Chapter 19
FIXED-INCOME PORTFOLIO
MANAGEMENT
Chapter 19 Questions
What are three major bond-portfolio
management strategies?
What are the two specific strategies for
passive portfolio management?
What are the five strategies available for
active portfolio management?
Chapter 19 Questions
What is meant by core-plus bond
management and what are some plus
strategies?
What do we mean by matched-funding
techniques, and what are the four specific
strategies for these techniques?
How are futures contracts used to hedge
against cash deposits or withdrawals from a
bond portfolio?
Chapter 19 Questions
How are futures used to change the
systematic risk (i.e., duration) of an
actively managed portfolio?
What are some of the general
advantages of using futures and options
in bond-portfolio management?
Alternative Bond
Portfolio Strategies
1. Passive portfolio strategies
2. Active management strategies
3. Matched-funding techniques
Passive Portfolio
Strategies
Passive strategies
emphasize buy-andhold, low energy
management
Try to earn the
market return rather
than beat the market
return
Passive Portfolio
Strategies
Buy and hold


Buy a portfolio of bonds and hold them to maturity
Can by modified by trading into more desirable
positions
Indexing


Match performance of a selected bond index
Performance analysis involves examining tracking
error for differences between portfolio
performance and index performance
Active Management
Strategies
Active management
strategies attempt to
beat the market
Mostly the success
or failure is going to
come from the
ability to accurately
forecast future
interest rates
Active Management
Strategies
Interest-rate anticipation



Risky strategy relying on uncertain forecasts of
future interest rates, adjusting portfolio duration
Ladder strategy staggers maturities
Barbell strategy splits funds between short
duration and long duration securities
Valuation analysis

A form of fundamental analysis, this strategy
selects bonds that are thought to be priced below
their estimated intrinsic value
Active Management
Strategies
Credit analysis


Determines expected changes in default risk
Try to predict rating changes and trade
accordingly




Buy bonds with expected upgrades
Sell bonds with expected downgrades
Credit analysis models such as Altman’s Z-score
model may be useful for predicting changes in
ratings
High yield bonds may warrant special attention
Active Management
Strategies
Yield-spread analysis


Monitor spread within and across sectors, bond
ratings, or industries
Trade in anticipation of changing spreads
Bond swaps


Selling one bond (S) and buying another (P)
simultaneously
Swaps to increase current yield or YTM, take
advantage of shifts in interest rates or realignment
of yield spreads, improve quality of portfolio, or for
tax purposes
Active Management
Strategies
Bond Swaps

Pure yield pickup swap


Substitution swap


Swapping a seemingly identical bond for one that is
currently thought to be undervalued
Tax swap


Swapping low-coupon bonds into higher coupon bonds
Swap in order to manage tax liability (taxable & munis)
Swap strategies and market-efficiency

Bond swaps by their nature suggest market inefficiency
A Global Fixed-Income
Investment Strategy
Factors to consider
1. The local economy in each country including the
effects of domestic and international demand
2. The impact of total demand and domestic
monetary policy on inflation and interest rates
3. The effect of the economy, inflation, and interest
rates on the exchange rates among countries
Core-Plus Bond
Management
A combination approach of passive and
active bond management styles
A large, significant part of the portfolio is
passively managed in one of two sectors:


The U.S. aggregate sector, which includes
mortgage-backed and asset-backed securities
The U.S. Government/Corporate sector alone
The rest of the portfolio is actively managed


Often focused on high yield bonds, foreign bonds,
emerging market debt
Diversification effects help to manage risks
Matched-Funding
Techniques
Classical (“pure”) immunization strategies
attempt to earn a specified rate of return
regardless of changes in interest rates

Must balance the components of interest rate risk



Price risk: problem with rising interest rates
Reinvestment risk: problem with falling interest rates
Immunize a portfolio from interest rate risk by
keeping the portfolio duration equal to the
investment horizon

Duration strategy superior to a strategy based only a
maturity since duration considers both sources of interest
rate risk
Matched-Funding
Strategies
Many immunization
strategies are
designed to take the
sting out of rising
interest rates for a
bond portfolio!
Matched-Funding
Techniques
Immunization Strategies

Difficulties in Maintaining Immunization
Strategy
Rebalancing required as duration declines
more slowly than term to maturity
 Modified duration changes with a change in
market interest rates
 Yield curves shift

Matched-Funding
Techniques
Dedicated portfolios
Designing portfolios that will service liabilities
Different types:

Exact cash match



Conservative strategy, matching portfolio cash flows to
needs for cash
Useful for sinking funds and maturing principal payments
Dedication with reinvestment


Does not require exact cash flow match with liability
stream
Great choices, flexibility can aid in generating higher
returns with lower costs
Matched-Funding
Techniques
Horizon matching
Combination of cash-matching and
immunization
 With multiple cash needs over specified
time periods, can duration-match for the
time periods, while cash-matching within
each time period

Derivatives in FixedIncome Management
Derivatives can be used to modify
portfolio risk and return
Using derivative for asset allocation
Adjusting allocations in the underlying
assets can be very expensive
 Less costly to achieve a similar asset
allocation exposure using derivatives,
especially for temporary adjustments

Derivatives in FixedIncome Management
To control portfolio cash flows

Hedging portfolio cash inflows and outflows
Treasury bond futures contract
Typically used contract for risk
management of fixed-income portfolios
 Delivery in T-bonds, meeting criteria


Those that are delivered are the cheapest-todeliver (CTD) that satisfies contract
Derivatives in FixedIncome Management
Determining How Many Contracts to Trade to
Hedge a Deposit or Withdrawal
Cash Flow
 Conversion Factor  Duration Adjustment Factor
Value of 1 Contract
This is the hedge ratio, and it depends on:

Conversion factor


Adjusts the CTD bond to 8% (required for delivery)
Duration adjustment factor

Reflects the difference in interest rate risk between the
CTD bond and the portfolio being hedged
Derivatives in FixedIncome Management
Determining How Many Contracts to
Trade to Adjust Portfolio Duration
Here futures contracts are used to
adjust the duration of a portfolio,
thereby managing interest rate risk
Weighted average approach
 Target duration = Contribution of current
bond portfolio + contribution of the futures
component

Derivatives in FixedIncome Management
Using Futures in Passive Fixed-Income
Portfolio Management
Will use futures primarily to manage
deposits and withdrawals
Will not use futures to actively adjust
duration due to interest forecasts
Derivatives in FixedIncome Management
Using Futures in Active Fixed-Income Portfolio
Management
Modifying systematic risk


Changing the portfolio duration in light of interest
rate forecasts
Lengthen duration if rates are expected to fall
Modifying unsystematic risk

Opportunities are more limited here, but can
adjust exposure to various sectors to take
advantage of expected yield changes
Derivatives in FixedIncome Management
Changing the Duration of a Corporate Bond
Portfolio
There are no corporate bond futures
contracts, so strategies are based on using Tbond futures



Corporate bond yields also impacted by changes
in default risk, unlike T-bond yields
T-bonds are a “cross hedge” instrument
Differences could impact the number of contracts
required to hedge a corporate bond portfolio
Derivatives in FixedIncome Management
Modifying the Characteristics of an International
Bond Portfolio
Positions in foreign bonds are positions in
both securities and currencies

Futures and option contracts allow the portfolio
manager to manage the risks of the currency and
the security separately


In a passive strategy, the manager can hedge the risk
exposure
In an active strategy, the manager can adjust the
exposure to try to benefit from expected changes in
exchange rates