Managing Bond Portfolios
Managing Fixed Income Securities: Basic Strategies n Active strategy - Trade on fundamentals - Trade on market inefficiencies n Passive strategy - Control risk - Balance risk and return
Passive Management n Buy and hold n Bond-Index Funds: Salomon Smith Barney Broad Investment Grade index, the Lehman Brothers Aggregate Bond Index, and the Merrill Lynch Domestic Master Index: maturities > 1 yr n Performance is judged by tracking error n Cellular approach n Immunization of interest rate risk: - Net worth immunization: price risk and reinvestment risk cancel out Duration of assets = Duration of liabilities - Target date immunization: portfolio rebalancing Holding Period matches Duration n Cash flow matching and dedication
Example on rebalancing n Suppose a manager hold 3 -year zero-coupon bond and perpetuities paying annual coupon with yield at 10%. To match the 7 -year duration obligation, this year, the manager needs to: n w*3+(1 -w)*1. 1/0. 1=7, so w = 0. 5 n Next year: w*2+(1 -w)*1. 1/0. 1=6, so w = 5/9
Active Bond Management n Interest-rate anticipation - Risky strategy relying on uncertain forecasts n Valuation analysis - The portfolio manager attempts to select bonds based on their intrinsic value n Credit analysis - Involves detailed analysis of the bond issuer to determine expected changes in its default risk - For example, credit analysis on high yield bonds, Zscore models n Yield spread n Bond swaps
Bond Swaps Continued n Substitution swap: exchange of one bond for a nearly identical substitute to take advantage of temporary market anomalies in yield spreads between equivalent issues n Inter-market swap: if yield spread b/n two sectors of the bond mkt is temporarily out of line, LTCM n Pure yield pickup, get out of low-coupon bond, invest in high-coupon, similar bonds n Tax swap: try to offset capital gains in other securities through the sale of a bond currently held and selling at a discount from the price paid a purchase, and swapping into a similar bond to hold the position
Horizon Analysis: Yield Curve Ride Yield to Maturity % 1. 5 1. 25. 75 3 mon 6 mon 9 mon Maturity
Example on yield curve ride n 9 -month bill yield is 1. 5% per quarter Selling at 100/1. 015^3 = 95. 63 n If 1. 5% remains the same after 3 month, the new price is 100/1. 015^2 = 97. 07, return is 1. 5% n But with only 6 month remaining yield becomes 1. 25%, therefore Price is 100/1. 0125^2 = 97. 55, holding period is 2%
Contingent Immunization n A combination of active and passive management n The strategy involves active management with a floor rate of return. n As long as the rate earned exceeds the floor, the portfolio is actively managed. n Once the floor rate or trigger rate is reached, the portfolio is immunized.
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