Bond portfolio management

strategies
(Chapter 16)

Investment Process
1. Investment objectives
Vary between type of institution, e.g.:

Pension funds generate cash flow (return) from

investment to satisfy pension obligations
Life insurance cover payments in future, generate
more return than repaid.
Banks return on investments higher than cost of
acquiring them.
Mutual funds target dividend payout.

Investment Process
2. Establishing investment policy
Guidelines for meeting investment objectives.
Asset allocation decision distribution among
major classes of investments:

Cash equivalents
Equities
Fixed-income securities
Real estate
Foreign securities

Investment Process

Investment policy depending on client or regulatory

constraints:
Example:

Restriction on amount allocated to certain major asset classes,

e.g. equity
No investment in bond issuer with credit rating below a
specified level
Maximum percentage of funds assets in a particular industry
Derivatives only to protect asset values not for speculation
Tax regulations may also affect investment policy

Investment Process
3. Selecting portfolio strategy
Portfolio strategy consistent with objectives
and policy guidelines.

Broadly:

Active strategy (forming expectations about future)

(Structured strategy) (elements of both active and

passive strategies)
Passive strategy (indexing)

Investment Process
Which strategy do chose?
Depends on view of market efficiency and nature of liabilities to
satisfy:

Efficient market: All prices fully reflect all available information

relevant for the valuation of the security at all times.

If markets are efficient no superior return from active

management theory suggest choosing passive strategy (indexing).

Liabilities, e.g. for pension fund, may require immunization

preserve the value of a fund rather than following an index.

Investment Process
4. Selecting assets
Depending on strategy:

Passive: Assets needed to follow a chosen index or for

Active: Evaluation of individual securities trying to

creation of a hedge for immunization.

identify mispriced securities.

Attempts to create an efficient portfolio, i.e. greatest expected

return for a given level of risk or lowest risk for a given
expected return.

Investment Process
5. Measuring and evaluating performance
Measuring performance of portfolio, then

evaluating performance relative a benchmark

(normal) portfolio.

Benchmark return often some index (S&P 500

for equity, bond index), or customized
benchmark portfolios with similar risk
structure.

Active portfolio strategies

Two broad approaches:
1) Interest rate forecasting
Profit by making superior forecasts
Hard to predict future interest rate movements

2) Identification of relative miss-pricing within the

fixed-income market:
Classification of strategies (in book):

Substitution swap
Intermarket spread swap
Rate anticipation swap
Pure yield pickup swap

Active portfolio strategies

A. Interest-Rate Expectations Strategies

Based on the ability to forecast the direction of

future interest rates.

Important: The market consensus (forward

rates) are embodied in the market prices of

bonds, i.e. only manager expectations different

from the market consensus are possible to use

in speculative trading.

Active portfolio strategies

Managers alter bond portfolios sensitivity (duration) to interest rate
changes depending on future belief about interest rate changes.
Increase duration if interest rates are expected to fall
Decrease duration if interest rates are expected to rise.

Rate anticipation swap: Portfolios duration altered by swapping

(exchanging) bonds in the portfolio for new that will achieve the
target duration.

Alternative use futures on bonds:

Buying futures increases a portfolios duration.

Selling futures decreases a portfolios duration

Active portfolio strategies

Doubtful whether betting on future

interest rate movements can provide a

superior return.
Most evaluations (academic) show that it
is hard to correctly predict future interest
rate movements.

Active portfolio strategies

B. Yield curve strategies
Yield curve: relationship between Treasury yields
and maturity times.

Shape changes over time.

Yield curve strategies involve positioning the

bond portfolio to capitalize on expected changes

in the shape of the yield curve.

Active portfolio strategies

Types of yield curve shifts
Parallel shifts in the yield curve same for all maturities.

Nonparallel shifts in the yield curve change in yield

different for different maturities:

Twists (change in slope spread short-long).

Butterfly shifts (change in humpedness).

Most common change (US, 1979-1990):

Downward shift combined with a steepening of the yield curve.

Upward shift combined with a flattening of the yield curve

Yield curve strategies require forecast for the direction of

shift and for type of twist

Active portfolio strategies

Yield curve strategies

Bullet strategies

The maturity of the securities in the portfolio are highly

concentrated at one point on the yield curve, e.g. 10 years.

Barbell strategies

The maturity of the securities in the portfolio are concentrated

at two extreme maturities point on the yield curve, e.g. 5 and 20
years.

Ladder strategies

Approximately equal amounts of each maturity, e.g. equal

amount on one, two, three, years maturity.

Active portfolio strategies

Each of the strategies results in different

performance when the yield curve
changes, depending on type and
magnitude of shift.

Active portfolio strategies

Important reflection: Duration and Yield curve shifts
Duration: measure of the price sensitivity of a bond price or value of
a bond portfolio to changes in market yields.

Example:
Portfolio (bonds with 2, 5 and 10 years to maturity) with a
duration = 2.
Change in market yields 100 basis points.
Portfolio value changes by approximately 2 percent.
Note: Duration assumes a parallel shift in the yield curve, i.e. the
yield increases for the 2, 5 and 10 years to maturity bonds with 100
basis points.

Active portfolio strategies

Thus, two portfolios with same duration may

perform quite differently for non-parallel shifts in

the yield curve the packaging of maturities
matters.

Also note: two portfolios with same duration

may perform differently for parallel shifts in the

yield curve if convexity for the bonds differs.

Active portfolio strategies

To evaluate different investment strategies:

Total return analysis based on expected change in

total yield curve.
Total return analysis: calculate the return for strategy
(bullet, barbell and ladder) given expected change in
yield curve (shape and magnitude).
Measures as yield (to maturity or similar), duration
and convexity show little about performance over
some investment period, e.g. 6 month.

Active portfolio strategies

C. Yield spread strategies
Bond market classified into sectors:

Type of issuer (Government, corporations, mortagebacked)

Credit groups (Treasury, AAA, AA,)
Coupon (High, low,)
Maturity (short, intermediate, long term)

Yield spread strategies capitalize on expected

changes in yield spreads between sectors of the

bond market, e.g. credit spreads.

Substitution swap, intermarket spread swap

Passive strategies
Two broad categories:

Indexing strategy (return on specific benchmark

index).

Liability-driven strategy (generate sufficient

funds to pay off predetermined future liability)

Immunization

Indexing
Advantages:
No dependence on expectations.
Little risk of underperforming the index.
Reduced advisory and non-advisory fees.
Greater risk control within organization.
Disadvantages:

Bond indexes may not reflect optimal performance.

Bond index return may not match liabilities in the future.
Restrictions on portfolio may ignore opportunities.

Indexing
Selection of index to replicate:
Based on:
Risk tolerance different indexes represent
different risk, e.g. some include corporate bonds
(credit risk) some do not.
Investor objective variability of different bond
indexes differ some investors may prefer less
variability and a more constant flow of return.

Indexing
Bond Indexes
Broad range of indexes:
Broad-based market indexes

Lehman Brothers US Aggregate Bond Index.

Salomon Smith Barney Broad Investment-Grade Bond Index (BIG).
Merrill Lynch Domestic Market Index.
OMRX Total Bond Index.

Specialized market indexes

OMRX Government Debt Index.

OMRX Treasury Bond Index.
US Corporate Index.
US MBS Index.

Indexing
Indexing Methodologies
Select index (accept the risk-reward profile of the bond market
index).

Construct portfolio that will track the index, i.e. create a bond

portfolio that mirrors the composition of a bond market index.

Similar to stock market indexing differences however due to the

nature of the bond indexes:

Large number of bonds in the index (5000-7000 bonds in the US)

Bonds are dropped from the index as maturity falls below 1 year
New bonds are constantly added to the index
Bonds generate considerable interest income that must be reinvested

Indexing
Stratified sampling/Cell approach
Index divided into cells representing different characteristics of the
index, e.g:
Duration (e.g. less than 4 years/more than 4 years).
Coupon (e.g. High/low).
Maturity (e.g. less than 5 years/5-15 years/more than 15 years).
Market sectors (e.g. Treasury/corporate).
Credit rating (e.g. AAA/AA/A/BBB).
Call factors.
Sinking fund features.

Select one or a few bonds that represent each cell.

Purchase the bond in a given cell equal to the proportion of the total
market value of the bond index that the cell represents.

Indexing
Optimization approach
Same as stratified sampling but choice of
bonds to include in each cell satisfy
constraints and optimize some objective,
e.g. maximize portfolio yield, maximize
convexity.
Solve with mathematical programming.

Indexing
Tracking error minimization using multi-factor risk models

Construct replicating portfolio using multi-factor risk

model so that its forward-looking tracking error is
minimized.

Include securities based on historical data that minimize

the tracking error.

Tracking error

Portfolio managers benchmark: bond

market index.

Common risk measure: Tracking error

(active risk).
Tracking error = standard deviation of the
portfolio return relative to the return of
the benchmark index.

Calculating tracking error

Calculate active return = total return for

bond portfolio for given periods total
return for benchmark index for
corresponding periods.
Calculate the tracking error = standard
deviation of the active returns.

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Tracking error
Month

retport

Retind

Active return

Jan

-0.02

-0.04

0.02

Feb

1.58

1.54

0.04

March

-0.04

0.00

-0.04

April

0.61

0.54

0.07

May

-0.71

-0.76

0.05

June

-0.27

-0.30

0.03

July

0.91

0.83

0.08

Aug

1.26

1.23

0.03

Sept

0.69

0.76

-0.07

Oct

0.95

0.90

0.05

Nov

1.08

1.04

0.04

Dec

0.02

0.28

-0.26

Sum

0.041

Mean

0.0034

Variance

0.0086

S.d. (tracking error)

0.0930 (9.3 bps)

Tracking error
Tracking error is in terms of the observation

period, i.e. monthly if based on monthly data,

weekly if weekly data.

Tracking error

Backward-looking tracking error (ex-post

or actual tracking error) = tracking errors

calculated from historical active returns.
Problem: May have little predictive value
describing future bond portfolio risk, if
current portfolio is significantly changed,
e.g. duration or exposure towards
mortgage market sector.

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Tracking error
Forward-looking tracking error (predicted or ex

ante tracking error) = predicted tracking errors

based on multi-factor risk model

Tracking error
Active vs passive strategy
If portfolios constructed to have a
forward-looking tracking error equal to
zero replicates the performance of the
benchmark index i.e. a passive strategy.

Non-zero forward-looking tracking errors

indicate an active strategy.

Liability-Driven Strategies
Liability a cash outlay that must be made at a specific
time to satisfy the contractual terms of an issued
obligation.

The nature of liabilities key factor in some portfolio

managers selection of strategy and of asset classes to

include in portfolios, e.g. for pension funds.

Liability-driven strategies assets are chosen so that

future cash flows (from assets) will equal or exceed the

obligations (payment of liability).

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Liability-Driven Strategies
Classification of liabilities
Liability Type

Amount of Cash Outlay

Timing of cash outlay

Known

Known

II

Known

Uncertain

III

Uncertain

Known

IV

Uncertain

Uncertain

Liability-Driven Strategies
Type I Liabilities
Both the amount and the timing of the liability is known with
certainty, e.g. SEK 100,000 must be paid 6 month from now.
Type II Liabilities

The amount is known but not the timing of the payment, e.g. life

insurance payment of a specified amount upon the death of the

insured (uncertain).

Type III Liabilities

Timing of payment known but amount uncertain, e.g. payments on

floating-rate fixed income securities.

Type IV Liabilities

Both the amount and timing is uncertain, e.g. numerous insurance

products (automobile, home insurance,).

Liability-Driven Strategies
Asset/liability management (surplus management)

The task of managing funds of a financial

institution to accomplish:

An adequate return on invested funds.

To maintain a comfortable surplus of assets beyond
liabilities.

Must consider the risk of both assets and

liabilities.

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Liability-Driven Strategies

Institutions may calculate three types of

surpluses:

Economic
Accounting
Regulatory

Liability-Driven Strategies
Economic surplus
Difference between market value of assets and
market value of liabilities (present value of
liabilities), i.e.:
Economic surplus = market value of assets present
value of liabilities.

Note: both market values (assets and liabilities)

may depend on discounting and will therefore be

affected by changes in the interest rate.

Liability-Driven Strategies
Example: An institution with only bonds as assets:

Interest rates increase:

Bond portfolio value decrease and present value of liabilities

decreases.
Note: higher interest rate, ceteris paribus, in discounting gives a
lower present value.

Interest rates decrease:

Bond portfolio value increase and present value of liabilities

increase.

Nett effect on economic surplus depends on the relative

interest rate sensitivity of assets and liabilities.

Duration as a measure of interest rate sensitivity may be

used both for bonds and for liabilities.

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Liability-Driven Strategies
Accounting surplus
May be calculated in different ways (different ways of
valuing assets and liabilities).
Must follow accounting standards, e.g. GAAP.
May be substantial differences in surplus depending on
chosen method.
Regulatory surplus

Some institutions are obligated to provide financial

reports to regulators (Finansinspektionen in Sweden)

and may calculate surplus according to certain specified
rules.

Liability-Driven Strategies
Immunization single liability
Shield against exposure to interest rate
fluctuations.
Immunization of interest rate risk:
Net worth immunization
Duration of assets = Duration of liabilities

Target date immunization

Holding Period matches Duration

Immunization an example

A company must make a payment of

14,701 in 7 years. The market interest

rate is 5% PV is 10,000.

The company has the money today and

want to hedge against the interest rate
risk using 3-year zero coupons and
perpetuities paying annual coupons

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Immunization (cont.)
Immunization requires that the duration of
the portfolio of the asset equal the
duration of the liability.

Step 1: Calculate the duration of the

liability! Here 7 years.

Step 2: Calculate the duration of the asset

portfolio.

Zero coupon bond: 3 years (=maturity)

The perpetuity: (1+y)/y=1,05/0,05=21 years

Immunization (cont.)
Step 3: Find the asset mix that sets the duration of assets equal to

the 7-year duration of liabilities

W * 3years + (1 W)*21years = 7 years
W is 7/9, that is 78% is invested in 3-year zero coupons and
22% in the perpetuities

Step 4: Purchase zero coupon bonds for 7800 and perpetuities for
2200.

The fund manager will have to rebalance its portfolio as time

passes!!

Duration of portfolio affected by

yield changes
time to maturity

Liability-Driven Strategies

Rebalancing an immunized Portfolio is a

tradeoff between transaction costs and
deviation in durations between portfolio
and liability.

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Liability-Driven Strategies
Cash flow matching
Create portfolio with payments (par value and coupon) that matches
liabilities in time.

Principle:
Match the last liability stream with par value + coupon payment
from a bond.

Match the coupon payments and the liability stream during the life
of the first bond.

If liability stream exceeds coupon payments match a new bonds

par value + coupon payment to the next last liability stream, and so
on.

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