Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 20

Chapter 20 - Bond Portfolio Management Strategies Questions to be answered: What are the four major bond portfolio management strategies? What are the two specific passive portfolio management strategies available?

Chapter 20 - Bond Portfolio Management Strategies What are the five alternative strategies available within the active management category? What is meant by care-plus bond management and what are some plus strategies? What is meant by matched-funding techniques, and what are the four specific strategies available in this category?

Chapter 20 - Bond Portfolio Management Strategies What are the major contingent procedure strategies that are also referred to as structured active management strategies? What are the implications of capital market theory for those involved in bond portfolio management?

Chapter 20 - Bond Portfolio Management Strategies What is the evidence on the efficient market hypothesis as it relates to bond markets? What are the implications of efficient market studies for bond portfolio managers?

Alternative Bond Portfolio Strategies 1. Passive portfolio strategies 2. Active management strategies 3. Matched-funding techniques 4. Contingent procedure (structured active management)

Passive Portfolio Strategies Buy and hold –A manager selects a portfolio of bonds based on the objectives and constraints of the client with the intent of holding these bonds to maturity Indexing –The objective is to construct a portfolio of bonds that will equal the performance of a specified bond index

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 –The portfolio manager attempts to select bonds based on their intrinsic value Credit analysis –Involves detailed analysis of the bond issuer to determine expected changes in its default risk

Active Management Strategies Yield spread analysis –Assumes normal relationships exist between the yields for bonds in alternative sectors Bond swaps –Involve liquidating a current position and simultaneously buying a different issue in its place with similar attributes but having a chance for improved return

Bond Swaps Pure Yield Pickup Swap Substitution Swap Tax Swap Swap strategies and market-efficiency –Bond swaps by their nature suggest market inefficiency

A Global Fixed-Income Investment Strategy Factors to consider –The local economy in each country including the effects of domestic and international demand –The impact of total demand and domestic monetary policy on inflation and interest rates –The effect of the economy, inflation, and interest rates on the exchange rates among countries

Core-Plus Bond Portfolio Management This involves having a significant (core) part of the portfolio managed passively in a widely recognized sector such as the U.S. Aggregate Sector or the U.S. Government/Corporate sector. The rest of the portfolio would be managed actively in one or several additional “plus” sectors, where it is felt that there is a higher probability of achieving positive abnormal rates of return because of potential inefficiencies

Matched-Funding Techniques Dedicated Portfolios  Dedication refers to bond portfolio management techniques that are used to service a prescribed set of liabilities –Pure Cash ‑ Matched Dedicated Portfolios Most conservative strategy –Dedication With Reinvestment Cash flows do not have to exactly match the liability stream

Matched-Funding Techniques Immunization Strategies –A portfolio manager (after client consultation) may decide that the optimal strategy is to immunize the portfolio from interest rate changes –The immunization techniques attempt to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates

Immunization Strategies Components of Interest Rate Risk – Price Risk – Coupon Reinvestment Risk

Classical Immunization Immunization is neither a simple nor a passive strategy An immunized portfolio requires frequent rebalancing because the modified duration of the portfolio always should be equal to the remaining time horizon (except in the case of the zero-coupon bond)

Classical Immunization Duration characteristics –Duration declines more slowly than term to maturity, assuming no change in market interest rates –Duration changes with a change in market interest rates –There is not always a parallel shift of the yield curve –Bonds with a specific duration may not be available at an acceptable price

Matched-Funding Techniques Horizon matching –Combination of cash-matching dedication and immunization –Important decision is the length of the horizon period

Contingent Procedures A form of structured active management –Constrains the manager if unsuccessful Contingent immunization –duration of portfolio must be maintained at the horizon value –cushion spread is potential return below current market –safety margin –trigger point

Implications of Capital Market Theory and the EMH on Bond Portfolio Management Bonds and Total Portfolio Theory Bonds and Capital Market Theory Bond Price Behavior in a CAPM Framework Bond-Market Efficiency

The Internet Investments Online

End of Chapter 20 –Bond Portfolio Management Strategies

Future topics Chapter 21 An Introduction to Derivative Markets and Securities