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Chapter 22
Bond Portfolio
Management
Strategies
Learning Objectives
After reading this chapter, you will understand
 what is meant by asset allocation
 the composition of a portfolio management team
 top-down and bottom-up approaches to bond
portfolio management
 the spectrum of portfolio management strategies
 what is meant by a core/satellite strategy bond
indices
 the different types of active bond portfolio
strategies: interest-rate expectations strategies,
yield curve strategies, yield spread strategies,
option-adjusted spread-based strategies, and
individual security selection strategies
© 2013 Pearson Education
Learning Objectives(continued)
After reading this chapter, you will understand
 bullet, barbell, and ladder yield curve strategies
 the limitations of using duration and convexity to
assess the potential performance of bond portfolio
strategies
 why it is necessary to use the dollar duration when
implementing a yield spread strategy
 how to assess the allocation of funds within the
corporate bond sector
 why leveraging is used by managers and traders
and the risks and rewards associated with
leveraging
 how to leverage using the repo market
© 2013 Pearson Education
The Asset Allocation Decision
 Public pension funds have allocations of about 2/3 in
equities (which includes real estate and private
equity) and about 1/3 in fixed income.
 Regardless of the institutional investor, there are
two important decisions to be made by an
investor/client:
1) “How much should be allocated to bonds?”
2) “Who should manage the funds to be allocated to
bonds?”
© 2013 Pearson Education
The Asset Allocation Decision
(continued)
 How Much Should Be Allocated To Bonds?
 The decision as to how much to invest in the major asset
classes is referred to as the asset allocation decision.
The asset allocation decision must be made in light of the
investor’s investment objective.
 For institutions such as pension funds, the investment
objective is to generate sufficient cash flow from investments
to satisfy pension obligations. For life insurance companies, the
basic objective is to satisfy obligations stipulated in insurance
policies and generate a profit.
 For institutions such as banks and thrifts, funds are obtained
from the issuance of certificates of deposit,
short-term money market instruments, or floating-rate notes.
These funds are then invested in loans and marketable
securities. The objective in this case is to earn a return on
invested funds that exceeds the cost of acquiring those funds.
© 2013 Pearson Education
The Asset Allocation Decision
(continued)
 Who Should Manage the Bond Portfolio?
 Let’s assume that an investor has made the
decision to allocate a specified amount to the
fixed income sector.
 The next decision that must be made is whether
that amount will be managed by internal
managers or external managers or by a
combination of internal and external managers.
 If external managers are hired, a decision must
be made as to which asset management firm to
engage.
© 2013 Pearson Education
The Asset Allocation Decision
(continued)
 Who Should Manage the Bond Portfolio?

In practice, the term asset allocation is used in two contexts.
1) The first involves allocation of funds among major asset
classes that includes bonds, equities and alternative assets.
• Although we have mentioned bonds and equities as the
major asset classes, there is now accepted a group of
assets referred to as alternative assets. For example, for
CalPERS, the actual (as of January 31, 2011) and target
allocation (as of June 2009) asset allocation amongst the
asset classes defined by CalPERS is shown in Exhibit 22-1
(see Overhead 22-8).
2) The second way is how the funds should be allocated
amongst the different sectors within that asset class after a
decision has been made to invest in a specified asset class.
• In the case of equities, equities are classified by market
capitalization and by other attributes such as growth
stocks value.
© 2013 Pearson Education
Exhibit 22-1Asset Allocation of CalPERS: Actual
as of January 31, 2011, and Target Allocation as
of June 2009
Market Value
($ billion)
4.50
Actual
Allocation
2.0%
Target
Allocation
(%)
2.0%
Global Fixed Income
47.50
20.8%
20.0%
AIM
32.20
14.1%
14.0%
Equity
120.30
52.8%
49.0%
Total Global Equities
152.50
66.9%
63.0%
16.60
7.3%
10.0%
6.80
3.0%
5.0%
227.90
100.0%
100.0%
Asset Class
Cash Equivalents
Real Estate Global
Inflation Linked Global
Total Fund*
Source: http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/assetallocation.xml
© 2013 Pearson Education
The Asset Allocation Decision
(continued)
 Who Should Manage the Bond Portfolio?
 The asset allocation among the different sectors
of the bond is made at two levels.
1) The first is where a client must make a
decision as to allocate among each sector and
2) then if an external money manager is to be
hired, deciding on the asset management and
amount to be allocated to each.
© 2013 Pearson Education
Portfolio Management Team
 We refer to the person making the investment decisions
as the “manager” or “portfolio manager.”
 The composition and therefore risk exposure of a
portfolio is the result of recommendations and research
provided by the portfolio management team.
 At the top of the investment organization chart of the
investment group is the chief investment officer (CIO)
who is responsible for all of the portfolios.
 A chief compliance officer (CCO) monitors portfolios to
make sure that the holdings comply with the fund’s
investment guidelines and that there are no activities
conducted by the managers of the fund that are in
violation of federal and state securities laws or
investment policies.
© 2013 Pearson Education
Portfolio Management Team
(continued)
 An asset management firm employs analysts and traders.
 The analysts are responsible for the different sectors and
industries.
 The traders are responsible for executing trades approved
by a portfolio manager.
 The analysts and traders can support all of the portfolios
managed by the firm or just designated portfolios.
 A large firm may also employ an economist or an economic
staff that would support all portfolios managed by the firm.
 At the individual portfolio level there is either a lead or senior
portfolio manager or co-managers.
 It is the lead manager or co-managers who will make the
decision regarding the portfolio’s interest rate exposure and
the allocation of the fund’s assets among the countries,
sectors and industries.
© 2013 Pearson Education
Spectrum of Bond Portfolio
Strategies
 The bond portfolio strategy selected by an
investor or client depends on the investment
objectives and policy guidelines.
 In general, bond portfolio strategies can be
categorized into the following three groups:
1) bond benchmark-based strategies,
2) absolute return strategies, and
3) liability-driven strategies.
© 2013 Pearson Education
Spectrum of Bond Portfolio
Strategies (continued)

Bond Benchmark-Based Strategies



There is a wide range of bond portfolio management strategies for
an investor or client who has selected a bond index as a
benchmark.
Traditional bond benchmark-based strategies can be classified as:
1) pure bond index matching;
2) enhanced indexing: matching primary risk factors;
3) enhanced indexing: minor risk-factor mismatches;
4) active management: larger risk-factor mismatches; and
5) active management: full-blown active.
• These strategies range from low risk strategies at the top to
high risk-tolerance strategies at the bottom of the above list.
It is not only important to understand what the risk factors are,
but also how to quantify them.
© 2013 Pearson Education
Spectrum of Bond Portfolio
Strategies (continued)

Bond Benchmark-Based Strategies


A portfolio manager is not permitted to deviate from the
benchmark’s duration for bond benchmark-based
strategies, absolute return strategies, and liability-driven
strategies.
•
The last two strategies are active bond portfolio
management strategies.
•
They differ to the extent with which they allow
mismatches relative to the benchmark.
It is important to note that even if a manager pursues an
active strategy, the manager may still elect to have a
duration equal to that of the benchmark (i.e., pursue a
duration-matching strategy).
© 2013 Pearson Education
Spectrum of Bond Portfolio
Strategies
 Portfolio managers often pursue what is referred
to as a core/satellite strategy.
 Basically, this strategy involves building a
blended portfolio using an indexed and active
strategy.
 The core component is a low-risk portfolio
constructed using one of the indexing
strategies.
 The satellite component is constructed using
an active strategy with a benchmark that is
specialized rather than a broad liquid bond
market index.
© 2013 Pearson Education
Spectrum of Bond Portfolio
Strategies (continued)
 Absolute Return Strategies
 In an absolute return strategy, the portfolio
manager seeks to earn a positive return over
some time frame irrespective of market
conditions.
 Few restrictions are placed on the exposure to
the primary risk factors.
 Absolute return strategies are typically pursued
by hedge fund managers using leverage.
 Other absolute return managers set as their
target as earning a return from 150 to 400 basis
points per annum over the return on cash and
hence such strategies are referred to as
cash-based absolute return strategies.
© 2013 Pearson Education
Spectrum of Bond Portfolio
Strategies (continued)
 Liability-Driven Strategies
 A bond portfolio strategy that calls for structuring a
portfolio to satisfy future liabilities is called a
liability-driven strategy.
 When the portfolio is constructed so as to generate
sufficient funds to satisfy a single future liability
regardless of the course of future interest rates, a
strategy known as immunization is often used.
 When the portfolio is designed to funding multiple
future liabilities regardless of how interest rates
change, strategies such as immunization, cash
flow matching (or dedication), or horizon
matching can be employed.
© 2013 Pearson Education
Bond Indexes
 Typically, bond portfolio managers are given a
mandate that involves their performance evaluation
relative to a bond index.
 The wide range of bond market indexes available
can be classified as broad-based market indexes
and specialized market indexes.
 Why have broker/dealer firms developed and
aggressively marketed their bond indexes?
 Enhancing the firm’s image is only a minor
reason.
 The key motivation lies in the potential profit that
the firm will make by executing trades to set up
an indexed portfolio and rebalance it.
© 2013 Pearson Education
Bond Indexes (continued)
 The broad-based U.S. bond market indexes most
commonly used by institutional investors are the
Barclays Capital U.S. Aggregate Bond Index.
 The index is a market-value weighted index.
 The pricing of the securities in each index are either
trader priced or model priced.
 Each index is broken into sectors.
 Understanding the eligibility requirements for inclusion
in a bond index is important.
 Active bond portfolio strategies often attempt to
outperform an index by buying non-eligible or nonindex securities.
© 2013 Pearson Education
The Primary Risk Factors

Primary risk factors in bond indexes are those risk factors
that a portfolio manager can match or mismatch when
constructing a portfolio.

A portfolio manager will only intentionally mismatch if the
belief is that the manager has information that strongly
suggests there is a benefit that is expected to result from
mismatching.

The primary risk factors can be divided into two general
types:
1) systematic risk factors and
2) non-systematic risk factors.
 Systematic risk factors are forces that affect all
securities in a certain category in the benchmark.
 Non-systematic risk factors are the risks that are not
attributable to the systematic risk factors.
© 2013 Pearson Education
The Primary Risk Factors(continued)

Systematic risk factors, in turn, are divided into two categories:
term structure risk factors and non-term structure risk factors.
1) Term structure risk factors are risks associated with changes in
the shape of the term structure.
2) Non-term structure risk factors include sector risk, credit risk
and optionality risk.
 Sector risk is the risk associated with exposure to the sectors
of the benchmark.
 Credit risk, also referred to as quality risk, is the risk
associated with exposure to the credit rating of the securities
in the benchmark.
 Optionality risk is the risk associated with an adverse impact
on the embedded options of the securities in the benchmark.
 Non-systematic factor risks are classified as non-systematic
risks associated with a particular issuer, issuer-specific risk,
and those associated with a particular issue, issue-specific
risk.
© 2013 Pearson Education
Top-Down Versus Bottom-Up Portfolio
Construction and Management



There are two general approaches to construction and
management of a bond portfolio: top-down and bottom-up.
 Typically, a portfolio blends the elements of both
approaches in junction with certain considerations and
constraints in constructing a portfolio.
In the top-down approach, a bond portfolio manager looks
at the major macro drivers of bond returns (hence this
approach is also referred to as a macro approach) and
obtains a view (forecast) about these drivers in the form of a
macroeconomic forecast.
Among the major variables considered in obtaining a
macroeconomic forecast are monetary policy, fiscal policy, tax
policy, political developments, regulatory matters, exchangerate movements, trade policy, demographic trends, and credit
market conditions.
© 2013 Pearson Education
Top-Down Versus Bottom-Up Portfolio
Construction and Management (continued)


Given the amount of the portfolio's funds to be allocated to
each sector of the bond market, the manager must then
decide how much to allocate to each industry within a sector.
 In the case of bond portfolio manager who is entitled to
invest in both U.S. and non-U.S. bonds, the first decision
is the allocation among countries, then sectors within a
country, and then industries.
The bottom-up approach to active bond portfolio
management focuses on the micro analysis of individual bond
issues, sectors, and industries.
 The primary research tools used in this form of investing
is credit analysis, industry analysis, and relative value
analysis.
 To control the portfolio’s risk, risk modeling is used.
© 2013 Pearson Education
Active Portfolio Strategies
 Manager Expectations Versus the Market
Consensus



A money manager who pursues an active strategy will
position a portfolio to capitalize on expectations about
future interest rates, but the potential outcome (as
measured by total return) must be assessed before an
active strategy is implemented.
The primary reason for this is that the market
(collectively) has certain expectations for future interest
rates and these expectations are embodied into the
market price of bonds.
We emphasize the use of the total return framework for
evaluating active strategies rather than the blind
pursuit of a strategy based merely on general
statements.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)
 Interest-Rate Expectations Strategies



A money manager who believes that he or she can
accurately forecast the future level of interest rates will
alter the portfolio’s sensitivity to interest-rate changes.
A portfolio’s duration may be altered by swapping
(or exchanging) bonds in the portfolio for new bonds that
will achieve the target portfolio duration.
• Such swaps are commonly referred to as rate
anticipation swaps.
Although a manager may not pursue an active strategy
based strictly on future interest-rate movements, there can
be a tendency to make an interest-rate bet to cover inferior
performance relative to a benchmark index.
• There are other active strategies that rely on forecasts of
future interest-rate levels.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)
 Yield Curve Strategies
 The yield curve for U.S. Treasury securities
shows the relationship between their maturities
and yields.
• The shape of this yield curve changes over
time.
 Yield curve strategies involve positioning a
portfolio to capitalize on expected changes in
the shape of the Treasury yield curve.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)

Types of Shifts in the Yield Curve and Impact on
Historical Returns






A shift in the yield curve refers to the relative change in the yield for
each Treasury maturity.
A parallel shift in the yield curve is a shift in which the change in
the yield on all maturities is the same.
A nonparallel shift in the yield curve indicates that the yield for
maturities does not change by the same number of basis points.
Historically, two types of nonparallel yield curve shifts have been
observed: a twist in the slope of the yield curve and a change in the
humpedness of the yield curve.
A flattening of the yield curve indicates that the yield spread
between the yield on a long-term and a short-term Treasury has
decreased; a steepening of the yield curve indicates that the
yield spread between a long-term and a short-term Treasury has
increased.
The other type of nonparallel shift, a change in the humpedness of
the yield curve, is referred to as a butterfly shift.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)
 Yield Curve Strategies
 Frank Jones analyzed the types of yield curve shifts
that occurred between 1979 and 1990.
 He found that the three types of yield curve shifts are
not independent, with the two most common types of
yield curve shifts being
1) a downward shift in the yield curve combined
with a steepening of the yield curve.
2) an upward shift in the yield curve combined with
a flattening of the yield curve.
 These two types of shifts in the yield curve are
depicted in Exhibit 22-3 (see Overheads 22-29 and
22-30).
© 2013 Pearson Education
Exhibit 22-3 Combinations of Yield
Curve Shifts
Yield
Upward Shift / Flattening/ Positive Butterfly
Positive Butterfly
Flattening
Parallel
Maturity
© 2013 Pearson Education
Exhibit 22-3 Combinations of Yield
Curve Shifts
Yield
Downward Shift / Steepening / Negative Butterfly
Parallel
Steepening
Negative Butterfly
Maturity
© 2013 Pearson Education
Active Portfolio Strategies
(continued)

Yield Curve Strategies




In portfolio strategies that seek to capitalize on expectations based
on short-term movements in yields, the dominant source of return
is the impact on the price of the securities in the portfolio.
• This means that the maturity of the securities in the portfolio
will have an important impact on the portfolio’s return.
• The key point is that for short-term investment horizons, the
spacing of the maturity of bonds in the portfolio will have a
significant impact on the total return.
In a bullet strategy, the portfolio is constructed so that the
maturities of the securities in the portfolio are highly concentrated
at one point on the yield curve.
In a barbell strategy, the maturities of the securities in the
portfolio are concentrated at two extreme maturities.
In a ladder strategy the portfolio is constructed to have
approximately equal amounts of each maturity.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)
 Duration and Yield Curve Shifts



Duration is a measure of the sensitivity of the price of a
bond or the value of a bond portfolio to changes in
market yields.
A bond with a duration of 4 means that if market yields
change by 100 basis points, the bond will change by
approximately 4%.
However, if a three-bond portfolio has a duration of 4,
the statement that the portfolio’s value will change by
4% for a 100-basis-point change in yields actually
should be stated as follows:
The portfolio’s value will change by 4% if the yield on
five-, 10-, and 20-year bonds all change by 100 basis
points. That is, it is assumed that there is a parallel
yield curve shift.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)
 Analyzing Expected Yield Curve Strategies



The proper way to analyze any portfolio strategy is to look at its
potential total return.
If a manager wants to assess the outcome of a portfolio for any
assumed shift in the Treasury yield curve, this should be done by
calculating the potential total return if that shift actually occurs.
This can be illustrated by looking at the performance of two
hypothetical portfolios of Treasury securities assuming different
shifts in the Treasury yield curve.
• The three hypothetical Treasury securities shown in Exhibit
22-5 (see Overhead 22-34) are considered for inclusion in our
two portfolios.
• For our illustration, the Treasury yield curve consists of these
three Treasury securities: a short-term security (A, the
five-year security), an intermediate-term security (C, the
10-year security), and a long-term security (B, the 20-year
security).
© 2013 Pearson Education
Exhibit 22-5Three Hypothetical
Treasury Securities
Maturity Price Plus
(years)
Accrued
Yield to
Maturity
(%)
Dollar
Duration
Dollar
Convexity
Bond
Coupon
(%)
A
8.50
5
100
8.50
4.005
19.8164
B
9.50
20
100
9.50
8.882
124.1702
C
9.25
10
100
9.25
6.434
55.4506
© 2013 Pearson Education
Active Portfolio Strategies
(continued)
 Analyzing Expected Yield Curve Strategies
 Duration is just a first approximation of the change in
price resulting from a change in interest rates.
Convexity provides a second approximation.
 Dollar convexity has a meaning similar to convexity,
in that it provides a second approximation to the
dollar price change.
 For two portfolios with the same dollar duration, the
greater the convexity, the better the performance of a
bond or a portfolio when yields change.
 What is necessary to understand is that the larger the
dollar convexity, the greater the dollar price change
due to a portfolio’s convexity.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)
 Analyzing Expected Yield Curve Strategies
 Now suppose that a portfolio manager with a
six-month investment horizon has a choice of
investing in the bullet portfolio or the barbell
portfolio.
 Which one should he choose? The manager knows
that (1) the two portfolios have the same dollar
duration, (2) the yield for the bullet portfolio is
greater than that of the barbell portfolio, and (3) the
dollar convexity of the barbell portfolio is greater
than that of the bullet portfolio.
 Actually, this information is not adequate in making
the decision. What is necessary is to assess the
potential total return when the yield curve shifts.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)
 Analyzing Expected Yield Curve Strategies
 Exhibit 22-6 provides an analysis of the six-month total
return of the two portfolios when the yield curve shifts.
(See truncated version of Exhibit 22-6 in Overhead 22-38.)
 The numbers reported in the exhibit are the difference in
the total return for the two portfolios.
 Specifically, the following is shown:
difference in dollar return =
bullet portfolio’s total return – barbell portfolio’s total
return
 A positive value means that the bullet portfolio
outperformed the barbell portfolio, and a negative sign
means that the barbell portfolio outperformed the bullet
portfolio.
© 2013 Pearson Education
Exhibit 22-6 Relative Performance of Bullet
Portfolio and Barbell Portfolio over a
Six-Month Investment Horizon
Yield
Change
Parallel
Shift
Nonparallel
Shift
Nonparallel
Shift (%)
−5.000
−4.750
−4.500
−4.250
−4.000
−3.750
−3.500
…
3.750
4.000
4.250
4.500
4.750
5.000
−7.19
−6.28
−5.44
−4.68
−4.00
−3.38
−2.82
…
−1.39
−1.57
−1.75
−1.93
−2.12
−2.31
−10.69
−9.61
−8.62
−7.71
−6.88
−6.13
−5.44
…
−1.98
−2.12
−2.27
−2.43
−2.58
−2.75
−3.89
−3.12
−2.44
−1.82
−1.27
−0.78
−0.35
…
−0.85
−1.06
−1.27
−1.48
−1.70
−1.92
© 2013 Pearson Education
Active Portfolio Strategies
(continued)

Analyzing Expected Yield Curve Strategies
 Let’s focus on the second column of Exhibit 22-6 (as was seen in
Overhead 22-38), which is labeled “parallel shift.”
 This is the relative total return of the two portfolios over the
six-month investment horizon assuming that the yield curve shifts
in a parallel fashion.
 In this case parallel movement of the yield curve means that the
yields for the short-term bond (A), the intermediate-term bond (C),
and the long-term bond (B) change by the same number of basis
points, shown in the “yield change” column of the table.
 Which portfolio is the better investment alternative if the yield
curve shifts in a parallel fashion and the investment horizon is
six months? The answer depends on the amount by which yields
change.
 Notice that when yields change by less than 100 basis points, the
bullet portfolio outperforms the barbell portfolio. The reverse is true
if yields change by more than 100 basis points.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)

Analyzing Expected Yield Curve Strategies
 This illustration makes two key points.
i. First, even if the yield curve shifts in a parallel fashion,
two portfolios with the same dollar duration will not give
the same performance. The reason is that the two
portfolios do not have the same dollar convexity.
ii. The second point is that although with all other things
equal it is better to have more convexity than less, the
market charges for convexity in the form of a higher
price or a lower yield. But the benefit of the greater
convexity depends on how much yields change.
 From the second column of Exhibit 22-6 (as was seen in
Overhead 22-38), if market yields change by less than 100
basis points (up or down), the bullet portfolio, which has
less convexity, will provide a better total return.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)

Approximating the Exposure of a Portfolio’s Yield
Curve Risk



A portfolio and a benchmark have key rate durations.
The extent to which the profile of the key rate durations of a
portfolio differs from that of its benchmark helps identify the
difference in yield curve risk exposure.
Complex Strategies



A study by Fabozzi, Martinelli, and Priaulet finds evidence of the
predictability in the time-varying shape of the U.S. term
structure of interest rates using a more advanced econometric
model.
Variables such as default spread, equity volatility, and
short-term and forward rates are used to predict changes in
the slope of the yield curve and (to a lesser extent) changes in
its curvature.
Systematic trading strategies based on butterfly swaps reveal
that the evidence of predictability in the shape of the yield
curve is both statistically and economically significant.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)

Yield Spread Strategies



Yield spread strategies involve positioning a portfolio to capitalize
on expected changes in yield spreads between sectors of the
bond market.
Swapping (or exchanging) 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, and that the yield spread will realign by the end of the
investment horizon, are called intermarket spread swaps.
Credit Spreads


Credit or quality spreads change because of expected changes in
economic prospects. Credit spreads between Treasury and
non-Treasury issues widen in a declining or contracting economy
and narrow during economic expansion.
Spreads attributable to differences in callable and noncallable
bonds and differences in coupons of callable bonds will change as
a result of expected changes in (1) the direction of the change in
interest rates, and (2) interest-rate volatility.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)


Spreads between Callable and Noncallable Securities
 Spreads attributable to differences in callable and noncallable
bonds and differences in coupons of callable bonds will change
as a result of expected changes in (1) the direction of the
change in interest rates, and (2) interest-rate volatility.
 An expected drop in the level of interest rates will widen the
yield spread between callable bonds and noncallable bonds as
the prospects that the issuer will exercise the call option
increase.
Importance of Dollar Duration Weighting of Yield Spread
Strategies
 What is critical in assessing yield spread strategies is to
compare positions that have the same dollar duration.
 To understand why, consider two bonds, X and Y that are being
considered as alternative investments in a strategy other than
one based on anticipating interest-rate movements.
 The amount of each bond in the strategy should be such that
they will both have the same dollar duration.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)

Individual Security Selection Strategies



There are several active strategies that money
managers pursue to identify mispriced securities
The most common strategy identifies an issue as
undervalued because either
1) its yield is higher than that of comparably rated
issues, or
2) its yield is expected to decline (and price therefore
rise) because credit analysis indicates that its rating
will improve.
A swap in which a money manager exchanges one bond
for another bond that is similar in terms of coupon,
maturity, and credit quality, but offers a higher yield, is
called a substitution swap.
© 2013 Pearson Education
Active Portfolio Strategies
(continued)
 Strategies for Asset Allocation within Bond Sectors




The ability to outperform a benchmark index will depend
on the how the manager allocates funds within a bond
sector relative to the composition of the benchmark
index.
Exhibit 22-7 (see Overhead 22-46) shows a one-year
rating transition matrix (table) based on a Moody’s study
for the period 1970–1993.
Exhibit 22-8 (see Overhead 22-47) shows the expected
incremental return estimates for a portfolio consisting of
only three-year Aa-rated bonds.
Exhibit 22-9 (see Overhead 22-48) shows expected
incremental returns over Treasuries assuming the rating
transition matrix given in Exhibit 22-10 and assuming
that the horizon spreads are the same as the initial
spreads.
© 2013 Pearson Education
Exhibit 22-7 One-Year Rating
Transition Probabilities (%)
Aaa
Aa
A
Baa
Ba
Bb
C or D
Total
Aaa
91.90
7.38
0.72
0.00
0.00
0.00
0.00
100.00
Aa
1.13
91.26
7.09
0.31
0.21
0.00
0.00
100.00
A
0.10
2.56
91.20
5.33
0.61
0.20
0.00
100.00
Baa
0.00
0.21
5.36
87.94
5.46
0.82
0.21
100.00
Source: From Leland E. Crabbe, “A Framework for Corporate Bond Strategy,”
Journal of Fixed Income, June 1995, p. 16. Reprinted by permission of
Institutional Investor.
© 2013 Pearson Education
Exhibit 22-8Expected Incremental Return
Estimates for Three-Year
Aa-Rated Bonds over a One-Year Horizon
Initial Horizon Horizon
Spread Rating
Spread
Return
over
Treasuries
(bp) X
Transition Contribution to
Probability
Incremental
(%) =
Return (bp)
30
Aaa
25
38
1.13
0.43
30
Aa
30
30
91.26
27.38
30
A
35
21
7.09
1.49
30
Baa
60
–24
0.31
–0.07
30
Ba
130
–147
0.21
–0.31
Portfolio Incremental Return over Treasuries = 28.90
Source: From Leland E. Crabbe, “A Framework for Corporate Bond
Strategy,” Journal of Fixed Income, June 1995, p. 17. Reprinted by
permission of Institutional Investor.
© 2013 Pearson Education
Exhibit 22-9Expected Incremental Returns
over Treasuries When Rating Transitions Match
Historical Experience (One-Year Horizon, bp)
Initial
Spread
Incremental
Return
Incremental
Return
Incremental
Return
25
30
35
60
24.2
28.9
31.1
46.3
30
35
45
70
28.4
31.4
37.3
39.9
Initial
Spread
Incremental
Return
Incremental
Return
Incremental
Return
35
40
55
85
31.7
30.3
37.9
21.9
45
55
75
115
34.6
34.8
42.7
27.4
Aaa
Aa
A
Baa
Aaa
Aa
A
Baa
Source: From Leland E. Crabbe, “A Framework for Corporate Bond Strategy,”
Journal of Fixed Income, June 1995, p. 18. Reprinted by permission of
Institutional Investor.
© 2013 Pearson Education
The Use of Leverage
 If permitted by investment guidelines a manager may
use leverage in an attempt to enhance portfolio
returns.
 A portfolio manager can create leverage by borrowing
funds in order to acquire a position in the market that
is greater than if only cash were invested.
 The funds available to invest without borrowing are
referred to as the “equity.”
 A portfolio that does not contain any leverage is called
an unlevered portfolio.
 A levered portfolio is a portfolio in which a manager
has created leverage.
© 2013 Pearson Education
The Use of Leverage (continued)

Motivation for Leverage





The basic principle in using leverage is that a manager wants to earn
a return on the borrowed funds that is greater than the cost of the
borrowed funds.
The return from borrowing funds is produced from a higher income
and/or greater price appreciation relative to a scenario in which no
funds are borrowed.
The return from investing the funds comes from two sources.
i. interest income
ii. change in the value of the security (or securities) at the end of the
borrowing period
There are some managers who use leverage in the hopes of
benefiting primarily from price changes.
Small price changes will be magnified by using leveraging.
• For example, if a manager expects interest rates to fall, the
manager can borrow funds to increase price exposure to the
market.
• Effectively, the manager is increasing the duration of the portfolio.
© 2013 Pearson Education
The Use of Leverage (continued)
 Motivation for Leverage
 The risk associated with borrowing funds is that the
security (or securities) in which the borrowed funds
are invested may earn less than the cost of the
borrowed funds due to failure to generate interest
income plus capital appreciation as expected when
the funds were borrowed.
 Leveraging is a necessity for depository institutions
(such as banks and savings and loan associations)
because the spread over the cost of borrowed funds is
typically small.
 The magnitude of the borrowing (i.e., the degree of
leverage) is what produces an acceptable return for
the institution.
© 2013 Pearson Education
The Use of Leverage (continued)
 Duration of a Leveraged Portfolio

In general, the procedure for calculating the duration of
a portfolio that uses leverage is as follows:
Step 1: Calculate the duration of the levered portfolio.
Step 2: Determine the dollar duration of the portfolio
of the levered portfolio for a change in interest
rates.
Step 3: Compute the ratio of the dollar duration of the
levered portfolio to the value of the initial unlevered
portfolio (i.e., initial equity).
Step 4: The duration of the unlevered portfolio is then
ratio computed in Step 3 
found as follows:
100
rate change used in Step 2 in bps
© 2013 Pearson Education
 100
The Use of Leverage (continued)


How to Create Leverage Via the Repo Market
 A manager can create leverage in one of two ways. One way is
through the use of derivative instruments. The second way is to
borrow funds via a collateralized loan arrangement.
Repurchase Agreement
 A repurchase agreement is the 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.
The price at which the seller must subsequently repurchase the
security for is called the repurchase price, and the date that the
security must be repurchased is called the repurchase date.
 There is a good deal of Wall Street jargon describing repo
transactions. To understand it, remember that one party is
lending money and accepting a security as collateral for the
loan; the other party is borrowing money and providing
collateral.
© 2013 Pearson Education
The Use of Leverage (continued)
 Credit Risks
 Despite the fact that there may be high-quality
collateral underlying a repo transaction, both
parties to the transaction are exposed to credit
risk.
 Repos should be carefully structured to reduce
credit risk exposure.
 The amount lent should be less than the market
value of the security used as collateral, thereby
providing the lender with some cushion should
the market value of the security decline.
 The amount by which the market value of the
security used as collateral exceeds the value of
the loan is called repo margin or simply
margin.
© 2013 Pearson Education
The Use of Leverage (continued)
 Determinants of the Repo Rate
 There is not one repo rate.
 The rate varies from transaction to transaction
depending on a variety of factors: quality of collateral,
term of the repo, delivery requirement, availability of
collateral, and the prevailing federal funds rate.
 The more difficult it is to obtain the collateral, the
lower the repo rate.
 To understand why this is so, remember that the
borrower (or equivalently the seller of the collateral)
has a security that lenders of cash want, for whatever
reason. Such collateral is referred to as hot or special
collateral.
 Collateral that does not have this characteristic is
referred to as general collateral.
© 2013 Pearson Education
Key Points
●
●
●
●
The asset allocation decision is the decision made
to determine how much should be allocated amongst
the major asset classes and is made in the light of the
investment objective.
Once the asset allocation decision is made, the client must
decide whether to use only internal managers, use only
external managers, or use a combination of internal and
external managers.
The term asset allocation is also used after a decision has
been made to invest in a specified asset class to
indicate how funds should be allocated amongst the
different sectors within that asset class.
In general, there are three categories of bond portfolio
strategies: bond benchmark-based strategies, absolute
return strategies, and liability-driven strategies.
© 2013 Pearson Education
Key Points (continued)
●
●
●
●
Bond benchmark-based strategies include indexing type strategies
(pure bond index matching enhanced indexing with matching of
primary risk factors, and enhanced indexing with minor risk-factor
mismatches) and active management type strategies (with larger
risk-factor mismatches and full-blown active).
With a core/satellite strategy there is a blending of an indexed
strategy (to create a low-risk core portfolio) and an active strategy
(to create a specialized higher risk-tolerant satellite portfolio).
The wide range of bond market indexes available can be classified as
broad-based market indexes and specialized market indexes.
The primary risk factors affecting a portfolio are divided into
systematic risk factors and nonsystematic risk factors. In turn, each
of these risk factors is further decomposed. Systematic risk factors
are divided into term structure risk factors and non-term structure
risk factors. Examples of non-term structure risk factors are sector
risk, credit risk, and optionality risk. Non-systematic risk factors are
classified as issuer-specific risk and issue-specific risk.
© 2013 Pearson Education
Key Points (continued)
●
●
●
●
Active bond portfolio strategies seek to capitalize on expectations about
changes in factors that will affect the price and therefore the
performance of an issue over some investment horizon.
The total return framework should be used to assess how changes in
these factors will affect the performance of a strategy over some
investment horizon.
Leveraging involves creating an exposure to a market in excess of the
exposure that can be obtained without borrowing funds. The objective
is to earn a return in excess of the cost of the borrowed funds. The risk
is that the manager will earn a return less than the cost of the
borrowed funds. The return on the borrowed funds is realized from the
interest earned plus the change in the value of the securities acquired.
The duration of a portfolio is magnified by leveraging a portfolio.
The most common way in which a manager can borrow funds is via a
repurchase agreement. This is a collateralized loan arrangement in
which a party borrows funds. It is called a reverse repo agreement
when a party lends funds. There is credit risk in a repo agreement, and
there are mechanisms for mitigating this risk.
© 2013 Pearson Education