1. Session 10 Management of Funds Against a Bond Market Index
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
PowerPoint Slides by
David S. Krause, Ph.D., Marquette University
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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.