Chapter 4 Portfolio Management of Bonds Viewing recommendations for Windows: Use the Arial TrueType...

Chapter 4

Portfolio Management of Bonds

Viewing recommendations for Windows: Use the Arial TrueType font and set your screen area to at least 800 by 600 pixels with Colors set to Hi Color (16 bit).

Viewing recommendations for Macintosh: Use the Arial TrueType font and set your monitor resolution to at least 800 by 600 pixels with Color Depth set to thousands of colors

Copyright © Houghton Mifflin Company. All rights reserved. 4–2

Major Sectors of U.S. Dollar Bond Market

As % of total nominal value outstanding at year-end 2000 $16,192 billion

Source: Federal Reserve Flow of Funds; Salomon Smith Barney

Corporate28%

US government21%Mortgage-

backed15%

Other government

agencies11%

Foreign10%

Municipal10%

Asset-backed5%


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


End of Period

Year 1 Year 2 Year 3 Year 4 Year 5

Interest (coupon) payment

$60 $60 $60 $60 $60

Principal repayment

$1000

Current price

Basic Characteristics of Bonds (cont.)

• Cash flows

Discounted at effective yield (YTM)


Yield (rates)

Bond Prices

Bonds: Relationship Between Yield and Price

• There is an inverse relationship between yield and price

• 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


• Yield required increases as risks increase– In general

bond yield = risk-free yield + risk premium= treasury yield + yield (risk)

spread

Yield Spreads


Yield Spreads


4.13

10.33

4.35

11.10

5.00

25.00

0

5

10

15

20

25

30

5-year bonds 25-year bonds

9% coupon bond

6% coupon bond

Zero coupon bond

Calculated Duration

(stated maturity) (stated maturity)

Duration as a Measureof Comparability


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


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


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


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.


Impact Chance of Success

Duration management (Interest rate anticipation)

High 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

Major Fixed Income Investment Strategies*


• 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

Interest Rate Anticipation: Rising Rates

ratesmaturity length

bond price

bond price


Longer Maturity Bond Shorter Maturity Bond


Shorter Maturity Bond Longer Maturity Bond

• 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

Interest Rate Anticipation: Falling Rates


bond price

rates

bond price

maturity length


Prospective Total Return of Municipal Bonds Insured Revenue, Horizon = 365 days

Duration

0%

1%

2%

3%

4%

5%

6%

1 3 5 7 9 11 13

Yield

6-year maturity

12-year maturity

Yield Curve Example


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%


BKB = Bank of BostonROA = return on assetsNPA = non-performing assetsOREO = other real estate owned

Issuer CreditAnalysis Example

CREDIT SUMMARY NOTE

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.

Sector Issuer Analyst Agency Rating Date

Bank Bank ofBoston

MWO Moody Baa1 8/22/xx


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


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


Other Key Players in Bond Fund Management (cont.)

• Trader

– Provides current information about the bond market

– Handles execution of trades

Date post:	29-Dec-2015
Category:	Documents
Upload:	francine-hines
View:	217 times
Download:	3 times

Chapter 4 Portfolio Management of Bonds Viewing recommendations for Windows: Use the Arial TrueType...

Documents