Introduction to Bond Portfolio Management

by Frank J. Fabozzi

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PowerPoint Slides by

David S. Krause, Ph.D., Marquette University

Chapter 16 Introduction to Bond Portfolio

Management• Major learning outcomes:

– Identify the activities in the investment management process (setting the investment objectives, developing and implementing a portfolio strategy, monitoring the portfolio, and adjusting the portfolio).

– Explain the two types of benchmarks (liability structure and bond index) used to identify an investment objective.

Key Learning Outcomes

• Define liabilities.

• Classify different types of liabilities.

• Define what a funded investor is and the investment objective of a funded investor.

• Identify the major broad-based bond market indexes.

Key Learning Outcomes• Describe what performance risk is.

• Identify some of the risks associated with liabilities.

• Explain what the economic surplus of an entity is and how its exposure to changes in interest rates is assessed.

• Define what the duration of a liability is.

Key Learning Outcomes• Identify the types of constraints imposed on managers

and/or investors.

• Identify the elements in developing and implementing a portfolio strategy (writing an investment policy, selecting the type of investment strategy, formulating the inputs for portfolio construction, and constructing the portfolio).

• Distinguish between active and passive strategies.

• Explain how the degree of departure of a managed portfolio from the benchmark index determines the degree of active management.

Key Learning Outcomes

• Explain the role of forward rates in formulating the inputs for constructing a portfolio.

• Explain what is involved in the monitoring activity phase of the investment management process.

• Distinguish between performance measurement and performance evaluation.

The Investment Management Process

The investment management process involves the following activities:

1) setting the investment objectives

2) developing and implementing a portfolio strategy

3) monitoring the portfolio

4) adjusting the portfolio

Investment Objectives

• Specified in terms of return and risk• Expressed quantitatively in terms of a

benchmark- benchmark in terms of the investor’s liability structure- benchmark as a particular bond market index

• The benchmark should reflect the client’s investment need from a risk, return, and cash flow perspective.

Liabilities as the Investment Objective

Two categories of investors

1) Investors borrow the funds and invest those funds – funded investors (banks, savings and loan associations, credit unions, hedge funds, insurance companies)– Objective: earn a return on the funds borrowed that is

greater than the cost of borrowing – Spread: the difference between the return on the funds

invested and the cost of borrowing

2) Institutional investors who must satisfy a liability structure but did not borrow the funds that created the liability (a pension sponsor)

Liabilities as the Investment Objective

• Liability – a potential cash outlay at a future date to satisfy the contractual terms of an obligation.

- amount of the liability

- timing of the liability

• Classification of Liabilities

Liability Type

Amount of Outlay

Timing of Cash Outlay

Example

Type I known known Fixed-rate CD

Type II known uncertain Life insurance policy

Type III uncertain known Floating-rate CD

Type IV uncertain uncertain Auto (home) insurance policy

Bond Market Index as the Investment Objective

• Basic characteristics of a benchmark- Unambiguous: clearly identifiable names and weights of the securities- Investable: buy-and hold the benchmark vs. actively managed funds- Measurable: return can be calculated on a frequent basis- Appropriate: consistent with the manager’s investment style - Reflective of current investment opinions: knowledge of the securities included- Specified in advance

Bond Market Index as the Investment Objective

1) Broad-based U.S. bond market indexes- Lehman Brothers U.S. Aggregate Index- Salomon Smith Barney Broad Investment-Grade Bond Index- Merrill Lynch Domestic Market Index

These are computed daily and are “market-value weighted”

The securities in the indexes are trader priced or model pricedIntra-month cash flows reinvested in different ways

2) Specialized U.S. bond market indexes

3) Global and international bond market indexes

Risk

Performance risk – the inability to satisfy an investment objective

1) Risk associated with managing relative to a bond market index

2) Risks associated with managing against a liability structure

Risk Associated with Managing Relative to a Bond Market IndexPortfolio relative performance – the difference between the risk profile of the benchmark index and the risk profile of the portfolio

Tracking error – a measure that allows the manager to incorporate all of the major risks associated with a portfolio relative to a benchmark index

The larger the tracking error, the greater the likelihood that the portfolio’s performance will differ from performance of the benchmark index

Risks Associated with Managing Against a Liability Structure

• Managing relative to a liability structure is referred to as asset-liability management

• Call risk for liabilitiesSimilar to call risk but at this case, a depository institution is concerned with the premature withdrawal of funds when interest rates rise

• Cap risk – the risk that the funding cost will exceed the rate earned on a floating-rate bond

• Interest rate riskEconomic surplus = market value of assets – present value of liabilitiesIf the duration of the assets is less than the duration of the liabilities, the economic surplus will decrease (increase) if interest rates fall (rise).Convexity should also be considered when analyzing interest rate sensitivity.

Constraints

• Client-imposed constraints

should be realistic and consistent with the investment objective

• Constraints by the regulators of state-regulated institutions

• Tax implications

Developing and Implementing a Portfolio Strategy

1) Writing an investment policy

2) Selecting the type of investment strategy

3) Formulating the inputs for portfolio construction

4) Constructing the portfolio

Developing and Implementing a Portfolio Strategy

1) Writing an Investment Policy- Links the investor’s investment objectives and the types of strategies to reach those objectives

- Should specify the permissible risk and the way the performance risk is measured

- Investment guidelines consistent with the investment policy and the investment philosophy of the manager

Developing and Implementing a Portfolio Strategy

2) Selecting the type of Investment Strategy- Active strategies – forecasts of interest rates; changes in the term structure of interest rates, interest rate volatility, yield spreads

- Passive strategies – indexing – replicates the performance of a designated bond market index.

- Structured portfolio strategies – designing a portfolio to achieve the same performance as a designated benchmark

Developing and Implementing a Portfolio Strategy

2) Selecting the type of Investment Strategy

- comprehensive analysis of the risk profile of the benchmark index – risk characteristics

- passive vs. active management

- use of derivatives

Developing and Implementing a Portfolio Strategy

3) Formulating the inputs for Portfolio Construction – two tasks:– Forecast of the inputs that are expected to impact the

performance of the portfolio: forecasting changes in interest rates, changes in interest rate volatility, changes in credit spreads.

– Extrapolate the market’s “expectations” from market data: the portfolio manager’s view is relative to what is “priced” into the market, or the forward rates and the view of future rates relative to the rates built into today’s prices of the securities.

Developing and Implementing a Portfolio Strategy

4) Constructing the portfolio– Bases on his forecasts and market-derived

information, the manager assembles the portfolio with specific issues.

– Active bond portfolio management involves identifying opportunities to enhance return relative to the benchmark

– Determining the “relative value” of the securities as “the ranking of foxed-income investments by sectors, structures, issuers, and issues in terms of their expected performance during some future interval”.

Monitoring the Portfolio

Monitoring the portfolio involves two activities:– Assessment of whether there have been changes in

the market that might suggest any of the key inputs used may not be realized.

– Monitor the performance of the portfolio:- performance measurement: calculation of the return realized by a manager over a specific time interval- performance evaluation: has the manager added value by outperforming the established benchmark and how he achieved the observed return? - Return attribution analysis – decomposition of the performance results to explain why those results were achieved.

Adjusting the Portfolio

• The activities involved in monitoring the portfolio indicate whether adjustment is needed. – The manager also determines whether to

revise the inputs used in the construction of the portfolio.

– Adjusting the portfolio includes analysis if trading costs: transaction costs and any adverse tax or regulatory consequences.