1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 20

2. Bond Portfolio Management Strategies

3. Alternative Bond Portfolio Strategies 1. Passive portfolio strategies 2. Active management strategies 3. Matched-funding techniques 4. Contingent procedure (structured active management)

4. (1) Passive Portfolio Strategies Buy and hold –A manager selects a portfolio of bonds based on the objectives and constraints of the client with the intent of holding these bonds to maturity –Two prominent strategies under this approach are the Laddered and Barbell strategies (see next six slides) Indexing –The objective is to construct a portfolio of bonds that will equal the performance of a specified bond index

5. Classic Passive Management Strategies A laddered strategy distributes fixed income dollars throughout the yield curve. par value maturity par value A barbell strategy differs from the laddered strategy in that less investment is made in the middle maturities. A credit barbell is a bond portfolio containing a mix of high-grade and low-grade securities.

6. Classic Passive Management Strategies Insert Figure 19-7 here.

7. Classic Passive Management Strategies Insert Figure 19-8 here.

8. Classic Passive Management Strategies Insert Figure 19-9 here.

9. Classic Passive Management Strategies Insert Figure 19-10 here.

10. If duration laddered portfolio > duration barbell portfolio, The Risk of Barbells and Ladders Yield curve inversion means short-term rates are rising faster than long-term rates. Duration as a pure measure of interest rate risk only works for parallel shifts in the yield curve. rising interest rate falling interest rate interest rate barbell ladder risk favored favored reinvestment barbell ladder rate risk favored favored

11. (2) Active Management Strategies Interest-rate anticipation –Risky strategy relying on uncertain forecasts –Ladder strategy staggers maturities –Barbell strategy splits funds between short duration and long duration securities Valuation analysis –The portfolio manager attempts to select bonds based on their intrinsic value Credit analysis –Involves detailed analysis of the bond issuer to determine expected changes in its default risk

12. Yield spread analysis –Assumes normal relationships exist between the yields for bonds in alternative sectors Bond swaps –Involve liquidating a current position and simultaneously buying a different issue in its place with similar attributes but having a chance for improved return (2) Active Management Strategies

13. Core-Plus Bond Portfolio Management This involves having a significant (core) part of the portfolio managed passively in a widely recognized sector such as the U.S. Aggregate Sector or the U.S. Government/Corporate sector. The rest of the portfolio would be managed actively in one or several additional “plus” sectors, where it is felt that there is a higher probability of achieving positive abnormal rates of return because of potential inefficiencies

14. (3) Matched-Funding Techniques Dedicated Portfolios  Dedication refers to bond portfolio management techniques that are used to service a prescribed set of liabilities –Pure Cash ‑ Matched Dedicated Portfolios Most conservative strategy –Dedication With Reinvestment Cash flows do not have to exactly match the liability stream

15. (3) Matched-Funding Techniques Immunization Strategies –A portfolio manager (after client consultation) may decide that the optimal strategy is to immunize the portfolio from interest rate changes –The immunization techniques attempt to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates

16. Immunization Strategies Components of Interest Rate Risk – Price Risk – Coupon Reinvestment Risk

17. Classical Immunization Immunization is neither a simple nor a passive strategy An immunized portfolio requires frequent rebalancing because the modified duration of the portfolio always should be equal to the remaining time horizon (except in the case of the zero-coupon bond)

18. Classical Immunization Duration characteristics –Duration declines more slowly than term to maturity, assuming no change in market interest rates –Duration changes with a change in market interest rates –There is not always a parallel shift of the yield curve –Bonds with a specific duration may not be available at an acceptable price

19. (3) Matched-Funding Techniques Horizon matching –Combination of cash-matching dedication and immunization –Important decision is the length of the horizon period

20. (4) Contingent Procedures A form of structured active management –Constrains the manager if unsuccessful Contingent immunization –duration of portfolio must be maintained at the horizon value –cushion spread is potential return below current market –safety margin –trigger point

21. End of Chapter 20 –Bond Portfolio Management Strategies