MANAGING BOND PORTFOLIOS

Managing Bond Portfolios There are various strategies that bond managers can pursue in managing bond portfolios, namely: Passive bond management Active bond management 21st February 2012 Passive Bond Management

Passive bond management Manager does not attempt to identify bonds that are over or under priced That is, passive bond managers take bond prices as fairly set and seek to control only the risk of their fixed-income portfolio 21st February 2012 Passive Bond Management

Passive Bond Management Strategies Two broad classes of passive management are pursued in the fixed-income market: Indexing strategies Immunisation /duration matching strategies 21st February 2012 Passive Bond Management

Passive Bond Management (a) Indexing Bond indexing involves designing a portfolio to match the performance of specified bond index While indexing is common in equity portfolios, it is a relatively recent phenomenon in the fixed income market Three major indexes of the broad bond market are : Citigroup BIG Formerly - The Salomon Smith Barney Broad Investment Grade (BIG) index, Barclays Capital Aggregate Bond Index Formerly - Lehman Brothers Aggregate Bond Index Merrill Lynch Domestic Master Index 21st February 2012 Passive Bond Management

Factors in selecting an index Factors that will influence the choice of benchmark include: Investors risk tolerance e.g. having a benchmark that includes corporate bonds exposes the investor to credit risk Investors objectives e.g with respect to volatility Different indices may have similar returns but due to different durations, different volatilities Whether a broad market index fund or specialised by market sector government bonds corporate bonds high yield bonds mortgage backed securities 21st February 2012 Passive Bond Management

Indexing Methodologies The primary aim is to minimise the tracking error i.e. the difference in the performance between the portfolio and the index Tracking error has three primary sources transaction costs differences in composition some of the large US broad based indices contain over 5000 issues discrepancies between prices used by the index provider and those paid and received by the fund manager Largely a trade-off between transaction costs and differences in composition 21st February 2012 Passive Bond Management

Indexing methodologies Stratified sampling or cell approach In this approach the index is divided into cells, each one representing a different characteristic of the index The most common characteristics used are: duration coupon maturity market sectors credit ratings call factors After the number of cells have been determined, the manager selects one or more issues that can be used to represent the cell – the dollar amount invested is determined by the market value of that cell in the index 21st February 2012 Passive Bond Management

Indexing methodologies Optimisation approach As above, break the index into cells and match the portfolio But in addition, you also seek to optimise a stated objective, e.g. maximise portfolio yield maximise portfolio return 21st February 2012 Passive Bond Management

Arguments For Indexing Performance of active managers empirical evidence suggests that active management performance has been poor SEI Funds Evaluation Corporation ranked the performance of active managers and compared the performance to the Salomon Brothers Investment Grade Index (as it was known) median return found to be lower than the index return 21st February 2012 Passive Bond Management

Arguments For Indexing Advisory Management Fees Fees are substantially lower for an indexed portfolio than for an actively managed portfolio Non-advisory fees non-advisory fees, such as custodial fees are also generally lower for indexed portfolios Also, sponsors have greater control over external managers 21st February 2012 Passive Bond Management

Criticisms of Indexing While indexing may result in the portfolio matching the performance of the index, it may not result in optimal performance It may not suit the specific requirements of clients It restricts the manager to the mainstream area’s of the market not allowing investment in possibly more attractive sub-markets 21st February 2012 Passive Bond Management

Logistical Problems with Indexing An index manager faces a number of problems prices used by the data provider may not be available to the investor factors such as illiquidity and availability are all constraints to the manager the reinvestment rate available on coupon interest may not match that assumed by the data provider 21st February 2012 Passive Bond Management

(b) Immunisation / Duration Matching Pioneered by Reddington (1952) can be defined as; “The investment of the assets in such a way that the existing business is immune to a general change in the rate of interest” Immunisation techniques refer to strategies used by investors (namely banks and pension funds) to shield their overall financial status from exposure to interest rate fluctuations Any institution with a future fixed obligation might consider immunisation a reasonable risk management policy 21st February 2012 Passive Bond Management

1) Net Worth Immunisation Many banks and institutions have a mismatch between asset and liability maturity structures. Bank liabilities are primarily the deposits owed to customers most of these are very short-term in nature and consequently of low duration Bank assets are composed largely of outstanding commercial loans or mortgages these assets are of longer duration than are deposits, and their values are correspondingly more sensitive to interest rate fluctuations 21st February 2012 Passive Bond Management

Net Worth Immunisation In periods where interest rates increase unexpectedly, bank can suffer serious decreases in net worth their assets fall in value by more than their liabilities Banks are not alone in this concern – any institution with a future fixed obligation might consider immunisation as a reasonable risk management policy. E.g. pension funds, insurance companies 21st February 2012 Passive Bond Management

Passive Bond Management Immunisation The idea behind immunization is that the duration-matched assets and liabilities let the asset portfolio meet the firm’s obligations, irrespective of interest rate movements 21st February 2012 Passive Bond Management

Passive Bond Management Fixed income investors face two types of offsetting interest rate risk Price risk Reinvestment (of the coupons) rate risk When interest rates rise, the resale value of the bond falls, but the coupons more than make up for this loss if they are reinvested at a higher rate 21st February 2012 Passive Bond Management

Passive Bond Management Immunisation If the portfolio duration is chosen appropriately, these two effects will cancel out exactly When the portfolio duration is set equal to the investor’s horizon date, the accumulated value of the investment fund at the horizon date will be unaffected by interest rate fluctuations 21st February 2012 Passive Bond Management

Rebalancing Immunised Portfolios: Duration changes with yield rebalancing As interest rates and asset durations change, a manager must rebalance the portfolio of fixed-income assets continually to realign its duration with the duration of the obligation Duration will change because of the passage of time (it decreases less rapidly than maturity) Thus even if an obligation is immunised at the outset, as time passes the durations of the asset and liability will fall at different rates. Without portfolio rebalancing, durations will become unmatched and the goals of immunisation will not be realised. Immunisation managers actively up-date and monitor their positions 21st February 2012 Passive Bond Management

Passive Bond Management 2) Cash Flow Matching The problems associated with immunisation seem to have a simple solution Why not simply buy a zero-coupon bond that provides a payment in an amount exactly sufficient to cover the projected cash outlay The principle of cash flow matching automatically immunize the portfolio from interest rate movements because the cash flow from the bond and the obligation exactly offset each other 21st February 2012 Passive Bond Management

Passive Bond Management Dedication Strategy Cash flow matching on a multi-period basis is referred to as a dedication strategy i.e. The manager selects either zero-coupon or coupon bonds that provide total cash flows in each period that match a series of obligations The advantage of dedication is that it is a once and for all approach to eliminating interest rate risk The dedicated portfolio provides the cash necessary to pay the firm’s liabilities regardless of the eventual path of interest rates Cash flow matching is not more widely pursued than immunization, probably because of the constraints that it imposes on bond selection 21st February 2012 Passive Bond Management