1. Chapter 20 BOND PORTFOLIO MANAGEMENT

2. Chapter 20 Questions What are three major bond-portfolio management strategies?What are three major bond-portfolio management strategies? What are the two specific strategies for passive portfolio management?What are the two specific strategies for passive portfolio management? What are the six strategies for active portfolio management?What are the six strategies for active portfolio management? What do we mean by matched-funding techniques, and what are the four specific strategies?What do we mean by matched-funding techniques, and what are the four specific strategies?

3. Chapter 20 Questions How are futures contracts used to hedge against cash deposits or withdrawals from a bond portfolio?How are futures contracts used to hedge against cash deposits or withdrawals from a bond portfolio? How are futures used to change the systematic risk (i.e., duration) of an actively managed portfolio?How are futures used to change the systematic risk (i.e., duration) of an actively managed portfolio? What are some of the general advantages of using derivatives in bond-portfolio management?What are some of the general advantages of using derivatives in bond-portfolio management?

4. Alternative Bond Portfolio Strategies 1. Passive portfolio strategies 2. Active management strategies 3. Matched-funding techniques

5. Passive Portfolio Strategies Passive strategies emphasize buy-and- hold, low energy managementPassive strategies emphasize buy-and- hold, low energy management Try to earn the market return rather than beat the market returnTry to earn the market return rather than beat the market return

6. Passive Portfolio Strategies Buy and holdBuy and hold –Buy a portfolio of bonds and hold them to maturity –Can by modified by trading into more desirable positions IndexingIndexing –Match performance of a selected bond index –Performance analysis involves examining tracking error for differences between portfolio performance and index performance

7. Active Management Strategies Active management strategies attempt to beat the marketActive management strategies attempt to beat the market Mostly the success or failure is going to come from the ability to accurately forecast future interest ratesMostly the success or failure is going to come from the ability to accurately forecast future interest rates

8. Active Management Strategies Interest-rate anticipationInterest-rate anticipation –Risky strategy relying on uncertain forecasts of future interest rates, adjusting portfolio duration –Ladder strategy staggers maturities –Barbell strategy splits funds between short duration and long duration securities Valuation analysisValuation analysis –A form of fundamental analysis, this strategy selects bonds that are thought to be priced below their estimated intrinsic value

9. Active Management Strategies Credit analysisCredit analysis –Detailed analysis of the bond issuer –Determines expected changes in default risk –Try to predict rating changes and trade accordingly Buy bonds with expected upgradesBuy bonds with expected upgrades Sell bonds with expected downgradesSell bonds with expected downgrades

10. Active Management Strategies Yield-spread analysisYield-spread analysis –Monitor spreads within and across sectors, bond ratings, or industries –Trade in anticipation of changing spreads Bond swaps Bond swaps –Selling one bond (S) and purchasing another (P) simultaneously –Swaps to increase current yield or YTM, take advantage of shifts in interest rates or realignment of yield spreads, improve quality of portfolio, or for tax purposes

11. Active Management Strategies Bond SwapsBond Swaps –Pure yield pickup swap Swapping low-coupon bonds into higher coupon bondsSwapping low-coupon bonds into higher coupon bonds –Substitution swap Swapping a seemingly identical bond for one that is currently thought to be undervaluedSwapping a seemingly identical bond for one that is currently thought to be undervalued –Tax swap Swap in order to manage tax liability (taxable & munis)Swap in order to manage tax liability (taxable & munis) –Swap strategies and market-efficiency Bond swaps by their nature suggest market inefficiencyBond swaps by their nature suggest market inefficiency

12. Active Management Strategies Core-PlusCore-Plus –A combination approach of passive and active bond management styles –A large, significant part of the portfolio is passively managed in one of two sectors: The U.S. aggregate sector, which includes mortgage- backed and asset-backed securitiesThe U.S. aggregate sector, which includes mortgage- backed and asset-backed securities The U.S. Government/Corporate sector aloneThe U.S. Government/Corporate sector alone –The rest of the portfolio is actively managed Often focused on high yield bonds, foreign bonds, emerging market debtOften focused on high yield bonds, foreign bonds, emerging market debt Diversification effects help to manage risksDiversification effects help to manage risks

13. Matched-Funding Techniques Classical (“pure”) immunization strategies attempt to earn a specified rate of return regardless of changes in interest ratesClassical (“pure”) immunization strategies attempt to earn a specified rate of return regardless of changes in interest rates –Must balance the components of interest rate risk Price risk: problem with rising interest ratesPrice risk: problem with rising interest rates Reinvestment risk: problem with falling interest ratesReinvestment risk: problem with falling interest rates –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 riskDuration strategy superior to a strategy based only a maturity since duration considers both sources of interest rate risk

14. Matched-Funding Strategies Many immunization strategies are designed to take the sting out of rising interest rates for a bond portfolio!

15. Matched-Funding Techniques Immunization StrategiesImmunization Strategies –Difficulties in Maintaining Immunization Strategy Rebalancing required as duration declines more slowly than term to maturityRebalancing required as duration declines more slowly than term to maturity Modified duration changes with a change in market interest ratesModified duration changes with a change in market interest rates Yield curves shiftYield curves shift

16. Matched-Funding Techniques Dedicated portfolios Designing portfolios that will service liabilitiesDesigning portfolios that will service liabilities Different types:Different types: –Exact cash match Conservative strategy, matching portfolio cash flows to needs for cashConservative strategy, matching portfolio cash flows to needs for cash Useful for sinking funds and maturing principal paymentsUseful for sinking funds and maturing principal payments –Dedication with reinvestment Does not require exact cash flow match with liability streamDoes not require exact cash flow match with liability stream Great choices, flexibility can aid in generating higher returns with lower costsGreat choices, flexibility can aid in generating higher returns with lower costs

17. Matched-Funding Techniques Horizon matchingHorizon matching –Combination of cash-matching and immunization –With multiple cash needs over specified time periods, can duration-match for the time periods, while cash-matching within each time period

18. Derivatives in Fixed-Income Management Derivatives can be used to modify portfolio risk and returnDerivatives can be used to modify portfolio risk and return Using derivatives for asset allocationUsing derivatives for asset allocation –Adjusting allocations in the underlying assets can be very expensive –Less costly to achieve a similar asset allocation exposure using derivatives, especially for temporary adjustments

19. Derivatives in Fixed-Income Management To control portfolio cash flowsTo control portfolio cash flows –Hedging portfolio cash inflows and outflows Treasury bond futures contractTreasury bond futures contract –Typically used contract for risk management of fixed-income portfolios –Delivery in T-bonds Those that are delivered are the cheapest-to- deliver (CTD) that satisfies the contractThose that are delivered are the cheapest-to- deliver (CTD) that satisfies the contract

20. Derivatives in Fixed-Income Management Determining How Many Contracts to Trade to Hedge a Deposit or Withdrawal This is the hedge ratio, and it depends on:This is the hedge ratio, and it depends on: –Conversion factor Adjusts the CTD bond to 8% (required for delivery)Adjusts the CTD bond to 8% (required for delivery) –Duration adjustment factor Reflects the difference in interest rate risk between the CTD bond and the portfolio being hedgedReflects the difference in interest rate risk between the CTD bond and the portfolio being hedged

21. Derivatives in Fixed-Income Management Using Futures in Passive Fixed-Income Portfolio Management –Will use futures primarily to manage deposits and withdrawals –Will not use futures to actively adjust duration due to interest forecasts

22. Derivatives in Fixed-Income Management Using Futures in Active Fixed-Income Portfolio Management –Modifying systematic risk Changing the portfolio duration in light of interest rate forecastsChanging the portfolio duration in light of interest rate forecasts Lengthen duration if rates are expected to fallLengthen duration if rates are expected to fall –Modifying unsystematic risk Opportunities are more limited here, but can adjust exposure to various sectors to take advantage of expected yield changesOpportunities are more limited here, but can adjust exposure to various sectors to take advantage of expected yield changes

23. Derivatives in Fixed-Income Management Determining How Many Contracts to Trade to Adjust Portfolio Duration –Here futures contracts are used to adjust the duration of a portfolio, thereby managing interest rate risk Weighted average approachWeighted average approach Target duration = Contribution of current bond portfolio + contribution of the futures componentTarget duration = Contribution of current bond portfolio + contribution of the futures component

24. Derivatives in Fixed-Income Management Changing the Duration of a Corporate Bond Portfolio –There are no corporate bond futures contracts, so strategies are based on using T-bond futures Corporate bond yields also impacted by changes in default risk, unlike T-bond yieldsCorporate bond yields also impacted by changes in default risk, unlike T-bond yields T-bonds are a “cross hedge” instrumentT-bonds are a “cross hedge” instrument Differences could impact the number of contracts required to hedge a corporate bond portfolioDifferences could impact the number of contracts required to hedge a corporate bond portfolio

25. Derivatives in Fixed-Income Management Modifying the Characteristics of a Global Bond Portfolio –Positions in foreign bonds are positions in both securities and currencies –Futures and option contracts allow the portfolio manager to manage the risks of the currency and the security separately In a passive strategy, the manager can hedge the risk exposureIn a passive strategy, the manager can hedge the risk exposure In an active strategy, the manager can adjust the exposure to try to benefit from expected changes in exchange ratesIn an active strategy, the manager can adjust the exposure to try to benefit from expected changes in exchange rates