1. 16 Investment Analysis and Portfolio Management First Canadian Edition
By Reilly, Brown, Hedges, Chang 16

2. Chapter 16 Bond Portfolio Management Strategies
Bond Portfolio Performance, Style, and Strategy
Passive Management Strategies
Active Management Strategies
Core-Plus Management Strategies
Matched-Funding Strategies
Contingent and Structured Strategies
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3. Bond Portfolio Performance, Style, and Strategy
Fixed-income portfolios generally produce both less return and less volatility than found in other asset classes (e.g., domestic equity, foreign equity)
The low historical correlation between fixed-income and equity securities—Reilly and Wright (2004) calculated this to be 0.27—has made bond portfolios an excellent tool for diversifying risk
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4. Bond Portfolio Performance, Style, and Strategy
Investment style of a bond portfolio can be summarized by two important characteristics:
credit quality
interest rate sensitivity
Average credit quality of the portfolio can be classified as high, medium, and low grades
Interest rate sensitivity of the bond portfolio can be separated as:
short-term
intermediate-term
long-term
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5. Bond Portfolio Performance, Style, and Strategy
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6. Bond Portfolio Performance, Style, and Strategy
Bond Portfolio Strategies (Exhibit 16.3)
Passive Portfolio Strategies
Active Management Strategies
Core-plus Management Strategy
Matched-funding Techniques
Contingent Procedure (Structured Active Management)
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7. Bond Portfolio Performance, Style, and Strategy
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8. Passive Management 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
Can by modified by trading into more desirable positions
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9. Passive Management Strategies
Indexing
The objective is to construct a portfolio of bonds that will track the performance of a bond index
Performance analysis involves examining tracking error for differences between portfolio performance and index performance
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10. Active Management Strategies
Active management strategies attempt to beat the market
Mostly the success or failure is going to come from the ability to accurately forecast future interest rates
Active Strategy Attributes
Scalability
Sustainability
Risk-adjusted performance
Extreme values
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11. 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
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12. Active Management Strategies
Valuation analysis
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
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13. Active Management Strategies
Credit Analysis Models
High-Yield Bond Research
Modified Z-score model
Exhibit 16.7, p. 503
Yield spread analysis
Assumes normal relationships exist between the yields for bonds in alternative sectors (Chapter 12)
Active Bond Transactions
Pure Yield Pickup Swap
Substitution Swap

14. Active Global Bond Investing
An active approach to global fixed-income management must consider the following three interrelated factors:
Local economy in each country including the effects of domestic and international demand
Impact of total demand and domestic monetary policy on inflation and interest rates
Effect of the economy, inflation, and interest rates on the exchange rates among countries

15. Core-Plus Management Strategies
Combination of passive and active styles (a form of enhanced indexing)
Large part of the portfolio is passively managed in one of two sectors:
U.S. aggregate sector, which includes mortgage-backed and asset-backed securities
U.S. Government/corporate sector alone
Rest of the portfolio is actively managed
Often focused on high yield bonds, foreign bonds, emerging market debt
Diversification effects help to manage risks
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16. Matched-Funding Strategies
Dedicated Portfolios
Designing portfolios that will service liabilities
Exact cash match
Conservative strategy, matching portfolio cash flows to needs for cash
Useful for sinking funds and maturing principal payments
Dedication with reinvestment
Does not require exact cash flow match with liability stream
Great choices, flexibility can aid in generating higher returns with lower costs
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17. Matched-Funding Strategies
Immunization Strategies
Process is intended to eliminate interest rate risk that includes:
Price Risk
Coupon Reinvestment Risk
Portfolio manager (after client consultation) may decide that the optimal strategy is to immunize the portfolio from interest rate changes
Immunization techniques attempt to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates
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18. Matched Funding Strategies
Classical Immunization
Immunize a portfolio from interest rate risk by keeping the portfolio duration equal to the investment horizon
Duration strategy superior to a strategy based only a maturity since duration considers both sources of interest rate risk
An immunized portfolio requires frequent rebalancing because the modified duration of the portfolio always should be equal to the remaining time horizon
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19. Matched Funding Strategies
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
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20. Matched-Funding Strategies
Horizon matching
Combination of cash-matching dedication and immunization
Important decision is the length of the horizon period
With multiple cash needs over specified time periods, can duration-match for the time periods, while cash-matching within each time period
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21. Matched-Funding Strategies
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22. Contingent & Structured Strategies
Contingent procedures for managing bond portfolios are a form of what has come to be called structured active management
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23. Contingent & Structured Strategies
Contingent Immunization
Duration of portfolio must be maintained at the horizon value
Cushion spread is potential return below the current market return
Safety margin is a portfolio value above the required value
Trigger point refers to the minimum return that will stop active portfolio management
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24. Contingent & Structured Strategies
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25. Contingent & Structured Strategies
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26. Contingent & Structured Strategies
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