Fixed Income Portfolio Management

Role of Fixed Income in Portfolio

• Diversification:
  • Returns are not perfectly correlated, which reduces risk.
  • Fixed Income has a correlation (ρ < 1)\ with other asset classes like equity and real estate.
  • Within Fixed Income, correlations are largely driven by interest rates.
• Regular Cash Flows:
  • Used to meet future obligations such as pension and insurance payments.
  • A "Buy-and-Hold" strategy can fund future obligations.
• Inflation Hedge:
  • Floating-rate coupons adjust for inflation based on market rates.
  • Inflation-linked bonds provide a hedge against inflation.

Scenario: Risk Reduction and Consistent Cash Flow

• Situation: Mark is concerned about equity market volatility and wants to reduce portfolio risk, generate consistent cash flow, and maintain purchasing power over a 15-year horizon.
• Correlations:
  • \ρ\text{(Current, Fixed-Coupon)} = -0.10
  • \ρ\text{(Current, Inflation-Linked)} = 0.10
  • \ρ\text{(Fixed-Coupon, Inflation-Linked)} = 0.65
• Advisor A: Diversify 50% into nominal fixed-coupon bonds.
• Advisor B: Diversify 50% into 25% fixed-coupon and 25% inflation-linked bonds.
• Effects Considered: Diversification, Cash Flows, and Inflation hedge.

Investment Mandates - Liability Based

• Liability-Based Investing: Considers an investor’s future obligations.
• Objective: Match or cover expected liability payments (future cash outflows) with projected cash inflows.
• ALM/LDI: Also known as Asset-Liability Management (ALM) or Liability Driven Investing (LDI).
• Strategies:
  • Cash Flow Matching: Ensure future liability payouts are precisely matched by cash inflows.
  • Duration Matching: Match the duration of assets and liabilities so that interest rate changes affect both equally.
  • Derivatives Overlay: Use futures, options, or swaps.
  • Contingent Immunization: Hybrid approach combining immunization with an active portfolio.
• Note: Only possible when Value of Assets > Value of Liabilities.

Investment Mandates - Total Return Objective

• Total Return Objective: Track or outperform a benchmark (e.g., Barclays Global Aggregate Bond Index).
• Pure Indexing:
  • Replicate a bond index as closely as possible (Full Replication).
• Active Return:
  • $(R<em>{\text{Portfolio}} - R</em>{\text{Benchmark}})$, also known as Tracking Error.
• Active Risk:
  • Stdev. of Active Returns, also known as Tracking Risk.
• Return Discrepancy: Even if Active Risk = 0, Portfolio Return < Benchmark Return (Active Return < 0) due to trading costs and management fees.
• Enhanced Indexing:
  • Track benchmark but seek to outperform it.
  • Allows for small deviations from benchmark portfolio holdings (e.g., in sector, quality).
  • Closely track primary risk factors such as duration.

Investment Mandates - Total Return (Continued)

• Active Management:
  • Can have large risk factor deviations from the benchmark.
  • These deviations should generate excess return (above benchmark).
  • May have significant portfolio turnover to take advantage of market opportunities, resulting in higher trading costs.
  • Managers typically charge a higher fee.

Total Return Mandates - Key Features

• Pure Indexing:
  • Objective: Match benchmark return and risk as closely as possible.
  • Portfolio Weights: Ideally the same as the benchmark or with slight mismatches.
• Enhanced Indexing:
  • Objective: Modest out-performance of benchmark (20-50 bps) but keep active risk low ($\leq$ 50 bps).
  • Portfolio Weights: Small deviations from benchmark acceptable.
• Active Management:
  • Objective: Outperform the benchmark ($\geq$ 50 bps), with high active risk levels acceptable.
  • Portfolio Weights: Can deviate significantly from benchmark.

Sample Problem: Funds A, B, and C

• Benchmark: Bloomberg Barclays Global Aggregate Bond Index.
• Task: Identify the approach (pure indexing, enhanced indexing, or active management) used by each fund based on characteristics.
• Fund A:
  • Average maturity: 8.61 years
  • Modified duration: 6.37 years
  • Average yield to maturity: 1.49%
  • Convexity: 0.65
• Fund B:
  • Average maturity: 8.35 years
  • Modified duration: 6.35 years
  • Average yield to maturity: 1.42%
  • Convexity: 0.60
• Fund C:
  • Average maturity: 9.45 years
  • Modified duration: 7.37 years
  • Average yield to maturity: 1.55%
  • Convexity: 0.72
• Index:
  • Average maturity: 8.34 years
  • Modified duration: 6.34 years
  • Average yield to maturity: 1.43%
  • Convexity: 0.60
• Answer: A - Enhanced Indexing, B - Pure Indexing, C - Active Management

Sample Problem Continued: Asset Quality

• Asset Quality Characteristics:
• Fund A:
  • AAA: 41.20%
  • AA: 15.13%
  • A: 28.51%
  • BBB: 14.51%
  • BB: 0.55%
  • Not rated: 0.10%
• Fund B:
  • AAA: 41.10%
  • AA: 15.32%
  • A: 28.01%
  • BBB: 14.53%
  • BB: 0.59%
  • Not rated: 0.45%
• Fund C:
  • AAA: 40.11%
  • AA: 14.15%
  • A: 29.32%
  • BBB: 15.23%
  • BB: 1.02%
  • Not rated: 0.17%
• Index:
  • AAA: 41.24%
  • AA: 15.05%
  • A: 28.78%
  • BBB: 14.55%
  • BB: 0.35%
  • Not rated: 0.05%
• Answer: A - Pure Indexing, B - Enhanced Indexing, C - Active Management

Sample Problem Continued: Maturity

• Maturity Characteristics:
• Fund A:
  • 0–3 years: 21.67%
  • 3–5 years: 24.17%
  • 5–10 years: 31.55%
  • 10+ years: 22.61%
• Fund B:
  • 0–3 years: 19.20%
  • 3–5 years: 22.21%
  • 5–10 years: 35.21%
  • 10+ years: 23.38%
• Fund C:
  • 0–3 years: 21.43%
  • 3–5 years: 23.01%
  • 5–10 years: 32.23%
  • 10+ years: 23.33%
• Index:
  • 0–3 years: 21.80%
  • 3–5 years: 24.23%
  • 5–10 years: 31.67%
  • 10+ years: 22.30%
• Answer: A - Pure Indexing, B - Active Management, C - Enhanced Indexing

Sample Problem Continued: Country Exposure

• Country Exposure Characteristics:
• Fund A:
  • United States: 42.55%
  • Japan: 11.43%
  • France: 7.10%
  • United Kingdom: 3.44%
  • Germany: 6.70%
  • Italy: 4.80%
  • Canada: 4.44%
  • Other: 19.54%
• Fund B:
  • United States: 39.44%
  • Japan: 18.33%
  • France: 6.11%
  • United Kingdom: 5.87%
  • Germany: 5.23%
  • Italy: 4.01%
  • Canada: 3.12%
  • Other: 17.89%
• Fund C:
  • United States: 35.11%
  • Japan: 13.33%
  • France: 6.01%
  • United Kingdom: 4.33%
  • Germany: 4.50%
  • Italy: 4.43%
  • Canada: 5.32%
  • Other: 26.97%
• Index:
  • United States: 39.56%
  • Japan: 18.36%
  • France: 6.08%
  • United Kingdom: 5.99%
  • Germany: 5.30%
  • Italy: 4.07%
  • Canada: 3.15%
  • Other: 17.49%
• Answer: A - Enhanced Indexing, B - Pure Indexing, C - Active Management

Liquidity in Fixed-Income Securities

• Fixed-income securities vary greatly in liquidity.
• Fixed-income markets are generally less liquid compared to equities.
• Typically operate as over-the-counter (OTC) dealer markets, leading to significant search costs to find a willing counter-party.
• Liquidity is highest immediately after issuance, especially for on-the-run issues and those from sovereign issuers or issuers with high creditworthiness.
• Higher YTM compensates investors for illiquidity.
• When a US Treasury bond shifts from on-the-run to off-the-run, it trades at higher yields (lower prices) compared to similar on-the-run bonds.

Effect of Liquidity on Portfolio Management

• Pricing:
  • Pricing of recent bond transactions (especially corporate bonds) is not always readily available, causing the problem of stale prices.
  • Reliance on last traded prices (may be outdated) could result in costly trading decisions.
  • Solution: Use matrix pricing, employing yields on similar benchmark bonds with similar maturity and duration and benchmark spreads with comparable times to maturity, credit quality, and sector or security type.
• Portfolio Construction:
  • Investors’ liquidity preferences directly influence portfolio construction.
  • Illiquid bonds typically have higher YTM, making them a good strategy for a "buy-and-hold" investor.
  • Investors who prefer liquidity opt for liquid bonds but with lower yields.

Conceptual Ranking of Liquidity

• Rank the following instruments from the most liquid to the least liquid:
  • A. Low-credit-quality corporate bond
  • B. Recently issued on-the-run sovereign bond
  • C. High-credit-quality corporate bond
  • D. Sovereign bond issued a year ago
• Answer: B > D > C > A

Alternatives to Investing in Bonds

• Mutual Funds:
  • Pooled investment vehicles providing more liquidity than the underlying securities.
  • Units represent a proportional share in the ownership of the assets in an underlying portfolio.
  • Open-end mutual funds can issue and redeem new shares at NAV (Net Asset Value).
  • NAV is computed at the end of each trading day.
  • Investors can redeem holdings instead of selling illiquid bonds.
• Exchange-traded Funds (ETFs):
  • Share some mutual fund characteristics.
  • More tradability, traded throughout the day like regular shares.

Alternatives to Bonds Continued

• Derivatives:
  • Exchange Traded: Futures and options provide exposure to underlying bonds.
  • Traded on an exchange, so they may be slightly more liquid than bonds.
  • No problem of "Stale Prices."
• Interest Rate Swap:
  • Most widely used OTC derivative.
• Total Return Swap:
  • Common over-the-counter portfolio derivative strategy.
  • Combines elements of interest rate swaps and credit derivatives.
  • Similar to interest rate swaps, involving the exchange of cash flows.
  • Instead of a benchmark rate as in interest rate swaps, the benchmark is an equity index/instrument.

Conceptual Problem #1

• Scenario: Alpha Partners fixed-income portfolio has a total return mandate.
• Specifications:
  • Return objective of 25 bps over the benchmark index.
  • Minor deviations in sector weights are permitted.
  • Portfolio must match on primary risk factors (duration).
  • Tracking error should be no greater than 50 bps.
• Question: What approach is the portfolio most likely using?
  • A. Pure indexing
  • B. Enhanced indexing
  • C. Active management
• Answer: B. Enhanced indexing

Conceptual Problem #2

• Question: Which fund most likely has an Active Management approach based on the following characteristics?


• Characteristics:
  

• Scenario: Hightower Investments has a domestic equity portfolio and plans to decrease the equity allocation while increasing the allocation to domestic bonds.
• Strategies:
  1. Purchase AAA rated fixed-coupon corporate bonds with a modified duration of two years and a correlation coefficient with the equity portfolio of –0.15.
  2. Purchase US government agency floating-coupon bonds with a modified duration of one month and a correlation coefficient with the equity portfolio of –0.10.
• Question: Strategy 2 is most likely preferred to Strategy 1 for meeting the objective of:
  • A. protecting against inflation.
  • B. funding future liabilities.
  • C. minimizing the correlation of the fund’s domestic bond portfolio and equity portfolio.
• Answer: A. protecting against inflation