Version 1.2 Copyright © 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department Harcourt, Inc Sea Harbor Drive Orlando, Florida Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapter 17
Copyright © 2000 by Harcourt, Inc. All rights reserved Alternative Bond Portfolio Strategies 1. Passive portfolio strategies 2. Active management strategies 3. Matched-funding techniques 4. Contingent procedure (structured active management)
Copyright © 2000 by Harcourt, Inc. All rights reserved Passive Portfolio Strategies Buy and hold –Can be modified by trading into more desirable positions –Note – can’t hold forever; holding periods are necessarily limited due to maturity of bonds –Ladder and barbell strategies are two possible approaches (see next slide) Indexing –Match performance of a selected bond index –Performance analysis involves examining tracking error
Copyright © 2000 by Harcourt, Inc. All rights reserved Classic Passive Management Strategies A laddered strategy distributes fixed income dollars throughout the yield curve. par value maturity par value A barbell strategy differs from the laddered strategy in that less investment is made in the middle maturities. On the other hand, a credit barbell is a bond portfolio containing a mix of high-grade and low-grade securities.
Copyright © 2000 by Harcourt, Inc. All rights reserved If duration laddered portfolio > duration barbell portfolio, rising interest rate falling interest rate interest rate barbell ladder risk favored favored reinvestment barbell ladder rate risk favored favored The Risk of Barbells and Ladders Yield curve inversion means short-term rates are rising faster than long-term rates. Duration as a pure measure of interest rate risk only works for parallel shifts in the yield curve.
Copyright © 2000 by Harcourt, Inc. All rights reserved Active Management Strategies Interest-rate anticipation –Risky strategy relying on uncertain forecasts –Ladder strategy staggers maturities –Barbell strategy splits funds between short duration and long duration securities Valuation analysis - intrinsic value Credit analysis –Determine default risk –Special case of high-yield bonds
Copyright © 2000 by Harcourt, Inc. All rights reserved Active Management Strategies Yield spread analysis Bond swaps
Copyright © 2000 by Harcourt, Inc. All rights reserved Analysis of High-Yield Bonds Firm’s competitive position –Cost and pricing Firm’s borrowing capacity and cash flow –Related to cash requirements for interest payments, research, and growth, during periods of economic decline Liquidity value of the firm’s assets Competence of total management team Firm’s financial leverage
Copyright © 2000 by Harcourt, Inc. All rights reserved Active Management Strategies Yield-spread analysis –By sectors - bond grade or industries Bond swaps –Selling one bond (S) and buying another (P) simultaneously –Swaps to increase current yield or YTM, take advantage of shifts in interest rates or realignment of yield spreads, improve quality of portfolio, or for tax purposes
Copyright © 2000 by Harcourt, Inc. All rights reserved Matched-Funding Techniques Classical (“pure”) immunization –Interest rate risk –Price risk –Reinvestment risk –Investment horizon –Maturity strategy –Duration strategy
Copyright © 2000 by Harcourt, Inc. All rights reserved Difficulties in Maintaining Immunization Strategy Rebalancing required as duration declines more slowly than term to maturity Modified duration changes with a change in market interest rates Yield curves shift
Copyright © 2000 by Harcourt, Inc. All rights reserved End of Chapter 17 –Bond Portfolio Management Strategies
Copyright © 2000 by Harcourt, Inc. All rights reserved Future topics Chapter 19 Why do industry analysis? Competition and expected industry returns Estimating an industry earnings multiplier
Copyright © 2000 by Harcourt, Inc. All rights reserved