Schweser QBank 201702 relative value methodolog bond portfolio management

If a bear bond market is expected, buy callable bonds instead of bullets.. Explanation Callable bonds generally outperform bullets in a bear bond market because the probability of a call

Question #1 of 40 Question ID: 466066

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Questions #3-8 of 40

Relative-Value Methodologies for Global Credit Bond Portfolio

Management

Test ID: 7428059

Which of the following strategies would normally result in the best bond performance?

Buy callable bonds rather than bullets, if a strong bullish bond market is

expected

If a bear bond market is expected, buy callable bonds instead of bullets

Buy callable bonds when interest rates decline

Explanation

Callable bonds generally outperform bullets in a bear bond market because the probability of a call is reduced As interest rates increase, the value of the embedded option decreases, with a resultant decrease in the differential yield between callable and noncallable bonds In a bull bond market the call option acts as a resistance point limiting the price appreciation of callable bonds

Marketability

Efficiency

Liquidity

Explanation

Liquidity is the ability to buy or sell quickly at a fair price

Edward Justice, CFA, is an analyst for Sierra Funds (Sierra) Justice is investigating the use of relative value methodologies for global corporate bond portfolio management and needs assistance from several Sierra Fund managers and traders He explains that relative value analysis involves comparing bonds and bond portfolios on characteristics such as sector, issue, and structure He adds that firms may use a top-down or a bottom-up approach to the analysis Sierra prefers a top-down approach

Sierra manages an employee pension fund for Ice Dreams, Inc (Ice Dreams) Sierra has been doing very little trading in Ice Dreams' account and has avoided specific structures and foreign bonds entirely Due to a recent increase in interest rates, there are several accounting losses in the portfolio at this time Sierra traders have been getting conflicting advice from buy side and sell side analysts and at this point are unsure of the optimal trading strategies for the pension fund Justin James, a Sierra trader, believes that it is a great time to trade He suggests that trading out of telecommunications industy bonds and into pharmaceutical industry bonds may enhance returns in the Ice Dreams portfolio He also believes that insurance industry bonds will see a ratings upgrade in the near future and is contemplating shifting a portion of the portfolio into insurance industry bonds

Question #3 of 40 Question ID: 466082

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Bond manager Mike Steere is interested in the implications of issues such as changes in dominant product structure and new issue supply for fixed-income portfolio managers In an attempt to understand these issues, he asks Justice several questions

He is specifically interested in the implications of cyclical and secular changes for fixed-income portfolio managers

Dan Baker is interested in the terminology related to different yield spreads He states that swap spreads are the difference in the fixed and floating rates in a swap Ashley Carlton, a Baker colleague at Sierra adds "the option adjusted spread is the spread on corporate securities after removing any embedded options when comparing them to mortgage-backed and U.S Agency issues."

Alexis Jones, a Sierra Funds bond trader is considering the following swap deal

On January 1, 2001, TTT Corporate 7.0s of 2006 traded at a bid side price of 120 basis points over the 5-year U.S Treasury yield of 6.20% at a time when LIBOR was 5.90%

On the same day, 5-year LIBOR-based swap spreads were at 100 basis points (to the U.S Treasury)

Assume that a bond manager bought the TTT issue and simultaneously enters into this 5-year swap

Jones indicates that a key advantage of the swaps spread framework for evaluating corporate bond purchases is "the

applicability of swap spreads across the quality spectrum." William Greavey adds that another key advantage of the framework

is "the convergence to a single spread standard derived from swap spreads " Both Jones and Greavey believe that the swaps spread framework is an important tool for traders and analysts alike when evaluating corporate bonds

Regarding yield spreads, Carlton and Baker are, respectively:

correct; incorrect

incorrect; correct

incorrect; incorrect

Explanation

Carlton is correct about the OAS and Baker is incorrect regarding the swap spread A swap spread is the spread paid by the fixed-rate payer over the rate on the on-the-run Treasury with the same maturity as the swap The option adjusted spread is the effective spread for the class after removing any embedded options (Study Session 9, LOS 21.e)

In answer to Steere's queries, Justice is most likely to indicate that all of the following are implications of both cyclical and secular changes in the corporate bond market EXCEPT:

asset/liability managers with long horizons may be willing to pay a premium for

long-term bonds

effective duration and aggregate interest-rate risk sensitivity will increase

securities with embedded options will command a premium price due to their scarcity

value

Explanation

Secular changes show that bullet and intermediate structures dominate the corporate bond market Implications associated with these product structures:

Securities with embedded options will command a premium price due to their scarcity value

Question #5 of 40 Question ID: 466084

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The percentage of long-term issues will decline Thus, effective duration and aggregate interest-rate risk sensitivity will decline Asset/liability managers with long horizons may be willing to pay a premium for long-term bonds

Credit-based derivatives will become increasingly used to achieve desired exposure to credit sectors, issuers, and

structures

(Study Session 9, LOS 21.b)

Regarding a swaps framework to evaluate corporate bond purchases, Jones and Greavey are, respectively:

correct; correct

correct; incorrect

incorrect; correct

Explanation

Jones is incorrect and Greavey is correct Many market practitioners expect a worldwide convergence to a single spread standard derived from swap spreads Swap spreads facilitate the comparison of securities across fixed-rate and floating-rate markets, particularly for investment-grade securities On the negative side, individual investors may not understand swap spreads and they are not applicable across the entire quality spectrum (Study Session 9, LOS 21.e)

In the trade Jones is considering, the fixed rate corporate bond's spread over LIBOR would be closest to:

20 basis points

10 basis points

50 basis points

Explanation

The fixed rate corporate bond's spread over LIBOR would be:

Receive from BSC (6.20% + 120 bp) 7.40%

- pay on swap (6.20% + 100 bp) 7.20%

+ receive from swap LIBOR

(Study Session 9, LOS 21.e)

Justice is contemplating the differences between callable bond and bullet bond strategies Which of the following statements does NOT accurately describe the relationship between callable bonds and bullet strategies? Callables:

outperform bullets when rates increase due to positive convexity

outperform bullets in bear bond markets because the probability of an early call

diminishes

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do not fully participate when bond markets rally due to the "resistance" level set by the

call price

Explanation

Callable bonds:

Underperform bullets when rates decline due to their negative convexity

Do not fully participate when bond markets rally due to the "resistance" level set by the call price

Outperform bullets in bear bond markets because the probability of an early call diminishes

(Study Session 9, LOS 21.e)

James' trading strategies regarding telecommunications and pharmaceutical industry bonds, and with respect to insurance industry bonds are, respectively:

yield/spread pickup trades; credit upside trades

structure trades; credit defense trades

sector rotation trades; credit upside trades

Explanation

The first trade that James describes, swapping out of telecommunications bonds and into pharmaceutical bonds because of a belief that the pharmaceutical bonds will perform better, is known as a sector rotation trade Expecting insurance company bonds to be upgraded, and trading on that expectation, is known as a credit-upside trade (Study Session 9, LOS 21.d)

Which of the following statements about the rationale for trading in the secondary bond market is least accurate?

The popularity of credit-defense trades is not related to expected levels of

economic uncertainty

The reason to engage in a sector-rotation trade is to shift out of a sector that is

expected to underperform on a total return basis, and buy into a sector that is

expected to outperform in total return

Altering the duration of a portfolio because of anticipated yield curve changes is

labeled a curve adjustment trade

Explanation

Credit-defense trades result from a bond manager's desire to reduce the portfolio's exposure to expected credit downgrades

As such, during periods of anticipated economic uncertainty, credit-defense trades normally increase

Which of the following statements about swaps is CORRECT?

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In the European market, swap spreads serve as a good proxy for credit

spreads

A swap spread is the spread paid by the fixed-rate payer over the seasoned Treasury

rate

A swap spread refers to the difference in yield between corporate issues of different

quality ratings

Explanation

It is because of the relative homogeneity of the European bond market that swap spreads are a good proxy for credit spreads European issues are generally high in quality and intermediate in maturity Swap spreads involve the on-the-run Treasury rate, not seasoned issues

Which of the following statements about bullet maturity bonds is CORRECT?

A majority of bullet maturity bonds have sinking funds

Bullet and intermediate structures are currently dominant in all but the high yield

segment of the corporate bond market

A call feature is an integral part of a bullet maturity bond

Explanation

Bullet and intermediate structures currently dominate all but the high yield segment of the corporate bond market Bullet maturities cannot be callable, putable, or have sinking funds

With regard to credit analysis, the quality of collateral and the servicer are most relevant to which types of securities?

Corporate securities

Asset-backed securities

Municipal securities

Explanation

The quality of collateral and the servicer is most relevant to the analysis of asset-backed securities

Which of the following statements about spread analysis is CORRECT?

Using quality-spread analysis, a bond portfolio manager would buy an issue

that has a wider spread than what is justified by its intrinsic value

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Percentage yield analysis uses the ratio between corporate bond yields and

government yields and is the only spread analysis that is based on maturity rather

than duration

With quality-spread analysis, one risk when purchasing a security is the spread

differential narrowing during the holding period

Explanation

If an issue trades at a spread that is (believed by the manager to be) higher than is warranted by its intrinsic value, the expectation is that this spread will decrease over time as this fact becomes understood by the market The risk is that the manager has misjudged the quality of the issue, and that the spread could remain high or even widen further

The capacity of corporate issuers to support cash flows needs

Global economic and political instability

The expansion in the universe of global bonds

Explanation

In order to be effective, managers must establish and support an effective credit analysis system within their managerial domains to assure that appropriate information is available to make the best possible choices This is becoming increasingly difficult as the global bond universe expands

Which of the following statements about classic relative-value analysis is least accurate?

The analytical process has substantially changed due to the recent increases

in the amount of available information and technology

Sector, issuer, and structural analysis are the core of relative-value analysis

Classic relative-value analysis only uses a top-down micro type approach

Explanation

Both the top-down and bottom-up approaches are used with classic relative-value analysis

Expectations that an issue will experience a quality upgrade that is not already reflected in the current spread could result in which type of trade?

Credit-upside

Credit defense

Sector rotation

Question #17 of 40 Question ID: 466078

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Explanation

A credit-upside trade is motivated by a bond portfolio manager's expectation that an issuer will experience a credit upgrade, and belief that this is not already reflected in the market value of the issue

Which of the following comments about relative-value analysis is least accurate?

Relative-value analysis is used to rank issues in terms of their expected

performance based upon total returns

Relative-value analysis is consistent with the concept that bond markets are efficient

Relative-value analysis gives bond portfolio managers an analytical structure that

allows them to develop a strategic perspective on the global corporate market

Explanation

If bond markets were perfectly efficient then relative-value analysis would not lead to superior returns on a consistent basis

For the management of a fixed-income portfolio, which of the following is an important implication of the increasing supply of corporate bonds within the last decade?

The average bond duration has increased

Portfolio managers have more ways to satisfy their risk and return objectives

The relative performance of corporate bonds has decreased

Explanation

Greater supply means more issues from which managers can choose The greater the number of issues provides managers with more opportunities to select securities that match their investment objectives, whether that be to fund some liability stream, or attempt to outperform some benchmark return

In classic relative-value analysis the top-down approach refers to:

looking for undervalued assets and ranking them from most to least

undervalued

ranking the holdings in a corporate bond portfolio according to the relative market

value of each asset class, beginning with the highest value

using large-scale economic information to allocate funds to various corporate asset

classes

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Explanation

Large scale (i.e macro) economic information concerns data such as inflation, interest rate changes, and the level and direction of the overall economy (both domestic and foreign) Top-down analysis seeks to allocate funds to those issues that would benefit the most from the expected large-scale economic changes/trends

Which of the following statements about bond markets is least accurate?

Although duration tilts can be accomplished with corporate bonds, many bond

managers prefer the use of Treasuries to play the yield curve

Qualitative issues that differentiate the management of an international bond portfolio

versus a purely domestic one, include, differences in time zones and differences in

market structure and conventions

Technological advancements, together with increased competition among corporate

bond traders, will lead to less liquid global corporate bond markets because the

number of issues available will not increase at a fast enough pace to keep up with the

increased level of demand

Explanation

Liquidity will most likely increase in the future because technological advances in trading systems and communication of information, together with greater competition among bond traders, will lead to higher volumes of bond trading, an important element in liquidity

A bond manager deciding against making an otherwise desired secondary transaction because of a desire to minimize portfolio turnover is most likely an example of what type of portfolio constraint?

Buy and Hold

Seasonality

Exposure Limits

Explanation

A disposition toward lower trading volume can lead to buy-and-hold behavior

Which of the following market conditions would suggest the use of callable bond structures in a corporate bond portfolio?

Bear bond market

Increasing interest rate volatility and a bull bond market

Bull bond market

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Explanation

In a bear bond market interest rates are increasing causing bond values to decrease thus the probability of an early call decreases Callable bonds are issued with a higher coupon rate as compared to noncallable bonds to compensate the purchaser for the probability of the bond being called In a rising interest rate environment callable bonds will not fall in price as much as a comparable option free bond due to the negative convexity of the callable bond in the callable region of the bond Thus, if portfolio managers expect interest rates to increase, they should buy callable structures instead of option-free bonds in order to capture the higher return of the callable bond since it will not fall in value as much as the non-callable bond

Which of the following is the major emphasis of the bottom-up approach of classic relative-value analysis? Identifying:

individual issues that are expected to outperform their peer groups

high-convexity issues

optimal allocations to individual issuers

Explanation

Bottom-up approaches focus on security by security analyses in the attempt to find those individual issues expected to outperform others

Which of the following is the best rationale for purchasing an issue in the secondary market?

Increasing credit risk for a particular bond

Expectations of an upgrade in an issuer's credit quality

High-default rates in a particular sector

Explanation

An upgrade in credit quality will result in less credit-premium demanded by investors Since discount rates and prices move in opposite directions for bonds, credit upgrades will result in an increase in price that will generate a greater total return from the investment

Treasury issues

private placements

large-sized issues

Explanation

Many investors are willing to give up additional return in exchange for greater liquidity Private placement issues typically have

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relatively low liquidity

With mean-reversion analysis:

if the current yield spread is greater than the historic mean, the market value of

the security will be higher than if the spread were negligible

statistical tools cannot be utilized to determine if the yield spread is significantly

different from the historical mean

if the current spread of a sector or issue is significantly greater than the historical

mean spread, then buy the sector or issue

Explanation

Mean-reversion analysis is the most used tool for the analysis of spreads between individual issues and across industry sectors and assumes that spreads will revert to their historic means If a current spread is greater than its historic mean, then

as the issue reverts to its mean, its yield will decline and its market value will therefore increase

Which of the following tools is thought to suffer from methodological deficiencies thereby rendering it inaccurate, and

therefore, of little use?

Percentage yield spread analysis

Structural analysis

Mean-reversion analysis

Explanation

Percentage yield spread analysis uses the ratio of yields of corporate to government issues of similar duration However, as so many other factors such as supply and demand, profitability, and liquidity have an effect on corporate yields, this analysis has little usefulness

In terms of a long-term investor, which of the following is a potential criticism of not investing in securities with low liquidity? These securities:

are less risky

have to provide higher returns as a compensation for low liquidity

offer arbitrage opportunities more frequently

Explanation

Less liquid securities must provide a liquidity premium to compensate for the low liquidity