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Fixed Income Analysis Session 10 Management of Funds Against a Bond Market Index.

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1 Fixed Income Analysis Session 10 Management of Funds Against a Bond Market Index

2 Managing Funds against a Bond Market Index by Frank J. Fabozzi Copyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright owner is unlawful. Request for futher information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. PowerPoint Slides by David S. Krause, Ph.D., Marquette University

3 Chapter 18 Managing Funds Against a Bond Market Index Major learning outcomes : – Describe the general principles for each of the following strategies: pure bond index matching, enhanced indexing/matching risk factors, enhanced indexing/minor risk factor mismatches, active management/larger risk factor mismatches, and unrestricted active management. – Explain the reasons for indexing.

4 Key Learning Outcomes Discuss the logistical problems with indexing. Describe the methodologies used to replicate a benchmark index. Describe interest rate expectations strategies, yield curve strategies, and inter- and intra-sector allocation strategies. Compute the total return for a bond over a specified investment horizon.

5 Key Learning Outcomes Describe scenario analysis. Explain how interest rate risk is controlled in a trade. Explain why total return analysis and scenario analysis should be used to assess the potential performance of a trade before the trade is implemented. Show how to use scenario analysis to evaluate the potential performance of a portfolio versus a benchmark index.

6 Key Learning Outcomes Explain how multi-factor risk models can be used to construct a portfolio that is managed against a benchmark index. Explain the objectives of performance attribution analysis. Explain the limitations of single-index performance evaluation measures. Explain leverage. Identify the advantages and disadvantages of lever

7 Key Learning Outcomes Explain a repurchase agreement. Compute the dollar interest of a repurchase agreement. Discuss the credit risks associated with a repurchase agreement. Explain the factors that affect the repo rate. Distinguish between special (or hot) collateral and general collateral. Calculate the duration of a leveraged portfolio.

8 Bond Portfolio Strategies Pure bond index matching Enhanced indexing/matching risk factors Enhanced indexing/minor risk factor mismatches Active management/larger risk factor mismatches Unrestricted active management

9 Bond Portfolio Strategies Pure bond index strategy – the strategy with the least risk of underperforming the index Reasons for indexing: – Historically, the overall performance of active bond managers has been poor, – Higher active management advisory fees, 15 to 50 basis points compared to 1 to 20 basis points for indexed portfolios, Managers might index only a portion of the portfolio, a particular sector, when: – They do not have the skills necessary to outperform the sector, – The particular sector is price efficient so that it is futile to attempt to outperform the market.

10 Bond Portfolio Strategies Pure bond index strategy – the strategy with the least risk of underperforming the index Logistical problems with an indexing strategy – Bid-ask spread – Logistical problems unique to certain sectors of the bond market – Total returns depend on the reinvestment rate available on interim cash flows

11 Bond Portfolio Strategies Enhanced indexing/matching risk facto This strategy can be used to construct a portfolio that matches the primary risk factors without acquiring each issue in the index. Generally, the smaller the number of issues used to replicate the benchmark index, the lower the transaction costs but the greater the difficulties in matching the risk factors. Two commonly used techniques: – Cell matching – Tracking error minimization using a multi-factor risk model

12 Bond portfolio strategies Enhanced indexing/minor risk factor mismatches The strategy is based on constructing a portfolio with minor deviations from the risk factors that affect the performance of the index. Similarly to the previous strategies, it matches the duration of the portfolio with the duration of the benchmark index, so that there are no duration bets.

13 Bond Portfolio Strategies Active management/Larger risk factor mismatches The decision to pursue this strategy is based on the belief that there is some gain to be derived from pricing inefficiencies. Two types of strategies: – In the more conservative one, the manager creates larger mismatches, in terms of risk factors, relative to the benchmark index. – The manager can invest a small percentage of the portfolio in one or more sectors that are not in the bond market index.

14 Bond Portfolio Strategies Active management/Larger risk factor mismatches Unrestricted active management – The manager is permitted to make a significant duration bet without any constraint.

15 Strategies Active portfolio strategies seek to generate additional return after adjusting for risk (alpha). These are value added strategies: Strategic strategies – Interest rate expectation strategies – Yield curve strategies – Inter- and intra-sector allocation strategies Tactical strategies – Strategies based on rich/cheap analysis – Yield curve trading strategies – Return enhancing strategies employing futures and options

16 Strategies Interest rate expectation strategies These strategies are based on forecasting the level of interest rates and altering the portfolio’s duration based on that forecast. The strategy requires increasing (reducing) a portfolio’s duration if interest rates are expected to fall (rise). Portfolio duration may be altered through: – Swapping bonds – Selling bonds and staying in cash – Using interest rate futures contracts

17 Strategies Yield curve strategies Top down yield curve strategies involve positioning a portfolio to capitalize on expected changes in the shape of the Treasury yield curve. The three yield curve strategies are: bullet, barbell, ladder. Each of these strategies results in different performance when the yield curve shifts and it depends on both the type and the magnitude of the shift.

18 Strategies Inter- and Intra-sector allocation strategies Inter-sector allocation strategy – the manager allocates funds among the major bond sectors in a manner that differs from the allocation of the benchmark index. Intra-sector allocation strategy – the manager’s allocation of funds within a sector differs from that of the index. Inter- and intra-sector allocation indicate that a manager anticipates certain changes in spreads.

19 Strategies Spreads reflect differences in credit risk, call (or prepayment) risk, and liquidity risk. Spreads due to credit risk When the spread for a particular sector is expected to decrease (increase), a manager might decide to overweight (underweight) that sector. Spreads due to call or prepayment risk – An expected drop in interest rates will widen the spread between callable and noncallable bonds as prospects increase that the issuer will exercise the call option. The spread narrows if interest rates are expected to rise. – An increase in interest rate volatility increases the value of the call option, thereby increases the spread between callable and noncallable bonds.

20 Strategies Individual security selection strategies Once the manager makes the allocation to a sector, he must select the specific issues. Managers pursue several different active strategies to identify mispriced securities. An issue might be undervalued if: – its yield is higher than that of comparably rated issues – its yield is expected to decline because of a potential upgrade

21 Strategies Individual security selection strategies Substitution swap – a swap of one bond for another that has similar coupon, maturity, and credit quality, but offers a higher yield.

22 Assessing Potential Performance Assessing trades Expected total return – the performance of the assets over the investment horizon. It is comprised of three sources: – Coupon payments – Change in the value of the bond – Income from reinvestment of coupon and principal from the time of receipt to the end of the investment horizon.

23 Assessing Potential Performance Assessing trades Computing the total return Step 1: compute the total coupon payments plus the reinvestment income based on an expected reinvestment rate. Step 2: determine the projected price of the bond at the investment horizon, also referred to as the horizon price. – Structure of rates at the horizon date – predicted values reflecting changes in interest rates and spreads from the current date to the investment horizon.

24 Assessing Potential Performance Assessing trades Step 3: add the values from step1 and step 2, and reduce that value by any borrowing costs. Step 4: compute the semiannual total return. Step 5: for semiannual-pay bonds, double the interest rate from step 4.

25 Assessing Potential Performance Assessing trades Controlling for interest rate risk in trades It is critical to compare positions with the same dollar duration, unless the objective of a trade is to alter the duration. Failure to adjust a trade to account for an expected change in yield spread, keeping the dollar duration constant, leads to the result that the outcome of the trade will be affected by the expected change in the yield spread and the yield level.

26 Assessing Potential Performance Assessing the portfolio The potential performance of any trading strategy can be quantified using total return analysis. Scenario analysis is used to determine the total return under different assumptions about what might occur over the investment horizon. Scenario analysis identifies the range of possible outcomes.


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