedelsewhere if they are relatively low

Interest rate volatility is reduced because the investornow determines the best investment option every fewyears, as each bond matures

Investors should be aware that laddering can requirecommitment of assets over time, and return of principalat time of redemption is not guaranteed


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Benefits

Ladder Increases and declines ininterest rates average over the businesscycle

Barbell For when short term interestrates are rising and long term steady orfalling. ST bonds can be reinvested else

where if conditions change. Bullet matching a liability or horizon


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Matched-Funding Strategies

Many immunizationstrategies aredesigned to take the

sting out of risinginterest rates for abond portfolio!


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Matched-Funding Techniques

Classical (pure) immunization strategiesattempt to earn a specified rate of returnregardless of changes in interest rates Must balance the components of interest rate risk

Price risk: problem with rising interest rates

Reinvestment risk: problem with falling interest rates

Set Duration equal to investment horizon


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Growth of Invested Funds


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Example

Fund a $1M liability 4 years from nowusing a 2 year zero and a perpetuity

(perp)


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Dedicated portfolios to service liabilities

Different types: Exact cash match

Dedication with reinvestment

Exact Cash Match


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Horizon matching

Combination of cash-matching andimmunization

With multiple cash needs over specified timeperiods, can duration-match for the timeperiods, while cash-matching within each time

period


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Contingent Immunization

Allow the managers to actively manageuntil the bond portfolio falls to a thresholdlevel

Once the threshold value is hit themanager must then immunize the portfolio

Active with a floor loss level


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gure - on ngenImmunization


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Term Structure of Interest Rates

Relationship between yields to maturityand maturity

Yield curve - a graph of the yields on

bonds relative to the number of years tomaturity

Usually Measured with Treasury Bonds

Have to be similar risk or other factorswould be influencing yields


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Theories of Term Structure

Expectations Long term rates are a function of expected future

short term rates

Upward slope means that the market is expecting

higher future short term rates Downward slope means that the market is expecting

lower future short term rates

Liquidity Preference

Upward bias over expectations The observed long-term rate includes a risk premium


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Figure 9.12 Returns to Two 2-yearInvestment Strategies


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Forward Rates Impliedin the Yield Curve

)1301.1()11.1()12.1(

)1()1()1(12

1

1

=

-= +++

-

fyy nnnnn

For example, using a 1-yr and 2-yr rates

Longer term rate, y(n) = 12%

Shorter term rate, y(n-1) = 11%

Forward rate, a one-year rate in one year = 13.01%


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Figure 9.13 Illustrative YieldCurves


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Figure 9-11 Yield Curves


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Figure 9.14 Term Spread


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Thank You..

fixed income portfolio strategies

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