Bond Portfolio Management

1. Bond Portfolio Management • Bond Portfolio Management in General • Active Portfolio Strategies • Use of Leverage • Index Strategies/Tracking errors

2. Asset Allocation Decision • How much should be allocated to bonds? • Who should manage the bond portfolio?

3. How much should be allocated to bonds? • Pension funds: generate sufficient cash flow from investments to satisfy pension • Life insurance companies: to satisfy obligations stipulated in insurance policies and generate a profit • Banks and thrifts: earn a profit exceeding the cost of obtaining the funds: CDs, short-term money market instruments, and floating rate notes.

4. Who should manage the bond portfolio? • Internal asset managers • External managers • A combination (Example of CalPERS’ bond allocation) • Portfolio Management Team (page 466-467) • CIO and CCO: the guy watching the portfolio to make sure that holding complies with fund investment guideline and legal requirements

5. Spectrum of Bond Portfolio Strategies • Bond benchmark-based strategies • Pure index matching • Enhanced indexing: matching primary risk factor • Absolute Return Strategies • Liability-driven Strategies • (page 469)

6. Top-down vs. Bottom-up Portfolio Construction • In the top-down approach, a bond portfolio manager looks at the major macro drivers of bond return and obtain a view about these drivers in form of a macroeconomic forecast. Then portfolio managers decide on how much of the portfolio’s fund to allocate among different sectors and in cash. • The bottom-up approach focuses on the micro analysis of individual bond issues, sectors, and industries.

7. Active Portfolio Strategies • Interest-rate expectations strategies • Yield Curve Strategies • Yield Spread Strategies • Individual Security Selection Strategies • Strategies for Asset Allocation within Bond Sectors

8. Interest-rate Expectations Strategies • Increase or decrease duration • increase duration when expected interest goes down • decrease duration when expected interest goes up • Approach: Rate anticipation swaps • Gambling incentive – make an interest bet to cover inferior performance relative to a benchmark index.

9. Yield Curve Strategy • Seek to capitalize on expectations based on short-term movements in yields; make profit from the change of yield curve in the portfolio • Key: if your investment horizon is 1 year, what strategy you want to take, put all your money in 1-year bonds or 30-year bonds • Depending on the shape of yield curve, or say yield curve changes

10. Types of Yield Curve Shifts • Parallel Shifts • Twists • Butterfly Shifts • (page 476)

11. Strategies • Bullet strategy (see page 477) • Barbell strategy • Ladder strategy • Bond portfolios under alternative strategies have the same durations – page 477. • To see which strategy to implement, investors need look at the impact of the strategy on the total return of the portfolio • Exhibit 22-6 on page 482 compares the relative performance of a bullet portfolio and a barbell portfolio • One factor driving the difference in portfolio performance is the difference in their convexity.

12. Yield Spread Strategies • Involve positioning a portfolio to capitalize on expected changes in yield spreads between sectors of the bond market. • Swapping one bond for another when the manager believes that the prevailing yield spread between the two bonds in the market is out of line with their historical yield spread.

13. Yield Spread Strategies • Credit spreads – depends on economic condition • Spreads between callable and noncallable bonds – depends on interest rate • Page 485

14. Individual Security Selection Strategy • Identify mis-priced securities • Its yield is higher than that of comparably rated issues • Its yield is expected to decline because credit analysis indicates that its rating will improve • To implement this strategy: swap.

15. Strategies for Asset Allocation with Bond Sectors • Government/agencies • Corporates • Mortgage backed securities • An example for guiding and assessing the allocation of funds among the credit sectors within the corporate bond sector. Page 487-489.

16. Use of Leverage • A portfolio in which a manager has created leverage. • If return from investing the amount borrowed exceed cost of funding. • Leveraging trades will generate a return needed to make the investment attractive to traders.

17. Create Leverage with Repo Repurchase agreement: sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. Repurchase price Repurchase date Repo rate Overnight repo versus term repo

18. Example • A dealer delivers (sells) $10 million of treasury security to a customer and buy it back in to the next day. Repo rate is 6.5%. (dealer is financing a long position) (page 541) • Dollar interest = (dollar amount borrowed)*(repo rate)*repo term/360

19. Repo • Questions: • What is amount borrowed by the dealer? • What is the dollar interest • Jargons: (1) reversing out securities, (2) reversing in securities – page 492

20. Bond Indexes • Broad-based market indexes • e.g., Barclays Capital U.S aggregate bond index, which can be broken into sectors: • Treasury • Agency • Corporate • PMBS and CMBS • asset-backed

21. Bond Indexes (2) • Specialized market indexes • Examples: • Barclays capital U.S. Intermediate Aggregate Bond index • Barclays Capital U.S. 1-3 year Treasury Bond index • Barclays Capital U.S. Government/Credit Bond Index

22. Risk Factors • Systematic risk factors • Term structure risk factors • Non-term structure risk factors • Sector risk • Credit risk • Optionality risk • Non-systematic risk factors • Issuer specific • Issue specific

23. Tracking Error • The standard deviation of the return of the portfolio relative to the return of the benchmark index. • (example on pages 505-508) • Calculate monthly or weekly tracking error • Annualize it

24. Two Faces of Tracking Error • Backward-looking (ex-post) tracking error: tracking error calculated from observed active returns for a portfolio • Forward-looking (ex-ante) tracking error: tracking errors associated with bond market index based on multi-factor models – setting an appropriate benchmark

25. Indexing • Designing a portfolio so that its performance will match the performance of some bond index • Benefits and costs (page 509) • Low management fee and expenses • Straightforward and easy to evaluate • Basis risk between indexing and matching to liabilities

26. Factors Affecting Index Selection • Level of Risk Tolerance • Investor’s objective • Difference in variability • Nonsymmetry in rising and falling markets

27. Issues of an Indexed Portfolio • Tracking error: the discrepancy between the performance of the indexed portfolio and the index • The tradeoff between transaction costs and mismatching of the characteristics of the indexed portfolio and the index. • Logistical problems in implementing an indexing strategy