1. Chapter 6 Portfolio Management of Bond Funds

2. Holdings in Taxable Bond Funds (1) Issued by the U.S. government. U.S. Treasures Issued by federal government agencies or by government-sponsored enterprises, which include Fannie Mae and Freddie Mac. Agencies Residential mortgages assembled in a pool. Pass-through securities. Often government-guaranteed Considerable prepayment risk. Mortgage-backed securities

3. Holdings in Taxable Bond Funds (2) Loans assembled in a pool. Can include many types of loans. “Structured” securities, rather than pass- throughs. Asset-backed securities Issued by a corporation. Corporate bonds with lower credit ratings are junk or high yield bonds. They have higher risk and the potential for higher returns. Corporate bonds

4. Holdings in Taxable Bond Funds (3) Issued by foreign governments, international agencies and companies incorporated in other countries. Non-U.S. bonds Contracts that derive their value from other securities. Commonly-used derivatives include bond futures, interest rate swaps and credit default swaps. Derivatives

5. Overview of the Taxable Bond Market As of December 31, 2009 Source: Barclays Capital

6. Asset-Backed Securities Based on pools of almost any type of debt. Allow lenders to manager risk Are structured securities divided into tranches; each tranche is entitle to different segment of the risk and reward. Begin with a special purpose entity that holds a pool of loans and issues the tranches. The most junior tranche absorbs losses first, while the most senior tranche receives income first.

7. Structure of an Asset-Backed Security

8. Credit Default Swaps Are similar to insurance policies because they can provide protection against loss. –The buyer of a CDS (Credit Default Swap) pays a premium to a counterparty. –The policy pays off if the bond goes into default. Are different from insurance policies because they can be bought without being at risk of loss. –In other words, they can be bought by someone who does not own the underlying bond.

9. Holdings in Tax-Exempt Bond Funds (1) Issued by states and local governments. Backed by full taxing power. General obligation bonds or GOs Issued to fund a specific state or municipal project. Only revenues from the project are used to repay investors. Some revenue bonds are subject to alternative minimum tax. Includes high yield bonds with lower credit ratings. Revenue bonds

10. Holdings in Tax-Exempt Bond Funds (2) Repayment of principal and interest is guaranteed by an insurance company. Insured bonds Backed by a portfolio of U.S. Treasuries. Pre-refunded bonds

11. Overview of the Tax-Exempt Bond Market As of December 31, 2009 Source: Barclays Capital

12. Bond Fund Investment Strategies (1) Top-down strategies Duration management or interest rate anticipation Adjust average duration of holdings in fund based on macroeconomic outlook. Yield curve positioning Predict changes in the slope of the yield curve. Buy bonds in different segments of the curve. Sector selection Adjust allocation among different types of bonds.

13. Two Common Yield Curve Strategies

14. Bond Fund Investment Strategies (2) Bottom-up strategies Credit selection Choose bonds of issuers with improving business prospects. Predicting calls or prepayments Calculate value of imbedded options or estimate expected prepayments.

15. Bond Fund Portfolio Construction Liquidity and trading Credit selection Sector selection Yield curve positioning Duration management Benchmarks: index and peer group Prospectus objectives and restrictions

16. Major Bond Rating Categories FitchMoody’sStandard & Poor’sSummary Description Investment grade AAA (Triple A)AaaAAAHighest quality AA (Double A)AaAAVery low credit risk A (Single A)AALow default risk BBB (Triple B)BaaBBBLow default risk but vulnerable to adverse conditions Noninvestment grade, or junk, bonds BB (Double B)BaBBFaces higher level of uncertainty B (Single B)BBAble to meet obligations, but high default risk CCCCaaCCCReasonable possibility of default CCCaCCHigh possibility of default DCDIn default

17. Bond Basics Defining characteristics of bonds: Issuer. Par value. Coupon rate. Maturity date. Option features. –Call, put or conversion.

18. Bond Basics Key analytical measures: Current yield. Yield to maturity. Option-adjusted yield. Yield spread. Duration.

19. Bond Basics Risks of bond investments: Market or interest-rate risk. Reinvestment rate risk. Credit or default risk. Call risk. Liquidity risk. Event risk.