Chapter 4
Portfolio
Management
of Bonds
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Major Sectors of U.S. Dollar
Bond Market
As % of total nominal value outstanding at year-end 2000 $16,192 billion
Asset-backed
Municipal 5%
10%
Corporate
28%
Foreign
10%
Other
government
agencies
11%
Mortgagebacked
15%
US government
21%
Source: Federal Reserve Flow of Funds; Salomon Smith Barney
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4–1
Basic Characteristics of Bonds
• Stated characteristics of par value,
coupon maturity, and optional features
(if any) are all related to current price
• An example: bond with 5 years
remaining to maturity; paying 6%
annual coupon on par (face) value of
$1,000
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4–2
Basic Characteristics
of Bonds (cont.)
• Cash flows
Interest (coupon)
payment
End of Period
Year 1
Year 2
Year 3
Year 4
Year 5
$60
$60
$60
$60
$60
Principal
repayment
$1000
Current price
Discounted at effective yield (YTM)
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4–3
Bonds: Relationship Between
Yield and Price
• There is an inverse relationship between yield and
price
Yield
(rates)
Bond
Prices
• Value of the bond today
– Depends on the interest rate (yield) used to discount each
year’s cash flows back to the present
– Will change as the yield demanded by investors changes
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4–4
Yield Spreads
• Yield required increases as risks
increase
– In general
bond yield = risk-free yield + risk premium
= treasury yield + yield (risk) spread
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4–5
Yield Spreads
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4–6
Duration as a Measure
of Comparability
Calculated Duration
30
25.00
25
20
9% coupon bond
15
10.33 11.10
10
5
6% coupon bond
Zero coupon bond
4.13 4.35 5.00
0
5-year bonds
25-year bonds
(stated maturity)
(stated maturity)
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4–7
Risks of Bond Investment
• Market risk
– Addresses inverse relationship between interest
rates and bond prices
• Reinvestment risk
– Relates to variability in bond returns that result
from fluctuations in the interest rate at which
interim cash flows are invested
• Credit risk
– Threat that the issuer of a bond may default
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4–8
Risks of Bond Investment (cont.)
• Call risk
– Relates to risk an investor faces when buying a
bond with an embedded call option attached
• Event risk
– Involves circumstances unforeseen at the time of
purchase that can have a large adverse effect on
bond prices
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4–9
Passive versus Active
Investment Strategies
• Passive management
– Buy and hold: objective is to achieve a
specific return
– Indexing: objective is to match the
performance of the bond market
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4–10
Passive versus Active
Investment Strategies (cont.)
• Active management
– Objective is to beat the return of the
market, defined as
• A market index and/or
• A competitive universe of funds with similar
objectives
– Portfolio manager is buying and selling
securities based on his or her expectations
about interest rates, credit risks, etc.
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4–11
Major Fixed Income
Investment Strategies*
Duration management
(Interest rate anticipation)
Impact
High
Chance of Success
Low
Yield curve positioning
Sector analysis
Issuer credit selection
Low
High
*Other strategies include: using credit derivatives to manage credit
risk, predicting prepayments, and using option adjusted spreads
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4–12
Interest Rate Anticipation:
Rising Rates
• If managers anticipate a rise in rates, they may
“shorten the maturity” of the bond fund
– Long maturity bonds are very price sensitive to changes in
rates
– Holding shorter maturity bonds reduces the amount that the
fund’s price may fall if rates increase
– Examples
rates
rates
bond
price
Longer Maturity Bond
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bond
price
Shorter Maturity Bond
4–13
Interest Rate Anticipation:
Falling Rates
• If managers anticipate a fall in rates, they may
“lengthen the maturity” of the bond fund
– Long maturity bonds are very price sensitive to changes in
rates
– Holding longer maturity bonds increases the amount that the
fund’s price may rise if rates decrease
– Examples
bond
price
bond
price
rates
Shorter Maturity Bond
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rates
Longer Maturity Bond
4–14
Yield Curve Example
Prospective Total Return of Municipal Bonds
Insured Revenue, Horizon = 365 days
Yield
6%
6-year maturity
5%
4%
12-year maturity
3%
2%
1%
0%
1
3
5
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7
Duration
9
11
13
4–15
Sector Exposure Example
Sector
Fund
Index
Difference
Corporates
10.1%
21.6%
–11.5%
Mortgages
18.4%
4.8%
13.6%
Asset-backed
securities
8.9%
1.4%
7.5%
Treasuries
32.4%
43.0%
–10.6%
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4–16
Issuer Credit
Analysis Example
CREDIT SUMMARY NOTE
Sector
Issuer
Analyst
Bank
Bank of
Boston
MWO
Agency Rating
Moody
Baa1
Date
8/22/xx
Credit Comment
Continued improvements. BKB posted an ROA of .89% (.97% excl.
a $16.4MM restructuring charge) compared with .76% in 2Q93.
NPAs are down to 2.76% of loans and OREO from 3.06 YE93.
BKB = Bank of Boston
ROA = return on assets
NPA = non-performing assets
OREO = other real estate owned
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4–17
A Manager’s Steps in the
Investment Process
1. Understand the fund’s objective and compliance
requirements
2. Develop a fund strategy
3. Work with analysts and traders to find value (e.g.,
individual security selection)
4. Review liquidity, risk, diversification requirements
5. Execute portfolio transactions
6. Evaluate performance attribution; return to step 2
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4–18
Other Key Players in Bond
Fund Management
• Credit analyst
–
–
–
–
Actively analyzes financial condition of issuers
Utilizes ratio analysis
Determines the credit risk/return profile of bond issuers
Note: some differences in corporate versus municipal
analysts
• Quantitative analyst
– Builds mathematical models to help identify potential
opportunities
– Examines analytical building blocks of bonds
– Produces valuation and risk parameters
– Quantifies and rewards of strategies under various scenarios
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4–19
Other Key Players in Bond
Fund Management (cont.)
• Trader
– Provides current information about the
bond market
– Handles execution of trades
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4–20