investment analysis and portfolio management first canadian edition

Investment Analysis and Portfolio Investment Analysis and Portfolio ManagementManagement

First Canadian EditionFirst Canadian EditionBy Reilly, Brown, Hedges, ChangBy Reilly, Brown, Hedges, Chang1616

Copyright © 2010 by Nelson Education Ltd. 16-2

•Bond Portfolio Performance, Style, and Strategy

•Passive Management Strategies•Active Management Strategies•Core-Plus Management Strategies•Matched-Funding Strategies•Contingent and Structured Strategies

Chapter 16 Bond Portfolio Management Strategies


Bond Portfolio Performance, Style, and Strategy

• Fixed-income portfolios generally produce both less return and less volatility than found in other asset classes (e.g., domestic equity, foreign equity)

• 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


• Investment style of a bond portfolio can be summarized by two important characteristics: • credit quality • interest rate sensitivity

• Average credit quality of the portfolio can be classified as high, medium, and low grades

• Interest rate sensitivity of the bond portfolio can be separated as:• short-term• intermediate-term• long-term



• Bond Portfolio Strategies (Exhibit 16.3)• Passive Portfolio Strategies• Active Management Strategies• Core-plus Management Strategy• Matched-funding Techniques• Contingent Procedure (Structured Active

Management)



Passive Management 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

Passive 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

Active 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• 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



• Credit Analysis Models• High-Yield Bond Research• Modified Z-score model• Exhibit 16.7, p. 503

• Yield spread analysis• Assumes normal relationships exist between the

yields for bonds in alternative sectors (Chapter 12)• Active Bond Transactions

• Pure Yield Pickup Swap• Substitution Swap


Active Global Bond Investing

• An active approach to global fixed-income management must consider the following three interrelated factors:• Local economy in each country including the

effects of domestic and international demand• Impact of total demand and domestic monetary

policy on inflation and interest rates• Effect of the economy, inflation, and interest

rates on the exchange rates among countries


Core-Plus Management Strategies

• Combination of passive and active styles (a form of enhanced indexing)

• Large part of the portfolio is passively managed in one of two sectors:• U.S. aggregate sector, which includes mortgage-backed and

asset-backed securities• U.S. Government/corporate sector alone

• Rest of the portfolio is actively managed• Often focused on high yield bonds, foreign bonds, emerging

market debt• Diversification effects help to manage risks


Matched-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


Matched-Funding Strategies

• Immunization Strategies• Process is intended to eliminate interest rate risk that includes:

• Price Risk• Coupon Reinvestment Risk

• Portfolio manager (after client consultation) may decide that the optimal strategy is to immunize the portfolio from interest rate changes

• Immunization techniques attempt to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates


Matched Funding Strategies

• 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


Matched Funding Strategies

• 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



• 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


Contingent & 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

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