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Active bond managers attempt to exploit the four general factors that
affect a fixed income portfolio’s return:
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Changes in the shape of the yield curve
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method, a manager can hold portfolio duration constant and select
bonds that provide superior performance for an expected change in
one point on the yield curve.
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manager would sell corporates and buy treasuries to reduce the price
loss due to the spread widening.
Another example is the decision to purchase callable or
noncallable bonds. If interest rates are expected to decline, callable
yields generally widen because the call option is becoming more
valuable. Callable bonds are short a call option which increases in
value as interest rates drop, and buyers of callable bonds will
demand more compensation in yield spread to offset the call risk as
interest rates decline. If interest rates are expected to fall, a manager
would sell callable bonds and purchase non-callable bonds to avoid
the depreciation in price of callable bonds due to spread widening
(negative convexity at work). Conversely, if interest rates are
expected to rise and callable bond spreads to narrow, the manager
would sell non-callable bonds and purchase callable bonds. Interest
rate volatility also plays a role in the spread. As volatility increases,
the value of the embedded call option rises, causing callable bond
prices to fall and the yield spread to widen. Thus, if volatility is
expected to increase, the manager would sell callable bonds and
purchase non-callable bonds; if volatility is expected to decrease,
non-callable bonds would be sold and callable bonds would be
purchased.
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Another example is to compare two mortgage backed securities
(MBSs) of similar coupon, maturity, and type, where different
prepayment assumptions lead to different prices and yield spreads. If
a manager expects a different prepayment assumption than the
market, the manager can act on that assumption in the hopes that the
market will agree with his prepayment assumption in the future and
“correctly” value that particular MBS. For example, for a particular
discount MBS or a PO, if a manager expects faster prepayments than
the market, the manager could purchase that security to realize the
greater value of receiving principal repayments quicker than the
market anticipates. Similarly, for a particular premium MBS or an IO,
if the manager expects slower prepayments than the market, the
manager would purchase that security because its lower price is
overly compensating for the prepayment risk
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2. active portfolio management
strategies
3. matched-funding strategies
• Buy-and-hold
• Indexing
Buy-and-hold Strategy
This strategy simply involves buying a bond and holding it until
maturity. Bond investors would examine such factors as quality
ratings, coupon levels, terms to maturity, call features and sinking
funds. These investors do not trade actively to earn returns, rather
they look for bonds with maturities or durations that match their
investment horizon.
There is also a modified buy-and-hold strategy in which investors buy
bonds with the intention of holding them until maturity, but they still
actively look for opportunities to trade into more desirable positions.
[However, if you modify this too much it turns into an active strategy.]
While the buy-and-hold strategy is a passive strategy, it still involves a
great deal of work. Agency issues typically provide high quality bonds
at a higher return than Treasury securities, callability affects the
attractiveness of an issue, etc. Plus, you may want to develop a
portfolio in which coupon payments are structured (and principal
repayments).
Techniques, Vehicles and Costs: Only default-free or very high
quality securities should be held. Also, those securities that are
callable by firm (allows the issuer to buy back the bond at a particular
price and time) or putable by holder (allows bondholder to sell the
bond to issuer at a specified price and time) will introduce alterations
in the firm's cash flows, and probably should not be included in the
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buy-and-hold strategy. Also, those investors seeking to lock in a rate
of return may choose a zero-coupon bond--good strategy for college
tuition or retirement. The buy-and-hold strategy minimizes transaction
costs and, if implemented astutely, can be highly productive. For
example, if interest rates are currently high and are expected to
remain so for an extended period of time, the buy-and-hold strategy
will do well.
Indexing
Indexing involves attempting to build a portfolio that will match the
performance of a selected bond portfolio index, such as the Shearson
Lehman Hutton Government/Corporate Bond Index, Merrill Lynch
Index, etc. This portfolio manager is judged on his ability to track the
index.
Techniques, Vehicles and Costs: The fixed income market is
broader (in terms of security types) than the equity market. Also, even
though the Shearson Lehman Hutton Corporate Bond Index has over
4,000 securities, it only represents high quality corporate bond issues.
Thus, a compromise must be made when selected among different
indexes. Also, the strategy of buying every bond in a market index
according to its weight in the index is not a practical one. However, a
relevant subset is possible. We may choose to emulate a narrower
bond index.
Alternative Vehicles: We may choose to randomly select bonds from
the universe of bonds, or, we may choose the stratified approach
(segmenting the index into components from which individual
securities are chosen). When choosing the indexing option, bond
portfolio management cannot be considered entirely passive. Also,
there will be transaction costs associated with (1) purchasing the
issues used to construct the index; and (2) reinvesting cash payments
from coupon and principal repayments; and (3) rebalancing of portfolio
if the composition of your target index changes. Whereas full
replication of the target index would work best, this is impractical. If
you choose the stratified method, your performance will probably not
mirror your target index.
How many securities should you have in your portfolio if you use the
random sampling approach? McEnally and Boardman (1979) have
found that, once an index is selected, close replication is possible with
perhaps 40 bonds (for the long term).
Stratified Approach: Consists of analyzing the index to determine
various stratification levels (what portion of securities that make up
index are Treasury, Aaa Industrial, Baa Financial, of X years to
maturity, of X% coupon rate, etc.). The next step is to select the
securities for your portfolio. Typically, at selection and at the
rebalancing period (usually once a month) one security is chosen from
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each category (there could be 40 categories). There's no requirement
as to which security is selected from each class.
Active Management Strategies
These strategies require major adjustments to portfolios, trading to
take advantage of interest rate fluctuations, etc. There are five major
active bond portfolio management strategies:
How your bond will be affected by changes in interest rates can usually
be directly related to the security's duration. Thus, if you expect IR to
drop, you should shift to high duration securities. Also, the timing as to
when you expect the interest rate shift is important. You don't want to
shift too early, because you may compromise some return. Obviously,
you don't want to wait too late.
Scenario Analysis: Say, "what if" interest rates rise/fall by this much
over the next month/year/etc. Analyze the individual bonds within
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your portfolio under each scenario and see how the returns are
affected under each scenario. [See p. 8-30] The scenario analysis
leads us to further analysis.
Relative Return Value Analysis: We can calculate the overall
expected return for each bond in our scenario (expected return under
each interest rate scenario weighted by the probability of that scenario
occurring) and the current duration of each bond in our portfolio and
graph the relationship. Those bonds falling above a regression line
(showing the general relationship) would be doing ok!
Strategic Frontier Analysis: We can graph the bonds in our portfolio
with the best case scenario (an interest rate decrease) on the vertical
axis and the worst case scenario on the horizontal axis, as shown
below:
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they will perform poorly regardless of the scenario. You should sell
securities falling into Quadrant IV. Normally a few securities would fall
into Quadrants II and IV, with most falling into Quadrants I and III.
Valuation Analysis
The portfolio manager looks for undervalued bonds--those bonds that
have a computed value (according to the portfolio manager) higher
than the current market price). This also translates to those bonds
whose expected YTM is lower than the current YTM. This strategy
requires lots of analysis (continuous evaluations) and lots of trading
based on the analysis. Based on your confidence in your analysis, you
would buy undervalued bonds and sell overvalued bonds (or ignore
them if they are not in your portfolio).
Valuation Analysis: We can examine the term structure of pure
discount bonds (zero coupon) and thus determine the value of US
Treasuries, thus we can determine the default free characteristics of
any other type of bond. Then we can attempt to determine the other
factors that will affect bond yield by using multiple factor regression
analysis (looking at things such as: quality rating, coupon effect,
sector effect, call provision, sinking fund attributes, etc.) Using this
factor analysis, we can determine the expected yield for the security (if
the expected yield < current YTM then buy). However, there is some
subjectivity in factor analysis. For instance, if there is some "event
risk" (something affecting the financial stability of firm) missing from
the analysis, or if there is any anticipation of a market upgrade...
Credit Analysis
Credit analysis involves examining bond issuers to determine if any
changes in the firm's default risk can be identified. We try to
determine if the bond rating agencies are going to change the firm's
rating. Rating changes are prompted by internal changes within the
firm as well as external changes. Various factors examined include
financial ratios, GNP, inflation, etc.
Many more downgradings occur during economic contractions
[However from 1985-1990 downgradings increased substantially
despite an economic expansion.]. To be successful in utilizing bond
rating changes, you must accurately predict when the bond rating
change will occur and take action prior to the change. The market does
react to unexpected bond rating changes, however, it reacts quickly.
Credit Analysis of High-Yield Junk Bonds. Junk bonds have a wide
spread over bonds rated BBB and higher. Also, these yield spreads
widen over time (during poor economic times the spread widens).
Altman and Nammacher point out that the net return of junk bonds
(average gross return minus losses from bonds that defaulted) has
been superior to higher-rated debt [Of course, they're of higher risk.]
Other points to note: Even though the rating categories have not
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changed, the quality of bonds today that fall into, let's say, the A
category, has lessened over time. "Specifically, the average values of
the financial ratios that determine whether bonds are included in the B
or CCC rating classes have declined over time."
Thus, bond portfolio managers will have to involved themselves in
detailed credit analysis to determine those bonds that will not default.
Credit Analysis: The assessment of default risk. Default risk has both
systematic and unsystematic elements. First, individual bond issuers
may experience difficulty in meeting their debt obligations. This could
be an isolated incident, and can be diversified away (or eliminated by
effective credit analysis). However, if default risk is precipitated by
adverse general business conditions, then this would require more
macro-oriented analysis. Many fixed-income investors complement the
bond ratings providing by bond agencies (Fitch's, Moody's, Duff &
Phelps, S&P's) with their own credit analysis, citing reasons such as:
more accurate, comprehensive, and timely analyses and
recommendations.
Yield Spread Analysis
A portfolio manager would monitor the yield relationships between
various types of bonds and look for abnormalities. If a spread were
thought to be abnormally high, you would trade to take advantage of a
return to a normal spread. Thus, you need to know what the "normal"
spread is, and you need the liquidity to make trades quickly to take
advantage of temporary spread abnormalities.
Spread Analysis: Involves anticipating changes in sectoral
relationships. For example, prices and yields on lower investment
grade bonds tend to move together (identifiable classes of securities
are referred to as sectors). Changes in relative yields (or the spread)
may occur due to:
The objective is to invest in the sector or sectors that will display the
strongest relative price movements. Brokerage firms maintain
historical records of yield spreads and are able to conduct specialized
analyses for clients, such as measurement of the historical average,
maximum, and minimum spread among sectors.
Potential drawbacks of this method include the need to make
numerous trades, the possibility of poor timing (how long will it take
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for the market to realize the abnormal spread), and the danger that
overall changes in interest rates will dwarf these efforts.
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