Chapter 4 Portfolio Management of Bonds Viewing recommendations for Windows: Use the Arial TrueType font and set your screen area to at least 800 by 600 pixels with Colors set to Hi Color (16 bit). Viewing recommendations for Macintosh: Use the Arial TrueType font and set your monitor resolution to at least 800 by 600 pixels with Color Depth set to thousands of colors

Copyright © Houghton Mifflin Company. All rights reserved. 4–1 Major Sectors of U.S. Dollar Bond Market As % of total nominal value outstanding at year-end 2000 $16,192 billion Source: Federal Reserve Flow of Funds; Salomon Smith Barney

Copyright © Houghton Mifflin Company. All rights reserved. 4–2 Basic Characteristics of Bonds Stated characteristics of par value, coupon maturity, and optional features (if any) are all related to current price An example: bond with 5 years remaining to maturity; paying 6% annual coupon on par (face) value of $1,000

Copyright © Houghton Mifflin Company. All rights reserved. 4–3 Basic Characteristics of Bonds (cont.) Cash flows Discounted at effective yield (YTM)

Copyright © Houghton Mifflin Company. All rights reserved. 4–4 Yield (rates) Bond Prices Bonds: Relationship Between Yield and Price There is an inverse relationship between yield and price Value of the bond today –Depends on the interest rate (yield) used to discount each year’s cash flows back to the present –Will change as the yield demanded by investors changes

Copyright © Houghton Mifflin Company. All rights reserved. 4–5 Yield required increases as risks increase –In general bond yield = risk-free yield + risk premium = treasury yield + yield (risk) spread Yield Spreads

Copyright © Houghton Mifflin Company. All rights reserved. 4–6 Yield Spreads

Copyright © Houghton Mifflin Company. All rights reserved. 4–7 Calculated Duration (stated maturity) Duration as a Measure of Comparability

Copyright © Houghton Mifflin Company. All rights reserved. 4–8 Risks of Bond Investment Market risk –Addresses inverse relationship between interest rates and bond prices Reinvestment risk –Relates to variability in bond returns that result from fluctuations in the interest rate at which interim cash flows are invested Credit risk –Threat that the issuer of a bond may default

Copyright © Houghton Mifflin Company. All rights reserved. 4–9 Risks of Bond Investment (cont.) Call risk –Relates to risk an investor faces when buying a bond with an embedded call option attached Event risk –Involves circumstances unforeseen at the time of purchase that can have a large adverse effect on bond prices

Copyright © Houghton Mifflin Company. All rights reserved. 4–10 Passive versus Active Investment Strategies Passive management –Buy and hold: objective is to achieve a specific return –Indexing: objective is to match the performance of the bond market

Copyright © Houghton Mifflin Company. All rights reserved. 4–11 Passive versus Active Investment Strategies (cont.) Active management –Objective is to beat the return of the market, defined as A market index and/or A competitive universe of funds with similar objectives –Portfolio manager is buying and selling securities based on his or her expectations about interest rates, credit risks, etc.

Copyright © Houghton Mifflin Company. All rights reserved. 4–12 *Other strategies include: using credit derivatives to manage credit risk, predicting prepayments, and using option adjusted spreads Major Fixed Income Investment Strategies*

Copyright © Houghton Mifflin Company. All rights reserved. 4–13 If managers anticipate a rise in rates, they may “shorten the maturity” of the bond fund –Long maturity bonds are very price sensitive to changes in rates –Holding shorter maturity bonds reduces the amount that the fund’s price may fall if rates increase –Examples Interest Rate Anticipation: Rising Rates rates maturity length bond price rates maturity length Longer Maturity BondShorter Maturity Bond

Copyright © Houghton Mifflin Company. All rights reserved. 4–14 Shorter Maturity Bond Longer Maturity Bond If managers anticipate a fall in rates, they may “lengthen the maturity” of the bond fund –Long maturity bonds are very price sensitive to changes in rates –Holding longer maturity bonds increases the amount that the fund’s price may rise if rates decrease –Examples Interest Rate Anticipation: Falling Rates rates maturity length bond price rates bond price maturity length

Copyright © Houghton Mifflin Company. All rights reserved. 4–15 Prospective Total Return of Municipal Bonds Insured Revenue, Horizon = 365 days Duration Yield 6-year maturity 12-year maturity Yield Curve Example

Copyright © Houghton Mifflin Company. All rights reserved. 4–16 Sector Exposure Example

Copyright © Houghton Mifflin Company. All rights reserved. 4–17 BKB = Bank of Boston ROA = return on assets NPA = non-performing assets OREO = other real estate owned Issuer Credit Analysis Example CREDIT SUMMARY NOTE Credit Comment Continued improvements. BKB posted an ROA of.89% (.97% excl. a $16.4MM restructuring charge) compared with.76% in 2Q93. NPAs are down to 2.76% of loans and OREO from 3.06 YE93.

Copyright © Houghton Mifflin Company. All rights reserved. 4–18 A Manager’s Steps in the Investment Process 1.Understand the fund’s objective and compliance requirements 2.Develop a fund strategy 3.Work with analysts and traders to find value (e.g., individual security selection) 4.Review liquidity, risk, diversification requirements 5.Execute portfolio transactions 6.Evaluate performance attribution; return to step 2

Copyright © Houghton Mifflin Company. All rights reserved. 4–19 Other Key Players in Bond Fund Management Credit analyst –Actively analyzes financial condition of issuers –Utilizes ratio analysis –Determines the credit risk/return profile of bond issuers –Note: some differences in corporate versus municipal analysts Quantitative analyst –Builds mathematical models to help identify potential opportunities –Examines analytical building blocks of bonds –Produces valuation and risk parameters –Quantifies and rewards of strategies under various scenarios

Copyright © Houghton Mifflin Company. All rights reserved. 4–20 Other Key Players in Bond Fund Management (cont.) Trader –Provides current information about the bond market –Handles execution of trades