1. MANAGING BOND PORTFOLIOS

2. Managing Bond Portfolios
There are various strategies that bond managers can pursue in managing bond portfolios, namely:
Passive bond management
Active bond management
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Passive Bond Management

3. Passive bond management
Manager does not attempt to identify bonds that are over or under priced
That is, passive bond managers take bond prices as fairly set and seek to control only the risk of their fixed-income portfolio
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Passive Bond Management

4. Passive Bond Management Strategies
Two broad classes of passive management are pursued in the fixed-income market:
Indexing strategies
Immunisation /duration matching strategies
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Passive Bond Management

5. Passive Bond Management
(a) Indexing
Bond indexing involves designing a portfolio to match the performance of specified bond index
While indexing is common in equity portfolios, it is a relatively recent phenomenon in the fixed income market
Three major indexes of the broad bond market are :
Citigroup BIG
Formerly - The Salomon Smith Barney Broad Investment Grade (BIG) index,
Barclays Capital Aggregate Bond Index
Formerly - Lehman Brothers Aggregate Bond Index
Merrill Lynch Domestic Master Index
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Passive Bond Management

6. Factors in selecting an index
Factors that will influence the choice of benchmark include:
Investors risk tolerance
e.g. having a benchmark that includes corporate bonds exposes the investor to credit risk
Investors objectives
e.g with respect to volatility
Different indices may have similar returns but due to different durations, different volatilities
Whether a broad market index fund or specialised by market sector
government bonds
corporate bonds
high yield bonds
mortgage backed securities
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Passive Bond Management

7. Indexing Methodologies
The primary aim is to minimise the tracking error
i.e. the difference in the performance between the portfolio and the index
Tracking error has three primary sources
transaction costs
differences in composition
some of the large US broad based indices contain over 5000 issues
discrepancies between prices used by the index provider and those paid and received by the fund manager
Largely a trade-off between transaction costs and differences in composition
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Passive Bond Management

8. Indexing methodologies
Stratified sampling or cell approach
In this approach the index is divided into cells, each one representing a different characteristic of the index
The most common characteristics used are:
duration
coupon
maturity
market sectors
credit ratings
call factors
After the number of cells have been determined, the manager selects one or more issues that can be used to represent the cell – the dollar amount invested is determined by the market value of that cell in the index
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Passive Bond Management

9. Indexing methodologies
Optimisation approach
As above, break the index into cells and match the portfolio
But in addition, you also seek to optimise a stated objective, e.g.
maximise portfolio yield
maximise portfolio return
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Passive Bond Management

10. Arguments For Indexing
Performance of active managers
empirical evidence suggests that active management performance has been poor
SEI Funds Evaluation Corporation ranked the performance of active managers and compared the performance to the Salomon Brothers Investment Grade Index (as it was known)
median return found to be lower than the index return
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Passive Bond Management

11. Arguments For Indexing
Advisory Management Fees
Fees are substantially lower for an indexed portfolio than for an actively managed portfolio
Non-advisory fees
non-advisory fees, such as custodial fees are also generally lower for indexed portfolios
Also, sponsors have greater control over external managers
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Passive Bond Management

12. Criticisms of Indexing
While indexing may result in the portfolio matching the performance of the index, it may not result in optimal performance
It may not suit the specific requirements of clients
It restricts the manager to the mainstream area’s of the market
not allowing investment in possibly more attractive sub-markets
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Passive Bond Management

13. Logistical Problems with Indexing
An index manager faces a number of problems
prices used by the data provider may not be available to the investor
factors such as illiquidity and availability are all constraints to the manager
the reinvestment rate available on coupon interest may not match that assumed by the data provider
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Passive Bond Management

14. (b) Immunisation / Duration Matching
Pioneered by Reddington (1952) can be defined as;
“The investment of the assets in such a way that the existing business is immune to a general change in the rate of interest”
Immunisation techniques refer to strategies used by investors (namely banks and pension funds) to shield their overall financial status from exposure to interest rate fluctuations
Any institution with a future fixed obligation might consider immunisation a reasonable risk management policy
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Passive Bond Management

15. 1) Net Worth Immunisation
Many banks and institutions have a mismatch between asset and liability maturity structures.
Bank liabilities are primarily the deposits owed to customers
most of these are very short-term in nature and consequently of low duration
Bank assets are composed largely of outstanding commercial loans or mortgages
these assets are of longer duration than are deposits, and their values are correspondingly more sensitive to interest rate fluctuations
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Passive Bond Management

16. Net Worth Immunisation
In periods where interest rates increase unexpectedly, bank can suffer serious decreases in net worth
their assets fall in value by more than their liabilities
Banks are not alone in this concern – any institution with a future fixed obligation might consider immunisation as a reasonable risk management policy.
E.g. pension funds, insurance companies
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Passive Bond Management

17. Passive Bond Management
Immunisation
The idea behind immunization is that the duration-matched assets and liabilities let the asset portfolio meet the firm’s obligations, irrespective of interest rate movements
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Passive Bond Management

18. Passive Bond Management
Fixed income investors face two types of offsetting interest rate risk
Price risk
Reinvestment (of the coupons) rate risk
When interest rates rise, the resale value of the bond falls, but the coupons more than make up for this loss if they are reinvested at a higher rate
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Passive Bond Management

19. Passive Bond Management
Immunisation
If the portfolio duration is chosen appropriately, these two effects will cancel out exactly
When the portfolio duration is set equal to the investor’s horizon date, the accumulated value of the investment fund at the horizon date will be unaffected by interest rate fluctuations
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Passive Bond Management

20. Rebalancing Immunised Portfolios:
Duration changes with yield rebalancing
As interest rates and asset durations change, a manager must rebalance the portfolio of fixed-income assets continually to realign its duration with the duration of the obligation
Duration will change because of the passage of time (it decreases less rapidly than maturity)
Thus even if an obligation is immunised at the outset, as time passes the durations of the asset and liability will fall at different rates.
Without portfolio rebalancing, durations will become unmatched and the goals of immunisation will not be realised.
Immunisation managers actively up-date and monitor their positions
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Passive Bond Management

21. Passive Bond Management
2) Cash Flow Matching
The problems associated with immunisation seem to have a simple solution
Why not simply buy a zero-coupon bond that provides a payment in an amount exactly sufficient to cover the projected cash outlay
The principle of cash flow matching automatically immunize the portfolio from interest rate movements because the cash flow from the bond and the obligation exactly offset each other
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Passive Bond Management

22. Passive Bond Management
Dedication Strategy
Cash flow matching on a multi-period basis is referred to as a dedication strategy
i.e. The manager selects either zero-coupon or coupon bonds that provide total cash flows in each period that match a series of obligations
The advantage of dedication is that it is a once and for all approach to eliminating interest rate risk
The dedicated portfolio provides the cash necessary to pay the firm’s liabilities regardless of the eventual path of interest rates
Cash flow matching is not more widely pursued than immunization, probably because of the constraints that it imposes on bond selection
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Passive Bond Management