R23 fixed income portfolio management part II

Reading 23
Fixed Income Portfolio Management – Part II
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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute. Reproduced
and republished with permission from CFA Institute. All rights reserved.


Contents
5. Other Fixed-Income Strategies
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Combination Strategies
Leverage
Derivatives Enabled Strategies

6. International Bond Investing
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Active vs. Passive Management
Currency Risk
Breakeven Spread Analysis
Emerging Market Debt

7. Selecting a Fixed-Income Manager
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Historical Performance as a Predictor of Future Performance
Developing Criteria for Selection
Comparison with Selection of Equity Managers
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5. Other Fixed Income Strategies
• Combination Strategies
– Active/Passive Combination
– Active/Immunization Combination

• Leverage
– Leverage can be used to enhance portfolio returns
– Works if investment return > funding cost
– Interest rate sensitivity goes up

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Example 9 – Use of Leverage

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Leverage cuts both ways…

Borrow at 4%

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E=
B=
k=
rf =

Amount of equity
Amount of borrowed funds
Cost of borrowing
Return on invested funds

Return on borrow funds: RB = rf – k
Return on Equity: RE = rf
Return on Portfolio, Rp = rf + (B/E) x (rf – k)

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If portfolio has assets and liabilities, how do you calculate the duration of equity…
DE = (DAA – DLL) / E

Bond Portfolio = $140 mil with DA = 4
Borrowed funds = $100 mil with DL = 1
Calculate DE
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Repurchase Agreements (repo or RP)
• Sale of security coupled with agreement to repurchase

• Collateralized loan with price difference representing interest
• Transfer of securities
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Physical delivery
Credits/Debits to accounts of banks acting as clearing agents for customers
Deliver to custodial account at seller’s bank (trustee for both parties)
No delivery

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Factors that Affect Repo Rate
• Quality of collateral
• Term of the repo
• Delivery requirement
• Availability of collateral
• Prevailing interest rate in the economy
• Seasonal factors
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5.3 Derivatives Enabled Strategies
• Derivatives can create, reduce or magnify factor exposures
– Factors: duration and convexity, credit, liquidity

• This sub-section covers
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Interest Rate Risk
Other Risk Measures
Bond Variance vs. Duration

Interest Rate Futures
Interest Rate Swaps
Bond and Interest Rate Options
Credit Risk Instruments
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Interest Rate Risk
• Portfolio Duration = weighted average of individual durations
• Dollar Duration = (D x V)/100
• To maintain portfolio duration when security is being exchanged,
the dollar duration must match
• New bond market value = (DD0/DN) x 100

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Other Risk Measures
Measure
Semi-variance measures dispersion
below target value

Deficiency
Computationally challenging for large
portfolios
If returns symmetric  no additional
information
Asymmetries are difficult to forecast

Shortfall risk refers to probability of
not achieving a specified return

Does not account for magnitude of
losses in money terms

Value at risk (VAR) estimates loss in Does not indicate magnitude of worst
money terms that might be exceeded possible outcomes
with a given probability
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Bond Variance vs. Bond Duration
• Major issues with using variance of bond portfolio
– Estimated parameters increases dramatically as number of bonds

increases: n x (n + 1) / 2
– Accurately estimating variances and covariances is difficult

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Interest Rate Futures
• Interest rates up  price of deliverable bond down  futures price down
• Interest rate down 
• Buying futures contract increases portfolio duration
• Advantages of using futures contracts
– Liquidity
– Cost Effectiveness
– For duration reduction short futures contracts

• Duration management (next slide…)

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Hedging with futures contracts has some practical challenges
Outcome of hedge depends on relationship between cash prices and futures price  basis
Basis Risk: risk that basis will change in unpredictable way
Often bond to be hedged is not identical to bond underlying futures contract  cross hedging 
relatively high basis risk
To counter basis risk you need more futures contracts as dictated by a hedge ratio
Hedge ratio: (DHPH / DCTDPCTD) x Conversion Factor

Say we extend example 9 (prev. slide) by incorporating basis risk and a hedge ratio of 1.1
Number of futures contracts needed will become 131 x 1.1 = 141

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Interest Rate Swaps
Receive-fixed position can be viewed as:
Long a fixed-rate bond + Short a floating-rate bond
Dollar Duration of Swap = Dollar duration of a fixed-rate bond – Dollar duration of floating rate bond

Interest rate swap can be used to alter cash flow characteristics of your assets or liabilities
Fixed to floating or floating to fixed

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Bond and Interest Rate Options
Duration for an option = Delta of option x Duration of underlying x (price of underlying/price of option)

You can hedge with options to protect against rise in interest rates
Buy Protective Put

Write Covered Call

Caps, floor and collars

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Credit Risk Instruments
• Default Risk: risk that issuer may fail to meet obligations

• Credit Spread Risk: risk that spread may vary (increase)
• Downgrade Risk: risk that rating agency will downgrade

Types of
Credit
Risk

• Products that transfer credit risk
– Credit options
– Credit forwards
– Credit swaps

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Credit Options
Credit Options offer protection against credit risk. Triggering event can be based
either on:
1) Value decline of underlying asset OR
2) Spread change over a risk free rate

Binary credit options provide payoff contingent on the occurrence of a specified
negative credit event; only two possible scenarios
Example: Binary put option might pay option buyer X – V if bond rating falls below
investment grade

Credit spread options: payoff based on spread over a benchmark
Payoff function for in-the-money credit spread call option = (spread – k) x NP x

Risk Factor
Risk Factor: value change of security for one basis point change in spread
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