Bond Portfolio Management

1
Bond Portfolio Management

• Five steps in investment management process
• Tracking Errors
• Active Portfolio Strategies
• Use of Leverage
• Indexing

2
Five Steps in Investment Management

Setting investment objectives Establishing
Investment Policy (in cash equivalent, equities,
fixed-income, real estate) Select a portfolio
strategy (active, structured, or
indexing) Select assets Measuring and evaluating
performance (ch22)
3
Tracking Error

• The standard deviation of the return of the
  portfolio relative to the return of the benchmark
  index.
• (example on pages 416-417)
• Calculate monthly or weekly tracking error
• Annualize it

4
Two Types of Tracking Error

• Backward-looking (ex-post) tracking error
  tracking error calculated from observed active
  returns for a portfolio
• Forward-looking (ex-ante) tracking error
  tracking errors associated with bond market index
  based on multi-factor models setting an
  appropriate benchmark

5
Risk Factors

• Systematic risk factors
• Term structure risk factors
• Non-term structure risk factors
• Non-systematic risk factors
• Issuer specific
• Issue specific

6
Active Portfolio Strategies

• Interest-rate expectations strategies
• Yield Curve Strategies
• Yield Spread Strategies
• Individual Security Selection Strategies
• Strategies for Asset Allocation within Bond
  Sectors

7
Interest-rate Expectations Strategies

• Increase or decrease duration
• increase duration when expected interest goes
  down
• decrease duration when expected interest goes up
• Approach Rate anticipation swaps
• Gambling incentive make an interest bet to
  cover inferior performance relative to a
  benchmark index.

8
Yield Curve Strategy

• Seek to capitalize on expectations based on
  short-term movements in yields make profit from
  the change of yield curve in the portfolio
• Key if your investment horizon is 1 year, what
  strategy you want to take, put all your money in
  1-year bonds or 30-year bonds

9
Strategies

• Bullet strategy (see page 428)
• Barbell strategy
• Ladder strategy
• To see which strategy to implement, investors
  need look at the impact of the strategy on the
  total return of the portfolio
• Exhibit 19-8 on page 431 compares the relative
  performance of a bullet portfolio and a barbell
  portfolio
• One factor driving the difference in portfolio
  performance is the difference in their convexity.

10
Yield Spread Strategies

• Involve positioning a portfolio to capitalize on
  expected changes in yield spreads between sectors
  of the bond market.
• Swapping one bond for another when manager
  believes that the prevailing yield spread
  between the two bonds in the market is out of
  line with their historical yield spread.

11
Yield Spread Strategies

• Credit spread
• Spreads between callable and noncallable
  securities

12
Individual Security Selection Strategy

• Identify mis-priced securities
• Its yield is higher than that of comparably rated
  issues
• Its yield is expected to decline because credit
  analysis indicates that its rating will improve
• To implement this strategy swap.

13
Use of Leverage

• A portfolio in which a manager has created
  leverage.
• If return from investing the amount borrowed
  exceed cost of funding.
• Leveraging trades will generate a return needed
  to make the investment attractive to traders.

14
Create Leverage with Repo
Repurchase agreement 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. Repurchase
price Repurchase date Repo rate Overnight repo
versus term repo
15
Example

• A dealer delivers (sells) 10 million of treasury
  security to a customer and buy it back in to the
  next day. Repo rate is 6.5. (dealer is financing
  a long position) (page 441)
• What is amount borrowed by the dealer?
• What is the dollar interest
• Jargons (1) reversing out securities, (2)
  reversing in securities page 442

16
Indexing

• Designing a portfolio so that its performance
  will match the performance of some bond index
• Benefits and costs
• Low management fee and expenses
• Straightforward and easy to evaluate
• Basis risk between indexing and matching to
  liabilities

17
Factors Affecting Index Selection

• Level of Risk Tolerance
• Investors objective
• Difference in variability
• Nonsymmetry in rising and falling markets

18
Alternative Indexes

• Lehman Brothers U.S. Aggregate Bond Index
• Salomon Smith Barney (SSB) Broad Investment-grade
  Bond Index (BIG)
• Merrill Lynch Domestic Market Index
• Exhibit 20-2, sector breakdown of Lehman Brother
  index

19
How to Create an Indexed Portfolio

• Tracking error the discrepancy between the
  performance of the indexed portfolio and the
  index
• The tradeoff between transaction costs and
  mismatching of the characteristics of the indexed
  portfolio and the index.
• Have logistic problem (see pages 457, 458)

20
Specific Approaches

• Stratified sampling approach
• Based on characteristics (page 456)
• Optimization approach
• Jointly consider characteristics and fund
  objectives
• Tracking error minimization using multifactor
  model
• Enhanced indexing adding active portfolio
  management in indexing

21
Exercises Ch19 and 20

• 1. Problem 7, ch19 (a) 288.74, (b)
  backward-looking, (c) enhanced indexing
• 2. Problem 15, ch19 (a) II, (b) I, (c) the one
  having greater convexity, (d) dont worry about
  it.
• 3. Problem 7, ch20