1. Global Edition Chapter 22 Bond Portfolio Management Strategies1

2. Learning Objectives After reading this chapter, you will understand
what is meant by asset allocation
the composition of a portfolio management team
top-down and bottom-up approaches to bond portfolio management
the spectrum of portfolio management strategies
what is meant by a core/satellite strategy bond indices
the different types of active bond portfolio strategies: interest-rate expectations strategies, yield curve strategies, yield spread strategies, option-adjusted spread-based strategies, and individual security selection strategies

3. Learning Objectives(continued)
After reading this chapter, you will understand
bullet, barbell, and ladder yield curve strategies
the limitations of using duration and convexity to assess the potential performance of bond portfolio strategies
why it is necessary to use the dollar duration when implementing a yield spread strategy
how to assess the allocation of funds within the corporate bond sector
why leveraging is used by managers and traders and the risks and rewards associated with leveraging
how to leverage using the repo market

4. The Asset Allocation Decision
Public pension funds have allocations of about 2/3 in equities (which includes real estate and private equity) and about 1/3 in fixed income.
Regardless of the institutional investor, there are two important decisions to be made by an investor/client:
“How much should be allocated to bonds?”
“Who should manage the funds to be allocated to bonds?”

5. The Asset Allocation Decision (continued)
How Much Should Be Allocated To Bonds?
The decision as to how much to invest in the major asset classes is referred to as the asset allocation decision. The asset allocation decision must be made in light of the investor’s investment objective.
For institutions such as pension funds, the investment objective is to generate sufficient cash flow from investments to satisfy pension obligations. For life insurance companies, the basic objective is to satisfy obligations stipulated in insurance policies and generate a profit.
For institutions such as banks and thrifts, funds are obtained from the issuance of certificates of deposit, short-term money market instruments, or floating-rate notes. These funds are then invested in loans and marketable securities. The objective in this case is to earn a return on invested funds that exceeds the cost of acquiring those funds.

6. The Asset Allocation Decision (continued)
Who Should Manage the Bond Portfolio?
Let’s assume that an investor has made the decision to allocate a specified amount to the fixed income sector.
The next decision that must be made is whether that amount will be managed by internal managers or external managers or by a combination of internal and external managers.
If external managers are hired, a decision must be made as to which asset management firm to engage.

7. The Asset Allocation Decision (continued)
Who Should Manage the Bond Portfolio?
In practice, the term asset allocation is used in two contexts.
The first involves allocation of funds among major asset classes that includes bonds, equities and alternative assets.
Although we have mentioned bonds and equities as the major asset classes, there is now accepted a group of assets referred to as alternative assets. For example, for CalPERS, the actual (as of January 31, 2011) and target allocation (as of June 2009) asset allocation amongst the asset classes defined by CalPERS is shown in Exhibit (see Overhead 22-8).
2) The second way is how the funds should be allocated amongst the different sectors within that asset class after a decision has been made to invest in a specified asset class.
In the case of equities, equities are classified by market capitalization and by other attributes such as growth stocks value.

8. Market Value ($ billion)
Exhibit 22-1Asset Allocation of CalPERS: Actual as of January 31, 2011, and Target Allocation as of June 2009
Asset Class
Market Value ($ billion)
Actual Allocation
Target Allocation (%)
Cash Equivalents
4.50
2.0%
Global Fixed Income
47.50
20.8%
20.0%
AIM
32.20
14.1%
14.0%
Equity
120.30
52.8%
49.0%
Total Global Equities
152.50
66.9%
63.0%
Real Estate Global
16.60
7.3%
10.0%
Inflation Linked Global
6.80
3.0%
5.0%
Total Fund*
227.90
100.0%
Source:

9. The Asset Allocation Decision (continued)
Who Should Manage the Bond Portfolio?
The asset allocation among the different sectors of the bond is made at two levels.
The first is where a client must make a decision as to allocate among each sector and
then if an external money manager is to be hired, deciding on the asset management and amount to be allocated to each.

10. Portfolio Management Team
We refer to the person making the investment decisions as the “manager” or “portfolio manager.”
The composition and therefore risk exposure of a portfolio is the result of recommendations and research provided by the portfolio management team.
At the top of the investment organization chart of the investment group is the chief investment officer (CIO) who is responsible for all of the portfolios.
A chief compliance officer (CCO) monitors portfolios to make sure that the holdings comply with the fund’s investment guidelines and that there are no activities conducted by the managers of the fund that are in violation of federal and state securities laws or investment policies.

11. Portfolio Management Team (continued)
An asset management firm employs analysts and traders.
The analysts are responsible for the different sectors and industries.
The traders are responsible for executing trades approved by a portfolio manager.
The analysts and traders can support all of the portfolios managed by the firm or just designated portfolios.
A large firm may also employ an economist or an economic staff that would support all portfolios managed by the firm.
At the individual portfolio level there is either a lead or senior portfolio manager or co-managers.
It is the lead manager or co-managers who will make the decision regarding the portfolio’s interest rate exposure and the allocation of the fund’s assets among the countries, sectors and industries.

12. Spectrum of Bond Portfolio Strategies
The bond portfolio strategy selected by an investor or client depends on the investment objectives and policy guidelines.
In general, bond portfolio strategies can be categorized into the following three groups:
bond benchmark-based strategies,
absolute return strategies, and
liability-driven strategies.

13. Spectrum of Bond Portfolio Strategies (continued)
Bond Benchmark-Based Strategies
There is a wide range of bond portfolio management strategies for an investor or client who has selected a bond index as a benchmark.
Traditional bond benchmark-based strategies can be classified as:
pure bond index matching;
enhanced indexing: matching primary risk factors;
enhanced indexing: minor risk-factor mismatches;
active management: larger risk-factor mismatches; and
active management: full-blown active.
These strategies range from low risk strategies at the top to high risk-tolerance strategies at the bottom of the above list.
It is not only important to understand what the risk factors are, but also how to quantify them.

14. Spectrum of Bond Portfolio Strategies (continued)
Bond Benchmark-Based Strategies
A portfolio manager is not permitted to deviate from the benchmark’s duration for bond benchmark-based strategies, absolute return strategies, and liability-driven strategies.
The last two strategies are active bond portfolio management strategies.
They differ to the extent with which they allow mismatches relative to the benchmark.
It is important to note that even if a manager pursues an active strategy, the manager may still elect to have a duration equal to that of the benchmark (i.e., pursue a duration-matching strategy).

15. Spectrum of Bond Portfolio Strategies
Portfolio managers often pursue what is referred to as a core/satellite strategy.
Basically, this strategy involves building a blended portfolio using an indexed and active strategy.
The core component is a low-risk portfolio constructed using one of the indexing strategies.
The satellite component is constructed using an active strategy with a benchmark that is specialized rather than a broad liquid bond market index.

16. Spectrum of Bond Portfolio Strategies (continued)
Absolute Return Strategies
In an absolute return strategy, the portfolio manager seeks to earn a positive return over some time frame irrespective of market conditions.
Few restrictions are placed on the exposure to the primary risk factors.
Absolute return strategies are typically pursued by hedge fund managers using leverage.
Other absolute return managers set as their target as earning a return from 150 to 400 basis points per annum over the return on cash and hence such strategies are referred to as cash-based absolute return strategies.

17. Spectrum of Bond Portfolio Strategies (continued)
Liability-Driven Strategies
A bond portfolio strategy that calls for structuring a portfolio to satisfy future liabilities is called a liability-driven strategy.
When the portfolio is constructed so as to generate sufficient funds to satisfy a single future liability regardless of the course of future interest rates, a strategy known as immunization is often used.
When the portfolio is designed to funding multiple future liabilities regardless of how interest rates change, strategies such as immunization, cash flow matching (or dedication), or horizon matching can be employed.

18. Bond Indexes
Typically, bond portfolio managers are given a mandate that involves their performance evaluation relative to a bond index.
The wide range of bond market indexes available can be classified as broad-based market indexes and specialized market indexes.
Why have broker/dealer firms developed and aggressively marketed their bond indexes?
Enhancing the firm’s image is only a minor reason.
The key motivation lies in the potential profit that the firm will make by executing trades to set up an indexed portfolio and rebalance it.

19. Bond Indexes (continued)
The broad-based U.S. bond market indexes most commonly used by institutional investors are the Barclays Capital U.S. Aggregate Bond Index.
The index is a market-value weighted index.
The pricing of the securities in each index are either trader priced or model priced.
Each index is broken into sectors.
Understanding the eligibility requirements for inclusion in a bond index is important.
Active bond portfolio strategies often attempt to outperform an index by buying non-eligible or non- index securities.

20. The Primary Risk Factors
Primary risk factors in bond indexes are those risk factors that a portfolio manager can match or mismatch when constructing a portfolio.
A portfolio manager will only intentionally mismatch if the belief is that the manager has information that strongly suggests there is a benefit that is expected to result from mismatching.
The primary risk factors can be divided into two general types:
systematic risk factors and
non-systematic risk factors.
Systematic risk factors are forces that affect all securities in a certain category in the benchmark.
Non-systematic risk factors are the risks that are not attributable to the systematic risk factors.

21. The Primary Risk Factors(continued)
Systematic risk factors, in turn, are divided into two categories: term structure risk factors and non-term structure risk factors.
Term structure risk factors are risks associated with changes in the shape of the term structure.
Non-term structure risk factors include sector risk, credit risk and optionality risk.
Sector risk is the risk associated with exposure to the sectors of the benchmark.
Credit risk, also referred to as quality risk, is the risk associated with exposure to the credit rating of the securities in the benchmark.
Optionality risk is the risk associated with an adverse impact on the embedded options of the securities in the benchmark.
Non-systematic factor risks are classified as non-systematic risks associated with a particular issuer, issuer-specific risk, and those associated with a particular issue, issue-specific risk.

22. Top-Down Versus Bottom-Up Portfolio Construction and Management
There are two general approaches to construction and management of a bond portfolio: top-down and bottom-up.
Typically, a portfolio blends the elements of both approaches in junction with certain considerations and constraints in constructing a portfolio.
In the top-down approach, a bond portfolio manager looks at the major macro drivers of bond returns (hence this approach is also referred to as a macro approach) and obtains a view (forecast) about these drivers in the form of a macroeconomic forecast.
Among the major variables considered in obtaining a macroeconomic forecast are monetary policy, fiscal policy, tax policy, political developments, regulatory matters, exchange- rate movements, trade policy, demographic trends, and credit market conditions.

23. Top-Down Versus Bottom-Up Portfolio Construction and Management (continued)
Given the amount of the portfolio's funds to be allocated to each sector of the bond market, the manager must then decide how much to allocate to each industry within a sector.
In the case of bond portfolio manager who is entitled to invest in both U.S. and non-U.S. bonds, the first decision is the allocation among countries, then sectors within a country, and then industries.
The bottom-up approach to active bond portfolio management focuses on the micro analysis of individual bond issues, sectors, and industries.
The primary research tools used in this form of investing is credit analysis, industry analysis, and relative value analysis.
To control the portfolio’s risk, risk modeling is used.

24. Active Portfolio Strategies
Manager Expectations Versus the Market Consensus
A money manager who pursues an active strategy will position a portfolio to capitalize on expectations about future interest rates, but the potential outcome (as measured by total return) must be assessed before an active strategy is implemented.
The primary reason for this is that the market (collectively) has certain expectations for future interest rates and these expectations are embodied into the market price of bonds.
We emphasize the use of the total return framework for evaluating active strategies rather than the blind pursuit of a strategy based merely on general statements.

25. Active Portfolio Strategies (continued)
Interest-Rate Expectations Strategies
A money manager who believes that he or she can accurately forecast the future level of interest rates will alter the portfolio’s sensitivity to interest-rate changes.
A portfolio’s duration may be altered by swapping (or exchanging) bonds in the portfolio for new bonds that will achieve the target portfolio duration.
Such swaps are commonly referred to as rate anticipation swaps.
Although a manager may not pursue an active strategy based strictly on future interest-rate movements, there can be a tendency to make an interest-rate bet to cover inferior performance relative to a benchmark index.
There are other active strategies that rely on forecasts of future interest-rate levels.

26. Active Portfolio Strategies (continued)
Yield Curve Strategies
The yield curve for U.S. Treasury securities shows the relationship between their maturities and yields.
The shape of this yield curve changes over time.
Yield curve strategies involve positioning a portfolio to capitalize on expected changes in the shape of the Treasury yield curve.

27. Active Portfolio Strategies (continued)
Types of Shifts in the Yield Curve and Impact on Historical Returns
A shift in the yield curve refers to the relative change in the yield for each Treasury maturity.
A parallel shift in the yield curve is a shift in which the change in the yield on all maturities is the same.
A nonparallel shift in the yield curve indicates that the yield for maturities does not change by the same number of basis points.
Historically, two types of nonparallel yield curve shifts have been observed: a twist in the slope of the yield curve and a change in the humpedness of the yield curve.
A flattening of the yield curve indicates that the yield spread between the yield on a long-term and a short-term Treasury has decreased; a steepening of the yield curve indicates that the yield spread between a long-term and a short-term Treasury has increased.
The other type of nonparallel shift, a change in the humpedness of the yield curve, is referred to as a butterfly shift.

28. Active Portfolio Strategies (continued)
Yield Curve Strategies
Frank Jones analyzed the types of yield curve shifts that occurred between 1979 and 1990.
He found that the three types of yield curve shifts are not independent, with the two most common types of yield curve shifts being
a downward shift in the yield curve combined with a steepening of the yield curve.
an upward shift in the yield curve combined with a flattening of the yield curve.
These two types of shifts in the yield curve are depicted in Exhibit 22-3 (see Overheads and ).

29. Exhibit 22-3 Combinations of Yield Curve Shifts
Upward Shift / Flattening/ Positive Butterfly
Positive Butterfly
Flattening
Parallel
Yield
Maturity

30. Exhibit 22-3 Combinations of Yield Curve Shifts
Downward Shift / Steepening / Negative Butterfly
Yield
Maturity
Negative Butterfly
Steepening
Parallel

31. Active Portfolio Strategies (continued)
Yield Curve Strategies
In portfolio strategies that seek to capitalize on expectations based on short-term movements in yields, the dominant source of return is the impact on the price of the securities in the portfolio.
This means that the maturity of the securities in the portfolio will have an important impact on the portfolio’s return.
The key point is that for short-term investment horizons, the spacing of the maturity of bonds in the portfolio will have a significant impact on the total return.
In a bullet strategy, the portfolio is constructed so that the maturities of the securities in the portfolio are highly concentrated at one point on the yield curve.
In a barbell strategy, the maturities of the securities in the portfolio are concentrated at two extreme maturities.
In a ladder strategy the portfolio is constructed to have approximately equal amounts of each maturity.

32. Active Portfolio Strategies (continued)
Duration and Yield Curve Shifts
Duration is a measure of the sensitivity of the price of a bond or the value of a bond portfolio to changes in market yields.
A bond with a duration of 4 means that if market yields change by 100 basis points, the bond will change by approximately 4%.
However, if a three-bond portfolio has a duration of 4, the statement that the portfolio’s value will change by 4% for a 100-basis-point change in yields actually should be stated as follows:
The portfolio’s value will change by 4% if the yield on five-, 10-, and 20-year bonds all change by 100 basis points. That is, it is assumed that there is a parallel yield curve shift.

33. Active Portfolio Strategies (continued)
Analyzing Expected Yield Curve Strategies
The proper way to analyze any portfolio strategy is to look at its potential total return.
If a manager wants to assess the outcome of a portfolio for any assumed shift in the Treasury yield curve, this should be done by calculating the potential total return if that shift actually occurs.
This can be illustrated by looking at the performance of two hypothetical portfolios of Treasury securities assuming different shifts in the Treasury yield curve.
The three hypothetical Treasury securities shown in Exhibit (see Overhead 22-34) are considered for inclusion in our two portfolios.
For our illustration, the Treasury yield curve consists of these three Treasury securities: a short-term security (A, the five-year security), an intermediate-term security (C, the 10-year security), and a long-term security (B, the 20-year security).

34. Exhibit 22-5Three Hypothetical Treasury Securities
Bond
Coupon (%)
Maturity
(years)
Price Plus
Accrued
Yield to
Maturity (%)
Dollar
Duration
Convexity A
8.50 5
100
4.005 B
9.50 20
8.882 C
9.25 10
6.434

35. Active Portfolio Strategies (continued)
Analyzing Expected Yield Curve Strategies
Duration is just a first approximation of the change in price resulting from a change in interest rates. Convexity provides a second approximation.
Dollar convexity has a meaning similar to convexity, in that it provides a second approximation to the dollar price change.
For two portfolios with the same dollar duration, the greater the convexity, the better the performance of a bond or a portfolio when yields change.
What is necessary to understand is that the larger the dollar convexity, the greater the dollar price change due to a portfolio’s convexity.

36. Active Portfolio Strategies (continued)
Analyzing Expected Yield Curve Strategies
Now suppose that a portfolio manager with a six-month investment horizon has a choice of investing in the bullet portfolio or the barbell portfolio.
Which one should he choose? The manager knows that (1) the two portfolios have the same dollar duration, (2) the yield for the bullet portfolio is greater than that of the barbell portfolio, and (3) the dollar convexity of the barbell portfolio is greater than that of the bullet portfolio.
Actually, this information is not adequate in making the decision. What is necessary is to assess the potential total return when the yield curve shifts.

37. Active Portfolio Strategies (continued)
Analyzing Expected Yield Curve Strategies
Exhibit 22-6 provides an analysis of the six-month total return of the two portfolios when the yield curve shifts. (See truncated version of Exhibit 22-6 in Overhead )
The numbers reported in the exhibit are the difference in the total return for the two portfolios.
Specifically, the following is shown:
difference in dollar return =
bullet portfolio’s total return – barbell portfolio’s total return
A positive value means that the bullet portfolio outperformed the barbell portfolio, and a negative sign means that the barbell portfolio outperformed the bullet portfolio.

38. Exhibit Relative Performance of Bullet Portfolio and Barbell Portfolio over a Six-Month Investment Horizon
Yield
Change
Parallel
Shift
Nonparallel
Shift (%)
−5.000
−7.19
−10.69
−3.89
−4.750
−6.28
−9.61
−3.12
−4.500
−5.44
−8.62
−2.44
−4.250
−4.68
−7.71
−1.82
−4.000
−4.00
−6.88
−1.27
−3.750
−3.38
−6.13
−0.78
−3.500
−2.82
−0.35 …
3.750
−1.39
−1.98
−0.85
4.000
−1.57
−2.12
−1.06
4.250
−1.75
−2.27
4.500
−1.93
−2.43
−1.48
4.750
−2.58
−1.70
5.000
−2.31
−2.75
−1.92

39. Active Portfolio Strategies (continued)
Analyzing Expected Yield Curve Strategies
Let’s focus on the second column of Exhibit 22-6 (as was seen in Overhead 22-38), which is labeled “parallel shift.”
This is the relative total return of the two portfolios over the six-month investment horizon assuming that the yield curve shifts in a parallel fashion.
In this case parallel movement of the yield curve means that the yields for the short-term bond (A), the intermediate-term bond (C), and the long-term bond (B) change by the same number of basis points, shown in the “yield change” column of the table.
Which portfolio is the better investment alternative if the yield curve shifts in a parallel fashion and the investment horizon is six months? The answer depends on the amount by which yields change.
Notice that when yields change by less than 100 basis points, the bullet portfolio outperforms the barbell portfolio. The reverse is true if yields change by more than 100 basis points.

40. Active Portfolio Strategies (continued)
Analyzing Expected Yield Curve Strategies
This illustration makes two key points.
First, even if the yield curve shifts in a parallel fashion, two portfolios with the same dollar duration will not give the same performance. The reason is that the two portfolios do not have the same dollar convexity.
The second point is that although with all other things equal it is better to have more convexity than less, the market charges for convexity in the form of a higher price or a lower yield. But the benefit of the greater convexity depends on how much yields change.
From the second column of Exhibit 22-6 (as was seen in Overhead 22-38), if market yields change by less than 100 basis points (up or down), the bullet portfolio, which has less convexity, will provide a better total return.

41. Active Portfolio Strategies (continued)
Approximating the Exposure of a Portfolio’s Yield Curve Risk
A portfolio and a benchmark have key rate durations.
The extent to which the profile of the key rate durations of a portfolio differs from that of its benchmark helps identify the difference in yield curve risk exposure.
Complex Strategies
A study by Fabozzi, Martinelli, and Priaulet finds evidence of the predictability in the time-varying shape of the U.S. term structure of interest rates using a more advanced econometric model.
Variables such as default spread, equity volatility, and short-term and forward rates are used to predict changes in the slope of the yield curve and (to a lesser extent) changes in its curvature.
Systematic trading strategies based on butterfly swaps reveal that the evidence of predictability in the shape of the yield curve is both statistically and economically significant.

42. Active Portfolio Strategies (continued)
Yield Spread Strategies
Yield spread strategies involve positioning a portfolio to capitalize on expected changes in yield spreads between sectors of the bond market.
Swapping (or exchanging) one bond for another when the manager believes that the prevailing yield spread between the two bonds in the market is out of line with their historical yield spread, and that the yield spread will realign by the end of the investment horizon, are called intermarket spread swaps.
Credit Spreads
Credit or quality spreads change because of expected changes in economic prospects. Credit spreads between Treasury and non-Treasury issues widen in a declining or contracting economy and narrow during economic expansion.
Spreads attributable to differences in callable and noncallable bonds and differences in coupons of callable bonds will change as a result of expected changes in (1) the direction of the change in interest rates, and (2) interest-rate volatility.

43. Active Portfolio Strategies (continued)
Spreads between Callable and Noncallable Securities
Spreads attributable to differences in callable and noncallable bonds and differences in coupons of callable bonds will change as a result of expected changes in (1) the direction of the change in interest rates, and (2) interest-rate volatility.
An expected drop in the level of interest rates will widen the yield spread between callable bonds and noncallable bonds as the prospects that the issuer will exercise the call option increase.
Importance of Dollar Duration Weighting of Yield Spread Strategies
What is critical in assessing yield spread strategies is to compare positions that have the same dollar duration.
To understand why, consider two bonds, X and Y that are being considered as alternative investments in a strategy other than one based on anticipating interest-rate movements.
The amount of each bond in the strategy should be such that they will both have the same dollar duration.

44. Active Portfolio Strategies (continued)
Individual Security Selection Strategies
There are several active strategies that money managers pursue to identify mispriced securities
The most common strategy identifies an issue as undervalued because either
its yield is higher than that of comparably rated issues, or
its yield is expected to decline (and price therefore rise) because credit analysis indicates that its rating will improve.
A swap in which a money manager exchanges one bond for another bond that is similar in terms of coupon, maturity, and credit quality, but offers a higher yield, is called a substitution swap.

45. Active Portfolio Strategies (continued)
Strategies for Asset Allocation within Bond Sectors
The ability to outperform a benchmark index will depend on the how the manager allocates funds within a bond sector relative to the composition of the benchmark index.
Exhibit 22-7 (see Overhead 22-46) shows a one-year rating transition matrix (table) based on a Moody’s study for the period 1970–1993.
Exhibit 22-8 (see Overhead 22-47) shows the expected incremental return estimates for a portfolio consisting of only three-year Aa-rated bonds.
Exhibit 22-9 (see Overhead 22-48) shows expected incremental returns over Treasuries assuming the rating transition matrix given in Exhibit and assuming that the horizon spreads are the same as the initial spreads.

46. Exhibit 22-7 One-Year Rating Transition Probabilities (%)
Aaa Aa A
Baa Ba Bb
C or D
Total
91.90
7.38
0.72
0.00
100.00
1.13
91.26
7.09
0.31
0.21
0.10
2.56
91.20
5.33
0.61
0.20
5.36
87.94
5.46
0.82
Source: From Leland E. Crabbe, “A Framework for Corporate Bond Strategy,” Journal of Fixed Income, June 1995, p. 16. Reprinted by permission of Institutional Investor.

47. Exhibit 22-8Expected Incremental Return Estimates for Three-Year Aa-Rated Bonds over a One-Year Horizon
Initial
Spread
Horizon
Rating
Return over
Treasuries
(bp) X
Transition
Probability
(%) =
Contribution to
Incremental
Return (bp) 30
Aaa 25 38
1.13
0.43 Aa
91.26
27.38 A 35 21
7.09
1.49
Baa 60
–24
0.31
–0.07 Ba
130
–147
0.21
–0.31
Portfolio Incremental Return over Treasuries = 28.90
Source: From Leland E. Crabbe, “A Framework for Corporate Bond Strategy,” Journal of Fixed Income, June 1995, p. 17. Reprinted by permission of Institutional Investor.

48. Exhibit 22-9Expected Incremental Returns over Treasuries When Rating Transitions Match Historical Experience (One-Year Horizon, bp)
Initial
Spread
Incremental
Return
Aaa 25
24.2 30
28.4 Aa
28.9 35
31.4 A
31.1 45
37.3
Baa 60
46.3 70
39.9
31.7
34.6 40
30.3 55
34.8
37.9 75
42.7 85
21.9
115
27.4
Source: From Leland E. Crabbe, “A Framework for Corporate Bond Strategy,” Journal of Fixed Income, June 1995, p. 18. Reprinted by permission of Institutional Investor.

49. The Use of Leverage
If permitted by investment guidelines a manager may use leverage in an attempt to enhance portfolio returns.
A portfolio manager can create leverage by borrowing funds in order to acquire a position in the market that is greater than if only cash were invested.
The funds available to invest without borrowing are referred to as the “equity.”
A portfolio that does not contain any leverage is called an unlevered portfolio.
A levered portfolio is a portfolio in which a manager has created leverage.

50. The Use of Leverage (continued)
Motivation for Leverage
The basic principle in using leverage is that a manager wants to earn a return on the borrowed funds that is greater than the cost of the borrowed funds.
The return from borrowing funds is produced from a higher income and/or greater price appreciation relative to a scenario in which no funds are borrowed.
The return from investing the funds comes from two sources.
interest income
change in the value of the security (or securities) at the end of the borrowing period
There are some managers who use leverage in the hopes of benefiting primarily from price changes.
Small price changes will be magnified by using leveraging.
For example, if a manager expects interest rates to fall, the manager can borrow funds to increase price exposure to the market.
Effectively, the manager is increasing the duration of the portfolio.

51. The Use of Leverage (continued)
Motivation for Leverage
The risk associated with borrowing funds is that the security (or securities) in which the borrowed funds are invested may earn less than the cost of the borrowed funds due to failure to generate interest income plus capital appreciation as expected when the funds were borrowed.
Leveraging is a necessity for depository institutions (such as banks and savings and loan associations) because the spread over the cost of borrowed funds is typically small.
The magnitude of the borrowing (i.e., the degree of leverage) is what produces an acceptable return for the institution.

52. The Use of Leverage (continued)
Duration of a Leveraged Portfolio
In general, the procedure for calculating the duration of a portfolio that uses leverage is as follows: 
Step 1: Calculate the duration of the levered portfolio.
Step 2: Determine the dollar duration of the portfolio of the levered portfolio for a change in interest rates.
Step 3: Compute the ratio of the dollar duration of the levered portfolio to the value of the initial unlevered portfolio (i.e., initial equity).
Step 4: The duration of the unlevered portfolio is then found as follows:

53. The Use of Leverage (continued)
How to Create Leverage Via the Repo Market
A manager can create leverage in one of two ways. One way is through the use of derivative instruments. The second way is to borrow funds via a collateralized loan arrangement.
Repurchase Agreement
A repurchase agreement is the sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. The price at which the seller must subsequently repurchase the security for is called the repurchase price, and the date that the security must be repurchased is called the repurchase date.
There is a good deal of Wall Street jargon describing repo transactions. To understand it, remember that one party is lending money and accepting a security as collateral for the loan; the other party is borrowing money and providing collateral.

54. The Use of Leverage (continued)
Credit Risks
Despite the fact that there may be high-quality collateral underlying a repo transaction, both parties to the transaction are exposed to credit risk.
Repos should be carefully structured to reduce credit risk exposure.
The amount lent should be less than the market value of the security used as collateral, thereby providing the lender with some cushion should the market value of the security decline.
The amount by which the market value of the security used as collateral exceeds the value of the loan is called repo margin or simply margin.

55. The Use of Leverage (continued)
Determinants of the Repo Rate
There is not one repo rate.
The rate varies from transaction to transaction depending on a variety of factors: quality of collateral, term of the repo, delivery requirement, availability of collateral, and the prevailing federal funds rate.
The more difficult it is to obtain the collateral, the lower the repo rate.
To understand why this is so, remember that the borrower (or equivalently the seller of the collateral) has a security that lenders of cash want, for whatever reason. Such collateral is referred to as hot or special collateral.
Collateral that does not have this characteristic is referred to as general collateral.

56. Key Points
The asset allocation decision is the decision made to determine how much should be allocated amongst the major asset classes and is made in the light of the investment objective.
Once the asset allocation decision is made, the client must decide whether to use only internal managers, use only external managers, or use a combination of internal and external managers.
The term asset allocation is also used after a decision has been made to invest in a specified asset class to indicate how funds should be allocated amongst the different sectors within that asset class.
In general, there are three categories of bond portfolio strategies: bond benchmark-based strategies, absolute return strategies, and liability-driven strategies.

57. Key Points (continued)
Bond benchmark-based strategies include indexing type strategies (pure bond index matching enhanced indexing with matching of primary risk factors, and enhanced indexing with minor risk-factor mismatches) and active management type strategies (with larger risk-factor mismatches and full-blown active).
With a core/satellite strategy there is a blending of an indexed strategy (to create a low-risk core portfolio) and an active strategy (to create a specialized higher risk-tolerant satellite portfolio).
The wide range of bond market indexes available can be classified as broad-based market indexes and specialized market indexes.
The primary risk factors affecting a portfolio are divided into systematic risk factors and nonsystematic risk factors. In turn, each of these risk factors is further decomposed. Systematic risk factors are divided into term structure risk factors and non-term structure risk factors. Examples of non-term structure risk factors are sector risk, credit risk, and optionality risk. Non-systematic risk factors are classified as issuer-specific risk and issue-specific risk.

58. Key Points (continued)
Active bond portfolio strategies seek to capitalize on expectations about changes in factors that will affect the price and therefore the performance of an issue over some investment horizon.
The total return framework should be used to assess how changes in these factors will affect the performance of a strategy over some investment horizon.
Leveraging involves creating an exposure to a market in excess of the exposure that can be obtained without borrowing funds. The objective is to earn a return in excess of the cost of the borrowed funds. The risk is that the manager will earn a return less than the cost of the borrowed funds. The return on the borrowed funds is realized from the interest earned plus the change in the value of the securities acquired. The duration of a portfolio is magnified by leveraging a portfolio.
The most common way in which a manager can borrow funds is via a repurchase agreement. This is a collateralized loan arrangement in which a party borrows funds. It is called a reverse repo agreement when a party lends funds. There is credit risk in a repo agreement, and there are mechanisms for mitigating this risk.