2019 CFA level 3 finquiz curriculum note, study session 11, reading 23

Contingent immunization Cash flow matching is a classic strategy to eliminate the interest rate risk of a stream of liabilities simply by constructing a dedicated asset portfolio of high

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This reading centers around structured and passive total

return fixed-income investment strategies The term

‘passive’ and ‘active’ fixed-income strategies are with

reference to the asset manager’s outlook on interest

rates and credit market situations

Passive strategies do not mean ‘buy & hold’ rather these strategies also require continual monitoring and

rebalancing

2 Liability-Driven Investing

Asset-liabilities management (ALM) strategies take into

account rate sensitive assets and liabilities For example,

ALM approach helps institutions in reducing interest rate

risk by linking loan and deposits rate decisions and filling

gaps between asset and liability maturities

Asset-driven liabilities (ADL) and Liability-driven investing

(LDI) are special cases of ALM

1 In ADL, assets are given and liabilities are

structured to match the characteristics of those

assets i.e asset side of balance sheet signifies a

company’s primary business, and a liability

structure is used to reduce the interest rate risk

by matching the maturities of its assets and

liabilities

o For example, a manufacturing

company may get operating revenues that are highly dependent on business cycle, which in turn is positively correlated with interest rates Hence, the manufacturer will choose variable-rate liabilities to match its operating revenue

2 In LDI, liabilities are given and assets are

structured to match the characteristics of those

liabilities i.e liability side of balance sheet

represents a company’s core business and

financial decisions Assets are used to reduce

the interest rate risk

o For example, in case of a life-insurance

company or a DB pension plan, liabilities are given As the present value of these liabilities are highly sensitive to interest rate changes, estimation of interest rates plays a key role in making investment portfolio decisions

Individuals also use LDI approach, particularly when they require sufficient funds at some future date

o Consider an individual who holds a

portfolio of bonds, and plans to purchase an annuity on his retirement 10-years from now In order to fulfil his

goal, he will reinvest any cash flows from bonds and/or add a regular amount to his portfolio

Size and timing of liabilities are two major considerations for an entity Four liability types categorized by the degree of certainty regarding amount and timing of cash flows are given below:

Liability Type

Cash Outlay

III Uncertain Known

IV Uncertain Uncertain Note: Here, the primary focus is liability, though the same structure can apply to financial assets as well

Type I liabilities:

These liabilities have known amount(s) and timings e.g

an issuer of a fixed rate option-free bond For such type

of liabilities, duration measures can be used to estimate their interest rate sensitivities

Type II liabilities:

These liabilities have known amount but unknown timing

of payments e.g callable and putable bonds, term life insurance policy where, timing of the insurer’s death is unknown However, life insurance companies apply the law of large numbers to estimate the payout amounts in any given time period

Type III liabilities:

Type III liabilities have known payment dates but uncertain payment amounts e.g floating rate notes, inflation-indexed bonds, treasury inflation-protected securities etc

Type IV liabilities:

Type IV liabilities have unknown amount and timing of obligations Liabilities of property & casualty insurance companies and defined benefit pension plan fall in this category

Simple duration measure is appropriate to model type I liabilities, whereas effective duration is required to

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estimate interest rate sensitivity for type II, III and IV

liabilities The model assumes initial shape of the yield

curve, which is then shifted up and down to get new

estimates for the PV of liabilities

3 INTEREST RATE IMMUNIZATION – MANAGING THE INTEREST RATE

RISK OF A SINGLE LIABILITY

Technique and risks of interest rate immunization:

Immunization is a technique used to structure and

manage fixed-income portfolio to minimize the effects of

volatility of future interest rates on the realized rate of

return earned over a specific period At this point, it is

assumed that the bond portfolio’s default risk is zero

Single liability can be immunized simply by buying a

zero-coupon bond whose maturity date and face value

matches the liability’s due date and amount (termed as

Cash Flow Matching) There is no re-investment or price

risk

However, in many financial markets desired zero

coupon-bonds are unavailable In such situations,

immunization can be achieved by purchasing

coupon-paying bonds and matching the duration of assets to

investment horizon (i.e liability’s duration) and the PV of

assets to the PV of liabilities (termed as Duration

Matching)

Immunized portfolio by zero-coupon bonds is considered

to be the benchmark to measure the performance of

immunized portfolio using coupon-paying bonds

Macaulay duration is the weighted average of time until

the bond’s cash flows are received where the weights

are the percent of PV of cash flows with respect to sum

of PV of all cash flows

Note: A zero-coupon bond’s Macaulay duration is equal

to its maturity whereas, coupon-paying bond’s

Macaulay duration is less than its maturity

Money duration = bond’s modified duration x bond price

For a coupon bond currently trading at par:

• rise in interest rates will decrease bond price (i.e negative impact) Over the remaining time to maturity of the bond, price will rise to par and reduce the negative impact as time passes

• On the other hand, coupons will be reinvested

at higher rates generating positive impact of higher interest rates

• These positive (coupon reinvestment effect) and negative (price effect) impacts will cancel each other if investment horizon is equal to Macaulay Duration

These effects will be reversed in case of immediate downward shift in the yield curve

Conclusion:

If investor’s investment horizon = bond’s Macaulay duration, he is effectively immunized from interest rate risk i.e whether rates rise or fall, price and coupon-reinvestment effects will counterweigh each other

4 INTEREST RATE IMMUNIZATION – MANAGING THE INTEREST RATE

RISK OF MULTIPLE LIABILITIES

Four approaches to manage multiple liabilities (assuming

type-I) are as follows:

1 Cash flow matching

2 Duration matching

3 Derivatives overlay

4 Contingent immunization

Cash flow matching is a classic strategy to eliminate the

interest rate risk of a stream of liabilities simply by

constructing a dedicated asset portfolio of high quality

zero-coupon or fixed income bonds to match closely the timings and amount of cash outflows

Sometimes, accounting defeasance can be the reason

for cash flow matching for the company Accounting defeasance (a.k.a in-substance defeasance) is an

approach of vanishing the debt liability by setting aside sufficient high-quality assets to pay-off those liabilities i.e the outstanding debt and assets off-set each other and are removed from the company’s balance sheet

Cash-in-advance constraint is a concern when

implementing this strategy using coupon paying bonds because of availability of funds on or before payment

Practice: Example 1, Reading 23, Curriculum

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dates This would expose the portfolio to cash flow

reinvestment risk, particularly, in an upward-sloping yield

curve, when yields on high-rated short-term investments

are low or negative

Note: The purpose of this example is to understand the

motivation and mechanism of accounting defeasance

method, the accounting of such transactions is outside

the scope

Duration matching for multiple liabilities require:

i) matching of money duration(BPV/PVBP) of portfolio

and liabilities

ii) initial investment should be equal to or more than PV

of liabilities

iii) dispersion/convexity for assets must be equal to or

greater than for the liabilities (plus dispersion should be

as low as possible) For example, if liability convexity =

300 then asset convexity of 320 is preferred over 380

Duration matching achieves the objective of meeting

the liability even if there is a single large parallel shift in

interest rates Duration matching may fail if there are

multiple parallel shifts, single non-parallel shift or multiple

non-parallel shifts in the yield curve

Manager must rebalance portfolio (i.e repeat duration

matching) after every large parallel shift to keep the

portfolio immunized

Derivatives overlay is an efficient and cost-effective

strategy that can be used to rebalance the immunized

portfolio (single or multiple liabilities) to keep on its target

duration for yield curve shifts or twists or for the passage

of time

Suppose, a large sudden upward shift in the yield curve,

decreases both the duration and market value of an

immunized portfolio’s assets and liabilities i.e the BPV of

the assets and liabilities goes down Now, if there is a

duration gap e.g drop in the value of assets is higher

than the drop in the value of liabilities, the manager is required to close the money duration gap by increasing the portfolio duration The manager can reduce the duration gap by buying long duration bonds and selling short duration bonds Alternatively, the manager can opt for a more efficient and cost-effective method of using interest rate derivatives in the form of buying or going long, a few interest rate futures contracts

Managers often hold a portfolio of short-term bonds for many reasons including such bonds are highly liquid, can be obtained at favorable pricing, managers face liquidity constraints or due to regulatory requirements A derivative overlay strategy is then used to close the duration gap

4.4 Contingent Immunization

Contingent immunization combines immunization strategies with elements of active management If the market value of assets is greater than market value of labilities (surplus is available), the managers can consider contingent immunization as long as surplus is above a certain threshold If the portfolio’s return declines below the designated threshold, the immunization mode is activated

Surplus can be invested in any asset category such as equity, fixed-income, alternative investments,

commodity options, credit-default swaps etc

This strategy allows managers to pursue increased risk strategies that can lead to excess portfolio value and can reduce the cost of retiring the debt obligations The presence of surplus provides opportunities for managers

to take a view of interest rates i.e to be over-hedged when yields are expected to fall and under-hedged when yields are expected to rise

Practice: Example 3, Reading 23,

Curriculum

Refer to Curriculum for a very detailed example

Curriculum

Important: For further illustration and example please refer to Reading 23, 4.3 ‘Derivative Overlay’ from 5th paragraph on page 74 till end

Refer to CFA Curriculum, Reading 23, 4.4

‘Contingent Immunization’ paragraph 4th , 5th & 6th page 77 for illustration through example

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5 LIABILITY-DRIVEN INVESTING - AN EXAMPLE OF A DEFINED

BENEFIT PENSION PLAN

Due to the nature of this topic, Team FinQuiz

recommends reading it directly from the CFA Institute’s

Curriculum

6 RISKS IN LIABILITY DRIVEN INVESTING

The basic relationship of an immunization strategy of full

interest rate hedging (hedge ratio 100%) is expressed

below:

Asset BPV ∆ Asset yields + Hedge BPV ∆Hedge yields

Liability BPV ∆Liability yields

All ∆ in yields are measured in basis points

The relation is approximate because of ignoring

higher-order terms such as convexity

Use of assumptions regarding future events and

approximations to measure key parameters involve

model risk For example, asset BPV may be

mis-measured if the changes in certain variables (e.g

nominal interest rates or expected inflation) affect equity

and alternative assets not as modeled

Measurement error for asset BPV can occur when asset

portfolio duration is calculated using weighted average

of the individual durations for the component bonds

instead of using the cash flow yield to discount the future

coupon and principal payments

When derivatives overlay are used for immunization

purposes, futures BPV calculations are based on CTD

qualifying bond divided by its conversion factor Further,

advanced measurements involving short-term interest

rates and accrued interest, can change the number of

contracts needed to hedge the interest rate risk

Model risk also arise in LDI strategies For example, in the

measurement of liability BPV in DB pension plan, there is

difficulty associated with the estimation and assumption

of plan’s key inputs such as assumptions about

employees’ future salary increase, the discount rates,

employees’ life expectancy post-employment,

employee turnover etc

If the immunization is not perfect i.e the particular

fixed-income assets, the hedging derivatives and the liabilities

are positioned at varying points along the benchmark

yield curve and at varying spreads, non-parallel shifts

and twists in the yield curve can affect asset+derivatives

differently than liabilities

There is a presence of spread risk (the risk that the asset and liability discount rates and their PVs do not move equitably) in LDI strategies because spreads on high-quality corporate bonds/sectors or on broad index and spreads on government bonds do not move in

correspondingly

Spread risk also exists in the derivatives overlay LDI strategies because the future contracts that are used to hedge the interest rate risk of multiple liabilities are usually based on US treasury notes while liabilities are corporate obligations

Spread risk is also a concern in the use of interest rate swap overlays i.e when swaps or swaptions are used to change the duration gap between portfolio assets and liabilities

Hedging strategies based on interest rate swaps have less spread risk (because of credit risk being part of both 1)Bond Yield 2) Swap rate – which is based on LIBOR) Usually OTC derivatives contain counterparty credit risk Post 2008-2009 financial crises, the inclusion of collateral requirements and restrictions strengthened the over-the-counter derivatives market and mitigated over-the-counterparty credit risk

The risk that collateral becomes exhausted is particularly

a chief concern in strategies that use derivatives overlay

to reduce the duration gap between assets and liabilities

Concerns regarding cash management and collateral availability arises with the use of exchange-traded futures contracts because of daily mark-to-market valuation and settlement into a margin account Asset liquidity becomes a key consideration for strategies that involve active investing along with passive fixed-income portfolios and for contingent immunization

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7 BOND INDEXES AND THE CHALLENGES OF MATCHING A

FIXED-INCOME PORTFOLIO TO AN INDEX

Index-based investing generally provides diversification

at lower cost and a less risky alternative to active

management (protection from negative alpha)

The primary focus of indexed investing is selecting the

bonds for portfolio in a way that the portfolio returns

match the returns of the bond market index Therefore,

the major concern is to minimize tracking risk or tracking

error

Following are some approaches to match an underlying

market index

Pure indexing or full replication approach involves

replicating the index by purchasing all the securities in

the index

Enhanced indexing strategy involves matching the

primary risk factors of the index by purchasing fewer

securities than the index with an aim to replicate the

index performance more efficiently as compared to

pure indexing

Active management seeks to produce better returns in

which the portfolio can deviate from the primary risk

factors associated with the index

In contrast to equity markets, where equity market

indexes fairly represent the overall equity market

performance, in bond markets, the price and yield of

the recently issued government bonds more closely

gauge the overall bond market sentiment

Complexities associated with fixed-income markets

Numerous complexities associated with fixed income

markets make it is difficult to track or replicate a bond

market index These complexities include market size

and breadth, wide range of security features, unique

issuance and trading patterns, effects of these patterns

on index composition, pricing and valuation

Size and breadth of bond markets

Fixed income markets are significantly bigger and

broader than equity markets both in size of market

capitalization and in the number of securities

outstanding It is practically impossible to replicate a

broad fixed-income market index

Wide array of fixed-income security characteristics

There is a wide range of bonds (public and private)

available for investors with varying features such as

maturities, ratings, optionality, relative liquidity,

performance characteristics, coupon rate, multiple

bond issues by single issuer etc

Unique issuance and trading patterns of bonds versus other securities

Fixed-income securities are largely traded in OTC market through brokers/dealers using a quote-based trading system After 2008-09 financial crises, new regulations restricted dealers’ ability to take risk, and increased cost

to hold inventories Lower trading inventories, increased bid-ask spreads and reduced willingness to support block trades, particularly for less liquid off-the-run bonds

In many markets it is difficult to track fixed income trading transactions Even if trade data is available (e.g

in U.S from TRACE ), several bonds do not trade at all and many bonds trade only a few times during a particular year

Many non-traded bonds do not have observable prices

To estimate the current yields and prices of such bonds, matrix pricing or evaluated pricing method is used This estimation analysis is often conducted by external vendors which further increase discrepancies between index and portfolio performance

Challenges associated with index-based bond portfolios Managing an index-based bond portfolio is problematic due to bonds’ trading and valuation related intricacies Rebalancing of fixed-income indexes occur more frequently (usually monthly) due to several factors such

as new debt issuance, outstanding bonds’ maturities, changes in ratings, optionality etc Therefore, periodic rebalancing of a portfolio incurs higher transaction costs Due to the above-mentioned problems, asset managers pursuing a pure indexing strategy typically match the primary risk factors of the fixed-income index through a diversified portfolio

Matching the primary risk factors includes:

Effective duration is used to measure the change in the value of a portfolio given a small parallel shift in interest rates The indexed portfolio’s duration should be matched with the benchmark so that portfolio has same interest rate risk exposure as that of benchmark index However, for large parallel shift in interest rates, convexity adjustment must also be considered

Key rate duration is used to measure the effect of nonparallel shifts in the yield curve i.e change in slope or twist in the curve In this method, spot rate for particular key maturity is changed (all other spot rates are kept constant) to measure a portfolio’s sensitivity to a change

in that maturity This sensitivity is called the rate duration The portfolio and benchmark must have securities with same maturities, key rate durations and the same overall effective duration

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Percent in sector and quality The portfolio must match

the percentage weight in the various sectors and

qualities of the benchmark index in order to have the

same risk exposure

Sector and quality spread duration contribution

Sector Duration Contribution: The portfolio must match

the proportion of the index duration that is contributed

by each sector in the index to ensure that a change in

sector spreads has the same impact on both the

portfolio and the index

Spread duration is a measure used to describe how a

non-Treasury security’s price will change as a result of

widening or narrowing of the spread (spread risk) The

portfolio must, therefore, match the proportion of the

index duration that is contributed by each quality in the

index, (where quality refers to categories of bonds by

rating)

Sector/coupon/maturity cell weights: Convexity is

difficult to measure for callable bonds as they exhibit

negative convexity In order to match the convexity of

bonds (call exposure) in the index, the sector, coupon,

and maturity weights of the callable sectors in the index

should be matched instead of matching the convexity

because matching convexity involves high transaction

costs

Issuer Exposure: The portfolio should consist of a sufficient

number of securities so that the event risk attributable to

any individual issuer is minimized

Present Value Distribution (PVD) of Cash flows describes

how the total duration of the benchmark index is

distributed across its maturity In other words, it describes

the fraction of the portfolio’s duration that is attributable

to cash flows falling in that time period In order to

construct a portfolio to have same exposure to

nonparallel yield curve shifts and twists, portfolio must

have same present value distribution of cash flows as

that of benchmark index

Following are the steps to calculate PVD of Cash flows:

i Calculate the present value of the cash flows from the benchmark index for specific periods i.e every 6- month period is computed

ii Then each present value is divided by the present value of total cash flows from the benchmark to determine the percentage of the index’s total market value attributable to cash flows falling in each period e.g 3% of the index cash flows fall in the first 6-month period), 3.8% in the second period and so on

iii Since the cash flows in each 6-month period can be considered zero-coupon bonds, the time period is the duration of the cash flow For example, the very first 6-month time period has

a duration of 0.5 The next time period has duration of 1.0; the next 1.5, and so forth The duration of each period is multiplied by its weight to calculate the contribution of each period’s cash flows to portfolio duration For example, the contribution of the first 6-month period is calculated as 0.03(0.5) = 0.015 The contribution of the second period is 0.038(1.0) = 0.038, and so forth

iv The duration contribution for each of the period

is divided by the index duration (i.e., the sum of all the periods’ duration contributions) The resulting distribution is the benchmark’s PVD For example, suppose total index duration is 3.28 then PVD distribution is: Period 1 = 0.015 / 3.28 = 0.46%, Period 2 = 0.038 / 3.28 = 1.16% and so

on

Note: The goal of matching the primary risk factors is to minimize the tracking error (tracking risk) Tracking risk is the standard deviation of a portfolio’s active return for a given period whereas, active return is the difference between portfolio return and the benchmark return

8 ALTERNATIVE METHODS FOR ESTABLISHING PASSIVE BOND

MARKET EXPOSURE

In a ‘passive investment strategy’, manager tends to just

mimic the broader fixed-income market performance

without detailed analysis or involvement of active

management Full replication is the most direct method

to mimic the index performance Managers purchase or

sell securities only when there are changes to the index

to maintain full replication However, frequent changes

in the index and presence of illiquid securities make full

replication strategy expensive and to some extent

infeasible

Index enhancement strategies address many limitations

of full replication approach and are used by managers

to enhance portfolio returns This typical approach is referred to as stratified sampling or cell approach to indexing

In a cell-Matching technique (or stratified sampling), the manager first divides the bonds in the index into cells according to risk factors, such as sector, quality rating, duration, callability etc The manager then measures the total value of the bonds in each of the cells and

determines each cell’s weight in the index Finally, the manager selects a sample of bonds from each cell and dollar amount selected from each cell is based on that cell’s weight in the index e.g if A rated corporate bonds

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represent 4% of the entire index, then A rated bonds will

be sampled and added until they represent 4% of the

manager’s portfolio

Enhanced-indexing is also highly significant for ESG

investors who consider environmental, social, corporate

governance and other related factors in the selection of

their fixed income portfolios

The five index enhancement strategies are given below:

1 Lower Cost Enhancements: The portfolio’s net return

can be increased by maintaining tight controls on

trading costs and management fees

2 Issue Selection Enhancements: The manager can

identify and select issues that are undervalued relative

to a theoretical value or can select issues which

according to his/her credit analysis will soon be

upgraded to enhance portfolio returns

3 Yield Curve Positioning: Some maturities along the

yield curve tend to remain consistently undervalued or

overvalued The portfolio’s net return can be increased

by overweighting the undervalued areas and

underweighting the overvalued areas on the curve

4 Sector and Quality Positioning: It has two forms:

a Maintaining a yield tilt towards a specific sector

and/or quality e.g maintaining a yield tilt toward short

duration corporate issues

b Periodic over-or-under weighting of sectors (e.g

Treasuries vs Corporates) or qualities For example, when

spreads are expected to widen (narrow), portfolio’s net

return can be enhanced by overweighting

(underweighting) Treasuries

Note: Unlike active management strategy, the objective

of this strategy is not to outperform the benchmark by a

large margin

5 Call Exposure Positioning: For example, when interest

rates decrease, callable bonds underperform as

compared to non-callable issues Therefore, in case of

declining interest rates, portfolio’s net return can be

enhanced by underweighting these issues

The stratified sampling approach provides the following

benefits

No need to buy/sell thinly-traded securities

Limit the need of frequent rebalancing of

portfolio

Enhance portfolio return and minimize tracking

error by matching portfolio performance as

closely as possible using fewer securities

Indirect methods to seek passive bond-market exposures

Some alternatives to investing directly in fixed-income securities passively are through:

i Mutual funds

ii Exchanged-traded funds iii Total return swaps Mutual Funds are pooled investment vehicles whose shares represent proportional share in the ownership of the assets in an underlying portfolio

• Shares of open-ended mutual funds are bought or sold at their NAV (), which is based on fund’s underling securities and is calculated at the end of the trading day

• Mutual funds are particularly suitable for small investors

• Mutual funds help diversifying a portfolio without the involvement of large amount of cash needed to replicate a broad index

• Investors can redeem holdings easily at fund’s NAV with one day time lag though many funds charge early redemption penalties

• Sale and purchase of individual bonds is expensive whereas, mutual funds offer the benefits of economies of scale because mutual funds’ trading cost decrease as funds’ asset size increase

• Unlike the underlying bonds, mutual funds have no maturity date because fund managers continuously trade bonds to track the index

• Mutual fund’s monthly interest payments vary depending on fund holdings

• Mutual funds charge annual management fee and may charge additional fees in terms of upload or back load

Exchange Traded Funds

• ETFs are collection of securities that typically track a particular market index

• ETFs are more tradeable than mutual funds ETF shareholders buy or sell shares throughout the day in public markets

• ETFs differ from mutual funds with respect to the process through which funds shares are created and redeemed The

creation/redemption process take place between fund and broker/dealers referred to

as ‘authorized participants’ (APs)

• To create ETF share, an AP provides basket of underlying securities to the ETF and in return receives a ‘creation unit’ (a large block of ETF share) AP may hold ETF shares or sell some or all the shares in the secondary market

• AP redeems shares through the same process

in reverse i.e AP returns the specific number of shares in the creation unit to the ETF and receives either basket of shares available in

Curriculum

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the ETF portfolio or cash

• This in-kind redemption (exchange of ETF for

basket of shares) helps ETFs shares to trade at

price close to market value of their underlying

assets

• APs generally take advantage of any possible

arbitrage opportunities (difference between

market value of underlying securities and ETF’s

NAV) by selling(buying) ETF shares when ETF

shares trade at premium(discount) to their

NAV

Synthetic strategies provide another method to replicate

index exposure through over-the-counter (OTC) or

exchange-traded derivatives OTC instruments offer

customized arrangements between two counterparties

whereas, exchanged-traded solutions involve an

organized exchange and offer standardized products

Total return swap (TRS)

TRS is the most common OTC strategy with some

combine elements of interest-rate swaps and credit

derivatives

TRS involves periodic exchange of cash flows between

two parties based on some reference obligation such as

total return (including income and price change) of

equity, commodity or bond index versus Libor + spread

Total return payer is compensated for any

depreciation/default losses in the index or default losses

incurred on the portfolio

Basic TRS structure

TRS is an efficient risk transfer OTC derivative contract between two parties in which total return payer is typically a dealer One significant benefit of using TRS compared to ETF, mutual fund or direct investment is smaller initial outlay and lower transaction costs (lower swap bid-offer cost)

TRS is a customized OTC derivative instrument and can offer exposure to securities that are hard to obtain directly such as high-yield or commercial loan investments

Following are some disadvantages of using TRS

By entering into a TRS, an investor does not legally own the underlying assets but holds a synthetic long position

in the index The investor may face counterparty credit risk and rollover risk (due to the shorter nature of the contract) Counterparty credit risk can be resolved by necessary credit due diligence Rollover risk requires investor’s ability to renew the contract in the future with reasonable pricing and business terms

Costs and operational problems of derivative transactions have been increased lately due to fundamental changes to the market, increased regulatory control, stricter rules for dealers, requirement for holding more capital, more frequent mark-to-market collateralization etc

Though exchanged-traded derivatives on debt indexes are also available, however, it is challenging for investors

to rely on such derivatives compared to over-the-counter instruments on debt indexes because of frequent changes in the availability of such exchanged-traded instruments

Benchmark selection is one of the final step in the

broader asset allocation process

For fixed-income portfolios, the selection of a

benchmark is unique because the investor usually has

some form of fixed-income coverage embedded in

asset/liability portfolios and therefore, the investment

manager must take into account the implicit or explicit

duration preferences at the time of selection of

fixed-income benchmark

The benchmark selection decision should identify

numerous characteristics of bond indexes such as:

• The finite maturities of bonds suggest that the duration of the index drift downward with the passage of time even for static bond portfolios

• For broad-based indices, issuer composition and maturity selection depend on market dynamics

• Investors who track value-weighted index automatically assign large weights to more-levered borrowers or sectors As

creditworthiness and leverage are negatively correlated, this greater allocation to more levered borrowers leads to ‘bums problems’

Total return

receiver

pays

Total return payer

receives

Total return

receiver

Index cash flows + Appreciation

Total return payer

Libor + Spread Index depreciation + default losses

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When conducting fixed-income benchmark selection,

investors are required to vigorously comprehend and

describe their duration preferences and desired

risk-return profile within their fixed-income allocation

Targeted duration can be achieved by combining

several sub-benchmark categories

Smart beta is another alternative for fixed-income

investors who want to reduce the cost of their active

management while eliminating systematic biases such

as bums problems Smart beta is a simple rules-based strategy which is well-known among equity managers but now has gained widespread attention among fixed-income managers as well

Three maturity-based investment strategies involve

constructing a:

• laddered portfolio (bonds maturities evenly

distributed along the yield curve)

• bullet portfolio (bonds maturities concentrated

at a particular point on the yield curve)

• barbell portfolio (bonds maturities

concentrated at short and long ends of the

yield curve.)

If three portfolios (ladder, barbell and bullet) have same

duration, percentage change in the value of barbell,

bullet and ladder portfolios as a result of a:

• parallel yield curve shift, will approximately be

the same

• non-parallel shifts or twists, will be very different

Benefits of Laddered Portfolio

A laddered bond portfolio is popular investment strategy

in the wealth management industry

Diversification over maturity spectrum

Uniform cash flow distribution on maturity spectrum

feature of a laddered portfolio provides protection

(balanced ‘cash-flow reinvestment’ and ‘market price’

risks) against shifts and twists

Maintenance of the overall portfolio duration

In a stable, upward sloping yield curve environment;

proceeds from maturing bonds are re-invested in long

term bonds (offering higher yields) to maintain duration

of the portfolio This gives ladder portfolio an edge over

bullet and barbell

Convexity

A laddered portfolio offers high convexity because its

cash flows are distributed on the timeline If three

portfolios have same duration, the laddered portfolio

offers higher convexity than the bullet but lower than the

barbell However, compared to barbell, laddered

portfolio’s cash flow reinvestment risk is much lower

Liquidity Management

A laddered portfolio provides liquidity as bonds are

constantly maturing and being reinvested If liquidity is

needed, selling near-to-maturity bonds naturally offer favorable pricing or such bonds can provide high-quality less risky collateral on a personal loan or on a repo contract

Constructing a laddered bond portfolio

A laddered bond portfolio can be constructed by using individual bonds or fixed-maturity corporate ETFs These ETFs, often managed passively, have a designated term-to-maturity and credit risk profile For example, an ETF replicating the performance of some index such as 50 held-to-maturity investment-grade corporate bonds maturing in 2025

The decision to purchase pertinent ETFs instead of individual bonds offers similar benefits such as diversification over time spectrum, price stability in

near-to maturity ETFs, higher convexity etc ETFs are generally more liquid than individual bonds

Limitations of laddered portfolios Compared to laddered portfolio, fixed-income mutual fund bonds

• involve lower cost of acquisition

• offer greater diversification of default risk

• can be redeemed more rapidly at favorable pricing

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