R23 fixed income portfolio management part II

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Reading 23

Fixed Income Portfolio Management – Part II

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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced

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5 Other Fixed-Income Strategies

– Combination Strategies

– Leverage

– Derivatives Enabled Strategies

6 International Bond Investing

– Active vs Passive Management

– Currency Risk

– Breakeven Spread Analysis

– Emerging Market Debt

7 Selecting a Fixed-Income Manager

– Historical Performance as a Predictor of Future Performance

– Developing Criteria for Selection

– Comparison with Selection of Equity Managers

5 Other Fixed Income Strategies

– Active/Passive Combination

– Active/Immunization Combination

– Leverage can be used to enhance portfolio returns

– Works if investment return > funding cost

– Interest rate sensitivity goes up

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Example 9 – Use of Leverage

Leverage cuts both ways…

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Borrow at 4%

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E = Amount of equity

B = Amount of borrowed funds

k = Cost of borrowing

rf = Return on invested funds

Return on borrow funds: RB = rf – k

Return on Equity: RE = rf

Return on Portfolio, Rp = rf + (B/E) x (rf – k)

Bond Portfolio = $140 mil with DA = 4

Borrowed funds = $100 mil with DL = 1

Calculate DE

DE = (DAA – DLL) / E

If portfolio has assets and liabilities, how do you calculate the duration of equity…

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Repurchase Agreements (repo or RP)

• Sale of security coupled with agreement to repurchase

• Collateralized loan with price difference representing interest

• Transfer of securities

– Physical delivery

– Credits/Debits to accounts of banks acting as clearing agents for customers

– Deliver to custodial account at seller’s bank (trustee for both parties)

– No delivery

Factors that Affect Repo Rate

5.3 Derivatives Enabled Strategies

– Factors: duration and convexity, credit, liquidity

– Interest Rate Risk

– Other Risk Measures

– Bond Variance vs Duration

– Interest Rate Futures

– Interest Rate Swaps

– Bond and Interest Rate Options

– Credit Risk Instruments

Interest Rate Risk

the dollar duration must match

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Other Risk Measures

Semi-variance measures dispersion

below target value Computationally challenging for large portfolios

If returns symmetric  no additional information

Asymmetries are difficult to forecast

Shortfall risk refers to probability of

not achieving a specified return Does not account for magnitude of losses in money terms

Value at risk (VAR) estimates loss in

money terms that might be exceeded

with a given probability

Does not indicate magnitude of worst possible outcomes

Bond Variance vs Bond Duration

– Estimated parameters increases dramatically as number of bonds

increases: n x (n + 1) / 2

– Accurately estimating variances and covariances is difficult

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Interest Rate Futures

• Interest rates up  price of deliverable bond down  futures price down

• Interest rate down 

• Buying futures contract increases portfolio duration

• Advantages of using futures contracts

– Liquidity

– Cost Effectiveness

– For duration reduction short futures contracts

• Duration management (next slide…)

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Hedging with futures contracts has some practical challenges

Outcome of hedge depends on relationship between cash prices and futures price  basis

Basis Risk: risk that basis will change in unpredictable way

Often bond to be hedged is not identical to bond underlying futures contract  cross hedging relatively high basis risk

To counter basis risk you need more futures contracts as dictated by a hedge ratio

Hedge ratio: (DHPH / DCTDPCTD) x Conversion Factor

Say we extend example 9 (prev slide) by incorporating basis risk and a hedge ratio of 1.1

Number of futures contracts needed will become 131 x 1.1 = 141

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Interest Rate Swaps

Receive-fixed position can be viewed as:

Long a fixed-rate bond + Short a floating-rate bond

Dollar Duration of Swap = Dollar duration of a fixed-rate bond – Dollar duration of floating rate bond

Interest rate swap can be used to alter cash flow characteristics of your assets or liabilities

Fixed to floating or floating to fixed

Bond and Interest Rate Options

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Duration for an option = Delta of option x Duration of underlying x (price of underlying/price of option)

You can hedge with options to protect against rise in interest rates

Buy Protective Put

Write Covered Call

Caps, floor and collars

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Credit Risk Instruments

– Credit options

– Credit forwards

– Credit swaps

Types ofCreditRisk

Credit Options offer protection against credit risk Triggering event can be based

either on:

1) Value decline of underlying asset OR

2) Spread change over a risk free rate

Binary credit options provide payoff contingent on the occurrence of a specified

negative credit event; only two possible scenarios

Example: Binary put option might pay option buyer X – V if bond rating falls below

investment grade

Credit spread options: payoff based on spread over a benchmark

Payoff function for in-the-money credit spread call option = (spread – k) x NP x

Risk Factor

Risk Factor: value change of security for one basis point change in spread

Credit Options

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Example 12 Binary Credit Option

Example 14

Binary Credit OptionCredit Spread OptionCredit Spread Forward

Credit Swaps

Credit Default Swap (CDS) is the most popular credit swap

Protection Buyer, Protection Seller, Reference Entity, Credit Event

Example 15: You are bullish on long term debt issued by countries A, B and C.

Credit event = failure to make timely payments Will you sell protection or buy protection?

A few months later, the government of Country A defaults on its debt obligations, the rating of

debt issued by Country B is lowered by Moody’s from Baa to Ba because of adverse economicdevelopments in that country, and the rating of debt issued by Country C is upgraded by Moody’sfrom Baa to A in view of favorable economic developments For each country indicate whetheryou’d suffer a loss

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6 International Bond Investing

Diversification benefit because of low correlation across international bond markets

6.1 Active vs Passive Management

Active managers seek to add value through one or more of the following means:

1) Bond market selection

2) Currency selection

3) Duration management/yield management

4) Sector selection

5) Credit analysis of issuers

6) Investing in markets outside the benchmark

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When estimating the duration of a foreign bond you should consider the country beta

Example 16

6.2 Currency Risk

Currency risk can be hedged using forward contracts

Interest Rate Parity: F = S x (1 + i ) / (1 + i)

Forward premium, f = (F – S ) / S

f is approximately = id - if

Forward hedging  use forward contracts

Proxy hedging  forward contract bet home currency and currency which is highly correlated with bond’s cur.Cross hedging  hedging using two currencies other than home currency

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Hedged return vs unhedged return

R = rl + e

HR = rl + f

HR =

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6.3 Breakeven Spread Analysis

Quantify amount of spread widening to required to diminish foreign yield advantage

Example 20

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6.4 Emerging Market Debt (EMD)

EMD has matured as an asset class and frequently appears in many strategic asset allocations

Important role in core-plus fixed income portfolios

Sovereign EM govts can react quickly to

negative economic events

Access to IMF and WB

Some EM countries have high FX

Significant negative skewnessRelatively high credit riskLess transparency

Weak legal systemPolitical risk

Credit analysis is

7 Selecting a Fixed-Income Manager

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Average institutional investor has 85% assets managed actively

When funds are not managed in-house look for a fixed income portfolio manager

Consider past performance (active return and active risk), but this should NOT be the only criteria Develop selection criteria

Comparison with Selection of Equity Managers

1) In both cases a consultant is used to identify a universe of suitable investment

managers

2) In both cases, past performance is not necessarily a guide to future results

3) Many qualitative factors are common: manager’s philosophy, experience,

competitive advantages, etc

4) Management fees and expenses are more important in fixed income because

they represent a higher percentage of returns

Example 21: Due Diligence Questionnaire for a U.S Fixed Income Portfolio