CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r21 introduction to fixed income portfolio management IFT notes

ROLES OF FIXED-INCOME SECURITIES IN PORTFOLIOS Fixed-income securities play different important roles in investment portfolios, including diversification, regular cash flows, and possib

Introduction to Fixed-Income Portfolio Management

1 Introduction 2

2 Roles of Fixed-Income Securities in Portfolios 2

2.1 Diversification Benefits 2

2.2 Benefits of Regular Cash Flows 3

2.3 Inflation Hedging Potential 3

3 Fixed-Income Mandates 4

3.1 Liability-Based Mandates 4

3.1.1 Cash Flow Matching 4

3.1.2 Duration Matching 5

3.1.3 Contingent Immunization 6

3.1.4 Horizon Matching 6

3.2 Total Return Mandates 7

3.2.1 Pure Indexing 7

3.2.2 Enhanced Indexing 8

3.2.3 Active Management 8

4 Bond Market Liquidity 9

4.1 Liquidity among Bond Market Sub-Sectors 10

4.2 The Effects of Liquidity on Fixed-Income Portfolio Management 10

4.2.1 Pricing 10

4.2.2 Portfolio Construction 11

4.2.3 Alternatives to Direct Investment in Bonds 11

5 A Model for Fixed-Income Returns 11

5.1 Decomposing Expected Returns 12

5.2 Estimation of the Inputs 13

5.3 Limitations of the Expected Return Decomposition 13

6 Leverage 13

6.1 Using Leverage 13

6.2 Methods for Leveraging Fixed-Income Portfolios 14

6.2.1 Futures Contracts 14

6.2.2 Swap Agreements 14

6.2.3 Structured Financial Instruments 15

6.2.4 Repurchase Agreements 15

6.2.5 Securities Lending 16

6.3 Risks of Leverage 17

7 Fixed-Income Portfolio Taxation 17

7.1 Principles of Fixed-Income Taxation 17

7.2 Investment Vehicles and Taxes 18

Summary from the Curriculum 19

Examples from the Curriculum 22

Example 1 Adding Fixed-Income Securities to a Portfolio 22

Example 2 Liability-Based Mandates (1) 23

Example 3 Liability-Based Mandates (2) 23

Example 4 The Characteristics of Different Total Return Approaches 23

Example 5 Decomposing Expected Returns 25

Example 6 Components of Expected Return 27

Example 7 Managing Taxable and Tax-Exempt Portfolios 27

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This section addresses LO.a:

LO.a: discuss roles of fixed-income securities in portfolios;

2 ROLES OF FIXED-INCOME SECURITIES IN PORTFOLIOS

Fixed-income securities play different important roles in investment portfolios, including diversification, regular cash flows, and possible inflation hedging

2.1 Diversification Benefits

In general, fixed-income securities have low correlation with other asset classes (including equity securities, real estate, and commodities); hence, adding fixed-income securities to portfolios provide diversification benefits Refer to the table below There are various fixed income indexes and other asset classes, i.e., US S&P500 (which represents US equity) If we take Bloomberg Barclays US Aggregate (representing an overall index for US bonds), its correlation with S&P500 is -0.27

Source: Authors’ calculations for the period January 2003 to September 2015, based on data from

Barclays Risk Analytics and Index Solutions; J.P Morgan Index Research; S&P Dow Jones Indices

However, it is important to note that these correlations are not constant over time The correlation

between the asset classes may increase or decrease, depending on the circumstances and capital

market dynamics For example, during periods of market stress, the correlation between riskier assets

such as equity securities and high-yield bonds may increase while at the same time, the correlation between government bonds and equity securities, as well as between government bonds and high-yield bonds may decrease

Besides having a lower correlation with other asset classes, bonds are generally less volatile than other major asset classes and thus help in reducing the overall risk of a portfolio Like correlation, volatility (standard deviation) of asset class returns may also vary over time For example, if interest rate volatility increases, the near-term volatility of returns tends to increase relative to the average volatility over a long historical period Similarly, lower credit quality (high-yield) bonds may exhibit higher volatility of returns during times of financial stress, because a decline in credit quality leads to increase in the

probability of default

2.2 Benefits of Regular Cash Flows

Fixed-income investments play another important role in investment in the form of regular cash flows Regular and predictable cash flows help investors in meeting their known future obligations such as tuition payments, pension obligations, or payouts on life insurance policies Investors can select fixed-income securities whose timing and magnitude of cash flows match the timing and magnitude of the projected future liabilities For example, a 10-year coupon paying bond can be used to cover an

investor’s living expenses over a 10-year horizon Sometimes, investors may create “ladder” bond

portfolios which comprise bonds of different maturities Ladder portfolios help investors in balancing price and reinvestment risk

Regular cash flows benefit relies on the assumption that no credit event (such as an issuer defaulting on scheduled interest or principal payment) or other market events (such as a decrease in interest rates increasing prepayments of mortgages underlying mortgage-backed securities) will occur

2.3 Inflation Hedging Potential

Bonds with floating-rate coupons provide a hedge against inflation because the reference rate is

adjusted for inflation However, the principal payment at maturity is unadjusted for inflation linked bonds provide inflation hedging benefits as their coupon is directly linked to an index of

Inflation-consumer prices and the principal is also adjusted for inflation In inflation-linked bonds, the volatility of the returns depends on the volatility of real, rather than nominal, interest rates As a result, inflation-linked bonds exhibit lower return volatility than conventional bonds and equities Owing to lower

volatility and inflation hedging benefits, adding inflation-indexed bonds to diversified portfolios of bonds and equities results in superior risk-adjusted real portfolio returns

Exhibit 2 below illustrates inflation protection provided by type of bond

Exhibit 2

Fixed-coupon bonds Inflation unprotected Inflation unprotected

Floating-coupon bonds Inflation protected Inflation unprotected

Inflation-linked bonds Inflation protected Inflation protected

Zero-coupon inflation-linked

bonds

Capital-indexed inflation-linked

bonds

A fixed coupon rate is applied to a principal amount that is adjusted

for inflation throughout the bond’s life

Refer to Example 1 from the curriculum

This section addresses LO.b:

b describe how fixed-income mandates may be classified and compare features of the mandates;

Approaches to liability-based mandates: Liability-based mandates rely on immunization Immunization

is an asset/liability management approach that focuses on minimizing the risks associated with a change

in market interest rates in a fixed-income portfolio over a known time horizon Immunization

approaches include:

i Cash flow matching

ii Duration matching

iii Contingent immunization

iv Horizon matching

3.1.1 Cash Flow Matching

Cash flow matching aims at precisely matching all future liability payouts by cash flows from bonds or fixed-income derivatives, such as interest rate futures, options, or swaps

Exhibit 3 shows the results of a cash flow matching approach for a liability stream and a bond portfolio Future liability payouts are exactly matched by coupon and principal payments from bond portfolio As a result, cash inflows are not required to be reinvested

Limitations of cash flow matching approach:

 It is quite difficult to perfectly match cash flows

 It is a costly approach as it involves high transaction costs

 This approach suffers from timing mismatches because some cash inflows tend to precede

corresponding cash outflows This mismatch results in reinvestment risk

 As market conditions change, the lowest cost cash flow matching portfolio may change

 This approach may fail to meet its objective in case of a default event or a prepayment event 3.1.2 Duration Matching

As the name implies, duration matching approach aims at matching the duration of assets and liabilities, such that the liability portfolio and the bond portfolio are affected similarly by a change in interest rates

In duration matching following two conditions need to be met:

i A bond portfolio’s duration must equal the duration of the liability portfolio;

ii The present value of the bond portfolio’s assets must equal the present value of the liabilities at current interest rate levels

This implies the following,

 If interest rates decrease, an increase in bond prices offsets the decrease in reinvestment

income

 If interest rates increase, higher reinvestment income offsets the decrease in bond prices

It is important to note that immunized portfolio is not fully immunized and some immunization risk almost always exists Following are some important considerations for an immunized portfolio:

 Immunization protects only against a parallel shift in the yield curve

 A portfolio is an immunized portfolio only at a given point in time and thus portfolio needs to be rebalanced periodically in response to changes in market conditions in order to maintain

Exhibit 4 gives an overview of key features of duration matching and cash flow matching

Duration Matching Cash Flow Matching Yield curve

assumptions Parallel yield curve shifts None

Mechanism

Risk of shortfall in cash flows is minimized by matching duration and present value of liability stream

Bond portfolio cash flows match liabilities

Rebalancing Frequent rebalancing required Not required but often desirable

3.1.3 Contingent Immunization

Contingent immunization is a hybrid approach, which combines immunization with an active

management approach when the value of asset portfolio is greater than the present value of the liability portfolio The portfolio manager is allowed to actively manage the asset portfolio, or some portion of the asset portfolio by investing it into any asset category, including equity, fixed-income, and alternative investments, as long as the value of the actively managed portfolio exceeds a specified value

(threshold) However, if the actively managed portfolio value falls to the specified threshold, active management ceases and a conventional duration matching or a cash flow matching approach is put in place This strategy requires careful monitoring and adjusting down risk when approaching safety net level

3.1.4 Horizon Matching

This approach is a hybrid of cash flow and duration matching approaches Under this approach, term liability portion (i.e four or five years) is covered by a cash flow matching approach, whereas the long-term liability portion of total liability portfolio is covered by a duration matching approach In other words, the cash flows due up to a certain intermediate horizon are matched on a cash flow basis, and the cash flows due after this intermediate horizon are matched on a duration basis

short-Refer to Example 2 from the curriculum

Refer to Example 3 from the curriculum

3.2 Total Return Mandates

Total return mandates aim at meeting objectives based on a specified absolute return or a relative return For example, they focus on either tracking or outperforming a market-weighted fixed-income benchmark Unlike liability-based mandate, total return mandate does not attempt to match the liabilities Nevertheless, both mandates aim at achieving the highest risk-adjusted returns, given a set of constraints

Total return mandates can be classified into the following three approaches based on their target active return and active risk levels

risk are both zero

Advantages:

 This approach results in very little, or zero, tracking error

 Risk exposure (such as duration, credit (or quality) risk, sector risk, call risk, and prepayment risk) of the bond portfolio is the same as that of the index

 This approach involves relatively low administrative fees

Disadvantages:

 It is difficult and expensive to precisely replicate most bond indexes because many bonds included in standard indexes are illiquid

 Although all or most of the known systematic risk factors can be matched with the benchmark index

to the extent possible, but the issuer-specific (or idiosyncratic) risk remains This risk can be

mitigated if both the benchmark index and the portfolio are sufficiently diversified

 Even if the tracking error is zero, the portfolio return will almost always be lower than the

corresponding index return because of trading costs and management fees

3.2.2 Enhanced Indexing

Enhanced indexing approach attempts to precisely track the benchmark’s primary risk factor exposures (particularly duration) while allowing for mismatches for minor risk factors (e.g sector or quality bets) in order to generate higher returns than the benchmark This approach involves higher turnover compared with pure indexing

Advantages:

 It is relatively easy and less expensive to implement as compared with pure indexing approach

 This approach may generate returns higher than pure indexing approach while at the same time exposure to primary risk factor is matched with that of benchmark index

 Administration/management fees are relatively lower than that of fully active management

approach

Disadvantages:

 This approach has higher administration/management fees relative to pure indexing approach

 Owing to relatively higher turnover, close monitoring of turnover and the associated transaction costs is required in order to generate positive active returns net of fees and cost

 This approach has higher tracking error than pure indexing

3.2.3 Active Management

Active management involves large risk factor deviations from the benchmark (in particular, duration) in

an attempt to outperform the underlying benchmark

Advantages:

 This approach may result in higher expected return

 This approach provides more flexibility to managers

Disadvantages:

 This approach involves higher tracking error and higher risk

 This approach has higher management fees than pure or enhanced index managers As a result, it is quite difficult to generate positive active returns net of fees and cost

 This approach results in significant portfolio turnover

Refer to the table below that summarizes all the three approaches

Pure Indexing Enhanced Indexing Active Management

Objective

Match benchmark return and risk as closely as possible

Modest outperformance (generally 20 bps to 30 bps) of benchmark while active risk is kept low (typically around 50 bps

or lower)

Higher outperformance (generally around 50 bps or more) of benchmark and higher active risk levels

Portfolio

weights

Ideally the same as benchmark or only slight mismatches

Small deviations from underlying

Turnover Similar to underlying

This section addresses LO.c:

c describe bond market liquidity, including the differences among market sub-sectors, and discuss the effect of liquidity on fixed-income portfolio management;

4 BOND MARKET LIQUIDITY

A liquid security is one that can be bought or sold quickly and with little effect on its price Fixed-income securities are generally less liquid compared with equities owing to various reasons as discussed below

 Unlike company’s common stock which has identical features, bonds are very heterogeneous Each individual bond may have its own unique maturity dates, coupon rates, early redemption features, and other specific features

 Fixed-income markets are typically over-the- counter dealer markets and are less transparent

relative to equity markets

 Fixed income markets have higher search costs as investors have to locate desired bonds and get

quotes from multiple dealers to obtain the most advantageous pricing

Example: Bonds of a highly creditworthy government issuer are more liquid, have greater price

transparency, and have lower search costs than bonds of, for example, a corporate issuer with a lower credit quality

Bond liquidity is typically highest right after issuance; e.g., on-the-run issues are more liquid than the-run issues This is because soon after bonds are issued, dealers have a supply of the bonds in their inventory, but as time passes, many of these bonds are purchased by buy-and- hold investors

off-Liquidity also has an impact on bond yields as investors demand an incremental yield (referred to as liquidity premium) for investing in illiquid bonds, wherein the magnitude of the premium depends on issuer, issue size and date of maturity For example, the off-the-run 10-year US Treasury bond typically trades at several basis points higher yield than the on-the-run bond

4.1 Liquidity among Bond Market Sub-Sectors

Bond market liquidity varies across sub-sectors such as issuer type, credit quality, issue size, and

maturity

 Larger issue size implies higher liquidity: Due to large issuance size, use as benchmark bonds,

acceptance as collateral in the repo market, and well-recognized issuers, sovereign government bonds are typically more liquid than corporate and non-sovereign government bonds Similarly, in the corporate bond market, smaller issues are generally less liquid than larger issues Further, Bonds

of infrequent issuers are less liquid than the bonds of issuers with many outstanding issues

 High credit quality implies higher liquidity: sovereign government bonds of countries with high

credit quality are typically more liquid than bonds of lower-credit- quality countries and corporate bonds

 Shorter maturity implies higher liquidity: Bonds with shorter term maturities tend to be more liquid

than longer-term bonds because bonds are typically purchased by buy-and- hold investors, so

longer-term bonds may be unavailable for trading for a long period

4.2 The Effects of Liquidity on Fixed-Income Portfolio Management

Liquidity affects fixed-income portfolio management in multiple ways, including pricing, portfolio

construction, and consideration of alternatives to bonds (such as derivatives)

4.2.1 Pricing

Pricing in bond markets is less transparent than in equity markets Bonds typically trade infrequently; hence, it is not appropriate to use recent transaction prices to represent current value Similarly, last traded prices are also not representative of current market conditions, as they may be out dated For less frequently traded bonds, it is preferred to use matrix pricing In matrix pricing, we use recent

transaction prices of comparable bonds (i.e bonds which have similar features such as credit quality, time to maturity, and coupon rate) to estimate the market discount rate or required rate of return on less frequently traded bonds

Benefit of matrix pricing: It is not based on complex financial modeling of bond market characteristics

such as term structure and credit spreads

Limitation of matrix pricing: Matrix pricing method ignores some value-relevant features between

different bonds (for example, call features)

4.2.2 Portfolio Construction

Investors who prefer higher yield (e.g buy-and-hold investors) will likely prefer less liquid bonds for their higher yields In contrast, investors with higher liquidity needs would prefer more liquid bonds despite their low yields relative to illiquid bonds Hence, it is important to take into account the trade-off between yield and liquidity of fixed income securities while constructing fixed income portfolios Since, dealers often have to carry an inventory of illiquid bonds because buy and sell orders do not arrive simultaneously, illiquid bonds also tend to have higher bid-ask spread, which implies higher

trading costs Higher transaction costs reduce the benefits to active portfolio decisions

Bid-ask spreads are influenced by illiquidity, riskiness and complexity of securities For example,

 Riskiness: Bid–ask spreads in corporate or asset-backed securities tend to be higher than spreads in government bonds

 Complexity: Conventional (plain vanilla) corporate bonds tend to have lower spreads than corporate bonds with complex features, such as embedded options

 Illiquidity: Bonds of large, high-credit-quality corporations with many outstanding bond issues are relatively more liquid and thus, they tend to have lower spreads compared with smaller, less

creditworthy companies

4.2.3 Alternatives to Direct Investment in Bonds

Since transactions in fixed-income markets involve multiple challenges, investors can use fixed-income derivatives as an alternative to direct investment in fixed income securities Fixed-income derivatives include exchange-traded (standardized) derivatives (for example, futures and options on futures) and over the counter (OTC) derivatives (for example, interest rate swaps and credit default swaps) Based on notional amount outstanding, interest rate swaps are the most widely used OTC derivative world-wide Other alternative to transacting in individual bonds include fixed-income exchange-traded funds (ETFs) and pooled investment vehicles (such as mutual funds) ETFs are pooled investment vehicles and are more liquid than underling individual securities as they allow certain qualified financial institutions (authorized participants) to transact through in-kind deposits and redemptions (delivering and receiving

a portfolio of securities, such as a portfolio of bonds)

This section addresses LO.d:

d describe and interpret a model for fixed-income returns;

5 A MODEL FOR FIXED-INCOME RETURNS

Investment strategies should be evaluated in terms of expected returns rather than just yields In this section, we will discuss the model used to decompose expected returns, estimation of inputs used in the

model and limitations of this model

5.1 Decomposing Expected Returns

Expected returns can be decomposed (approximately) in the following manner It is important to note that this model only provides an approximate output and does not reflect taxes

Expected Return = E (R) ≈ Yield income+ Roll down return + E (Change in price based on investor's

views of yields and yield spreads) - E (Credit losses) + E (Currency gains or losses)

Where,

 Yield income (or Current yield) = Annual coupon payment/Current bond price

 Assuming there is no reinvestment income, yield income = bond’s annual current yield

 𝐀𝐧𝐧𝐮𝐚𝐥𝐢𝐳𝐞𝐝 𝐑𝐨𝐥𝐥𝐝𝐨𝐰𝐧 𝐑𝐞𝐭𝐮𝐫𝐧 =

(𝐁𝐨𝐧𝐝 𝐩𝐫𝐢𝐜𝐞𝐄𝐧𝐝−𝐨𝐟−𝐡𝐨𝐫𝐢𝐳𝐨𝐧 𝐩𝐞𝐫𝐢𝐨𝐝− 𝐁𝐨𝐧𝐝 𝐩𝐫𝐢𝐜𝐞𝐁𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠−𝐨𝐟−𝐡𝐨𝐫𝐢𝐳𝐨𝐧 𝐩𝐞𝐫𝐢𝐨𝐝)

𝐁𝐨𝐧𝐝 𝐩𝐫𝐢𝐜𝐞𝐁𝐞𝐠𝐢𝐧𝐧𝐢𝐧𝐠−𝐨𝐟−𝐡𝐨𝐫𝐢𝐳𝐨𝐧 𝐩𝐞𝐫𝐢𝐨𝐝

 The rolldown return represents the bond’s percentage price change assuming an

unchanged yield curve over the strategy horizon

 As time passes and issuer does not default, a bond’s price typically moves closer to par This price movement is referred to as “pull to par” effect on the price of a bond trading

at a premium or a discount to par value

 Bonds trading at a premium to their par value will experience capital losses during their remaining life, and bonds trading at a discount relative to their par value will experience capital gains during their remaining life

 Bond’s rolling yield = Yield income + Rolldown return

 𝐄 (𝐂𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐩𝐫𝐢𝐜𝐞 𝐛𝐚𝐬𝐞𝐝 𝐨𝐧 𝐢𝐧𝐯𝐞𝐬𝐭𝐨𝐫′𝐬 𝐯𝐢𝐞𝐰𝐬 𝐨𝐟 𝐲𝐢𝐞𝐥𝐝𝐬 𝐚𝐧𝐝 𝐲𝐢𝐞𝐥𝐝 𝐬𝐩𝐫𝐞𝐚𝐝𝐬) =

[−MD × ∆Yield] + [12 × Convexity × (∆ Yield)2]

Where, MD is the modified duration of a bond, ΔYield is the expected change in yield based on expected changes to both the yield curve and yield spread, and convexity1 estimates the effect

of the non-linearity of the yield curve

 The expected change in price reflects an investor’s expectation of changes in yields and yield spreads over the investment horizon If yield curves and yield spreads are expected to remain unchanged, this expected change is zero

 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐜𝐫𝐞𝐝𝐢𝐭 𝐥𝐨𝐬𝐬𝐞𝐬 =

Bond′s probability of default × Expected loss severity (also known as loss given default)

1

Effective duration and effective convexity in case of bonds with embedded options

Floating-rate notes have modified duration near zero

 Expected credit losses represent the expected percentage of decline in par value resulting from default

Note: In case of foreign currency denominated bonds, we need to factor in any expected fluctuations in

the currency exchange rate or expected currency gains or losses over the investment horizon

Refer to Example 5 from the curriculum

5.2 Estimation of the Inputs

In general,

 yield income is easy to estimate;

 rolldown return is relatively easy to estimate but depends on the curve-fitting technique

 Investor’s views of changes in yields and yield spreads, expected credit losses, and expected

currency movements are not easy to estimate These components are normally based on purely qualitative (subjective) criteria, on survey information, or on a quantitative model

5.3 Limitations of the Expected Return Decomposition

Following are some of the limitations of expected return decomposition model:

 Expected return decomposition model is an approximation and uses only duration and convexity to summarize the price–yield relationship

 Expected return decomposition model implicitly assumes that all intermediate cash flows of the bond are reinvested at the yield to maturity

 Expected return decomposition model ignores local richness/cheapness effects which represent

deviations of individual maturity segments from the fitted yield curve, which was obtained using a curve estimation technique, which produces relatively smooth curves

 Expected return decomposition model ignores potential financing advantages (e.g use of securities for short-term borrowing)

Refer to Example 6 from the curriculum

This section addresses LO.e:

e discuss the use of leverage, alternative methods for leveraging, and risks that leverage creates in fixed-income portfolios;

rB = borrowing rate (cost of borrowing)

rI = return on the invested funds (investment returns)

rp = return on the levered portfolio

Equation A implies that the degree to which the leverage increases or decreases portfolio returns is proportional to the use of leverage (amount borrowed), VB/VE, and the amount by which investment return differs from the cost of borrowing, (rI – rB)

 If the return of invested funds (rI) is higher than the cost of borrowing (rB), then leverage increases the portfolio’s return

 If the return of invested funds (rI) is lower than the cost of borrowing (rB), then leverage decreases the portfolio’s return

6.2 Methods for Leveraging Fixed-Income Portfolios

In fixed-income portfolio, there are varieties of tools available to create leveraged portfolio exposures These include futures contracts, swap agreements, structured financial instruments, repurchase

agreements, and securities lending

6.2.1 Futures Contracts

We can calculate the futures leverage using the following equation:

LeverageFutures= Notional value − Margin

MarginWhere,

Notional value = Current value of the underlying asset × Multiplier, or the quantity of the underlying asset

controlled by the contract

Futures contracts can be obtained for a modest investment in the form of a margin deposit

6.2.2 Swap Agreements

Swap agreements are derivative contracts, which typically exchange – or swap – fixed-rate interest payments for floating-rate interest payments For example, in an interest rate swap, the fixed-rate payer (receiver) has a short (long) position in a fixed-rate bond and long (short) position in a floating-rate