Fabozzi Ch23 BMAS 7thed

Chapter 23
Active Bond Portfolio

Management
Strategies
Copyright 2010 Pearson Education, Inc.
23-1
Learning Objectives
After reading this chapter, you will understand
the five basic steps involved in the investment
management process
the difference between active and passive strategies
what tracking error is and how it is computed
the difference between forward-looking and
backward-looking tracking error
the link between tracking error and active portfolio
management
the risk factors that affect a benchmark index
the importance of knowing the market consensus
before implementing an active strategy
23-2
Learning Objectives (continued)

After reading this chapter, you will understand
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
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
23-3
Overview of the Investment

Management Process
Regardless of the type of financial
institution, the investment management
process involves the following five
steps:
i. setting investment objectives
ii. establishing investment policy
iii.selecting a portfolio strategy
iv. selecting assets
v. measuring and evaluating performance
23-4

Management Process (continued)
Setting Investment Objectives
The first step in the investment management process is setting

investment objectives.
The investment objective will vary by type of financial institution.
Establishing Investment Policy
The second step in investment management process is

establishing policy guidelines for meeting the investment
objectives.
Setting policy begins with the asset allocation decision so as to
decide how the funds of the institution should be distributed
among the major classes of investments (cash equivalents, equities,
fixed-income securities, real estate, and foreign securities).
23-5

Selecting a Portfolio Strategy
Selecting a portfolio strategy that is consistent with
the objectives and policy guidelines of the client or
institution is the third step in the investment
management process.
Portfolio strategies can be classified as either active
strategies or passive strategies.
Essential to all active strategies is specification of
expectations about the factors that influence the
performance of an asset class. Passive strategies
involve minimal expectational input.
23-6

Strategies between the active and passive extremes
have sprung up that have elements of both extreme
strategies.
For example, the core of a portfolio may be
indexed, with the balance managed actively.
Or a portfolio may be primarily indexed but
employ low-risk strategies to enhance the indexed
portfolios return.
This strategy is commonly referred to as enhanced
indexing or indexing plus.
23-7

In the bond area, several strategies classified as structured portfolio
strategies have commonly been used.
A structured portfolio strategy calls for design of a portfolio to
achieve the performance of a predetermined benchmark.
Such strategies are frequently followed when funding liabilities.
When the predetermined benchmark is the generation of sufficient
funds to satisfy a single liability, regardless of the course of future
interest rates, a strategy known as immunization is often used.
When the predetermined benchmark requires 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.
23-8

Given the choice among active, structured, or passive
management, the selection depends on
i. the client or money managers view of the pricing efficiency of
the market
ii. the nature of the liabilities to be satisfied
Pricing efficiency is taken to describe a market where

prices at all times fully reflect all available information
that is relevant to the valuation of securities.
When a market is price efficient, active strategies will not
consistently produce superior returns after adjusting for
risk and transactions costs.
23-9

Selecting Assets
After a portfolio strategy is specified, the fourth step
in the investment management process is to select the
specific assets to be included in the portfolio, which
requires an evaluation of individual securities.
It is in this phase that the investment manager attempts to
construct an efficient portfolio.
An efficient portfolio is one that provides the greatest
expected return for a given level of risk, or, equivalently,
the lowest risk for a given expected return.
23-10

Measuring and Evaluating Performance
The measurement and evaluation of investment
performance is the fifth and last step in the
investment management process.
This step involves measuring the performance of the
portfolio, then evaluating that performance relative to some
benchmark.
The benchmark selected for evaluating performance is
called a benchmark or normal portfolio.
The benchmark portfolio may be a popular index such as
the S&P 500 for equity portfolios or one of the bond
indexes.
23-11
Tracking Error and Bond

Portfolio Strategies
Before discussing bond portfolio strategies, it is
essential to understand an important analytical
concept.
When a portfolio managers benchmark is a bond
market index, risk is not measured in terms of the
standard deviation of the portfolios return.
Instead, risk is measured by the standard deviation
of the return of the portfolio relative to the return
of the benchmark index.
This risk measure is called tracking error.
Tracking error is also called active risk.
23-12

Portfolio Strategies (continued)
Calculation of Tracking Error
Tracking error is computed as follows:
Step 1: Compute the total return for a portfolio for each period.
Step 2: Obtain the total return for the benchmark index for each
period.
Step 3: Obtain the difference between the values found in Step 1
and Step 2. The difference is referred to as the active return.
Step 4: Compute the standard deviation of the active returns. The
resulting value is the tracking error.
The tracking error measurement is in terms of the observation
period. If monthly returns are used, the tracking error is a
monthly tracking error. If weekly returns are used, the tracking
error is a weekly tracking error.
23-13

Exhibit 23-1 (see Overheads 23-15 and 23-16) shows the calculation of the
tracking error for two hypothetical portfolios assuming that the benchmark
is the Lehman U.S. Aggregate Index.
Portfolio As monthly tracking error (in Overhead 23-15) is 9.30 basis points
where the monthly returns of the portfolio closely track the return of the
benchmark indexthat is, the active returns are small.
In contrast, for Portfolio B (in Overhead 23-16), the active returns are large,
and thus, the monthly tracking error is large79.13 basis points.
The tracking error is unique to the benchmark used.
Exhibit 23-2 (see Overheads 23-17 and 23-18) shows the tracking error for
the portfolios using the Lehman Global Aggregate Index.
The monthly tracking error for Portfolio A (in Overhead 23-17) is 76.04
basis points compared to 9.30 basis points when the benchmark is the
Lehman U.S. Aggregate Index; for Portfolio B (in Overhead 23-18), it is
11.92 basis points for the Lehman Global Index versus 79.13 basis points
for the Lehman U.S. Aggregate Index.
23-14
Exhibit 23-1 Calculation of Tracking Error for Two Hypothetical Portfolios:

Benchmark Is the Lehman U.S. Aggregate Index (Portfolio A)
Observation period = January 2007December 2007; Benchmark index = Lehman U.S. Aggregate Index
Month in 2007
January
February
March
April
May
June
July
August
September
October
November
December
Sum
Mean
Variance
Portfolio A
Portfolio
Return (%)
-0.02
1.58
-0.04
0.61
-0.71
-0.27
0.91
1.26
0.69
0.95
1.08
0.02
Benchmark Index
Return (%)
-0.04
1.54
0.00
0.54
-0.76
-0.30
0.83
1.23
0.76
0.90
1.04
0.28
Active
Return (%)
0.02
0.04
-0.04
0.07
0.05
0.03
0.08
0.03
-0.07
0.05
0.04
-0.26
0.041
0.0034
0.0086
Standard Deviation = Tracking error
0.0930
Tracking error (in basis points)
9.30
23-15

Benchmark Is the Lehman U.S. Aggregate Index (Portfolio B)
Observation period = January 2007December 2007; Benchmark index = Lehman U.S. Aggregate Index
Month in 2007
January
February
March
April
May
June
July
August
September
October
November
December
Sum
Mean
Variance
Portfolio B
Portfolio
Return (%)
-1.05
2.13
0.37
1.01
-1.44
-0.57
1.95
1.26
2.17
1.80
2.13
-0.32
Benchmark Index
Return (%)
-0.04
1.54
0.00
0.54
-0.76
-0.30
0.83
1.23
0.76
0.90
1.04
0.28
Active
Return (%)
-1.01
0.59
0.37
0.47
-0.68
-0.27
1.12
0.03
1.41
0.90
1.09
-0.60
3.42
0.2850
0.6262
0.7913
79.13
23-16

Benchmark Is the Lehman Global Aggregate Index (Portfolio A)
Observation period = January 2007December 2007; Benchmark index = Lehman Global Aggregate Index
Month in 2007
January
February
March
April
May
June
July
August
September
October
November
December
Sum
Mean
Variance
Portfolio A
Portfolio
Benchmark Index
Return (%)
Return (%)
-0.02
-0.98
1.58
2.06
-0.04
0.24
0.61
1.13
-0.71
-1.56
-0.27
-0.44
0.91
2.03
1.26
1.23
0.69
2.24
0.95
1.63
1.08
1.91
0.02
-0.31
Active
Return (%)
0.96
-0.48
-0.28
-0.52
0.85
0.17
-1.12
0.03
-1.55
-0.68
-0.83
0.33
-3.119
-0.2599
0.5782
0.7604
76.04
23-17

Benchmark Is the Lehman Global Aggregate Index (Portfolio B)
Observation period = January 2007December 2007; Benchmark index = Lehman Global Aggregate Index
Month in 2007
January
February
March
April
May
June
July
August
September
October
November
December
Sum
Mean
Variance
Portfolio B
Portfolio
Benchmark Index
Return (%)
Return (%)
-1.05
-0.98
2.13
2.06
0.37
0.24
1.01
1.13
-1.44
-1.56
-0.57
-0.44
1.95
2.03
1.26
1.23
2.17
2.24
1.80
1.63
2.13
1.91
-0.32
-0.31
Active
Return (%)
-0.07
0.07
0.13
-0.12
0.12
-0.13
-0.08
0.03
-0.07
0.17
0.22
-0.01
0.26
0.0217
0.0142
0.1192
11.92
23-18
Tracking Error and Bond Portfolio

Strategies (continued)
Two Faces of Tracking Error
Calculations computed for a portfolio based on a portfolios actual
active returns reflect the portfolio managers decisions during the
observation period.
We call tracking error calculated from observed active returns for a
portfolio backward-looking tracking error.
It is also called the ex-post tracking error and the actual tracking
error.
The portfolio manager needs a forward-looking estimate of tracking
error to reflect the portfolio risk going forward.
The way this is done in practice is by using the services of a
commercial vendor or dealer firm that has modeled the factors that
affect the tracking error associated with the bond market index that is
the portfolio managers benchmark.
These models are called multi-factor risk models.
23-19

Two Faces of Tracking Error
Given a managers current portfolio holdings, the
portfolios current exposure to the various risk
factors can be calculated and compared to the
benchmarks exposures to the factors.
Using the differential factor exposures and the
risks of the factors, a forward-looking tracking
error for the portfolio can be computed.
This tracking error is also referred to as predicted
tracking error and ex-ante tracking error.
23-20

Tracking Error and Active Versus passive strategies
We can think of active versus passive bond portfolio strategies
in terms of forward-looking tracking error.
In constructing a portfolio, a manager can estimate its forwardlooking tracking error.
When a portfolio is constructed to have a forward-looking
tracking error of zero, the manager has effectively designed the
portfolio to replicate the performance of the benchmark.
If the forward-looking tracking error is maintained for the
entire investment period, the active return should be close to
zero.
Such a strategyone with a forward-looking tracking error of
zero or very smallindicates that the manager is pursing a
passive strategy relative to the benchmark index.
23-21

Risk Factors and Portfolio Management Strategies
Forward-looking tracking error indicates the degree of active
portfolio management being pursued by a manager.
Therefore, it is necessary to understand what factors (referred to as
risk factors) affect the performance of a managers benchmark index.
The risk factors affecting the Lehman Brothers Aggregate Bond
Index have been investigated.
A summary of the risk factors is provided in Exhibit 23-3 (see
Overhead 23-23).
Risk factors can be classified into two types:
i. A systematic risk factor is a force that affect all securities in a certain
category in the benchmark index.
ii. A nonsystematic risk factor refers to risk that is not attributable to
systematic risk factors.
23-22
Exhibit 23-3 Summary of Risk Factors for a Benchmark

Systematic
Risk Factors
Term Structure
Risk Factors
Non-Term Structure
Risk Factors
Non-Systematic
Risk Factors
Issuer
Specific
Issue
Specific
sector risk
quality risk
optionality risk
coupon risk
MBS sector risk
MBS volatility risk
MBS prepayment risk
23-23

Systematic risk factors, in turn, are divided into two categories: term structure
risk factors and non-term structure risk factors.
Term structure risk factors are risks associated with changes in the shape of
the term structure (level and shape changes).
Non-term structure risk factors include sector risk, quality risk, optionality
risk, coupon risk, MBS sector risk, MBS volatility risk, and MBS prepayment
risk.
Sector risk is the risk associated with exposure to the sectors of the
benchmark index.
Quality risk is the risk associated with exposure to the credit rating of the
securities in the benchmark index.
Optionality risk is the risk associated with an adverse impact on the
embedded options of the securities in the benchmark index.
Coupon risk is the exposure of the securities in the benchmark index to
different coupon rates.
23-24

The last three non-term risks (MBS sector risk, MBS volatility
risk, and MBS prepayment risk) are associated with the investing
in residential mortgage pass-through securities.
MBS sector risk is the exposure to the sectors of the MBS market
included in the benchmark.
MBS volatility risk is the exposure of a benchmark index to changes in
expected interest-rate volatility.
MBS prepayment risk is the exposure of a benchmark index to changes
in prepayments.
Nonsystematic factor risks are classified as nonsystematic risks

associated with a particular issuer, issuer-specific risk, and those
associated with a particular issue, issue-specific risk.
23-25

Determinants of Tracking Error
Once we know the risk factors associated with a
benchmark index, forward-looking tracking error can be
estimated for a portfolio.
The tracking error occurs because the portfolio constructed
deviates from the exposures for the benchmark index.
A manager provided with information about (forwardinglooking) tracking error for the current portfolio can
quickly assess if
i. the risk exposure for the portfolio is one that is acceptable
ii. if the particular exposures are being sought
23-26
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.
Though some managers might refer to an optimal strategy
that should be pursued given certain expectations, that is
insufficient information in making an investment decision.
23-27
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 portfolios
sensitivity to interest-rate changes.
A portfolios 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.
23-28

Yield Curve Strategies (pp. 529-30)
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.
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. (p. 529)
A nonparallel shift in the yield curve indicates that the yield for
maturities does not change by the same number of basis points.
23-29

Yield Curve Strategies (pp. 529-30)
Historically, two types of nonparallel yield curve shifts (p.
529) 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.
23-30

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
i. a downward shift in the yield curve combined with a
steepening of the yield curve
ii. 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 23-6 (see Overheads 23-32 and
23-33).
23-31
Exhibit 23-6 Combinations of Yield Curve Shifts

Upward Shift/Flattening/Positive Butterfly
Yield
Positive Butterfly
Flattening
Parallel
Maturity
23-32
Exhibit 23-6 Combinations of Yield Curve Shifts

Downward Shift/Steepening/Negative Butterfly
Yield
Parallel
Steepening
Negative Butterfly
Maturity
23-33

Yield Curve Strategies (p. 532)
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 portfolios 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.
23-34
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 portfolios value will change by 4% for a
100-basis-point change in yields actually should be stated as
follows:
The portfolios 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.
23-35

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 23-8 (see
Overhead 23-37) 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 longterm security (B, the 20-year security).
23-36
Exhibit 23-8 Three Hypothetical Treasury

Securities
Yield to
Maturity Price Plus
Maturity
(years)
Accrued
(%)
Bond
Coupon
(%)
Dollar
Dollar
Duration Convexity
8.50
100
8.50
4.005
19.8164
9.50
20
100
9.50
8.882
124.1702
9.25
10
100
9.25
6.434
55.4506
23-37
Analyzing Expected Yield Curve

Strategies
Bullet portfolio: 100% bond C
Barbell portfolio: 50.2% bond A and 49.8%
bond B.
Dollar duration of barbell portfolio
= .502 (4.005) + .498 (8.882) = 6.434
Dollar convexity of barbell portfolio
= .502 (19.8164) + .498 (124.1702) = 71.7846
Portfolio yield for barbell portfolio
= .502 (8.50%) + .498 (9.50%) = 8.998%
23-38
Cost of convexity (i.e., giving up

yield to get better convexity)
Bond C, the bullet portfolio, has a yield-tomaturity of 9.25% and a Dollar Convexity
of 55.4506.
Bond (A+B)/2, the Barbell portfolio, has a
yield-to-maturity of 8.998% and a Dollar
Convexity of 71.7846.
The difference in the two yields (9.25% 8.998%) is referred to the cost of convexity
(71.7846 55.4506) of Bond (A+B)/2, the
Barbell portfolio.
23-39

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
portfolios convexity.
23-40

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.
23-41

Exhibit 23-9 provides an analysis of the six-month total return
of the two portfolios when the yield curve shifts. (See
truncated version of Exhibit 23-9 in Overhead 23-41.)
The numbers reported in the exhibit are the difference in the
total return for the two portfolios.
Specifically, the following is shown:
difference in doll return =
bullet portfolios total return barbell portfolios total return
Thus, 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.
23-42
Exhibit 23-9 Relative Performance of Bullet Portfolio and

Barbell Portfolio over a Six-Month Investment Horizon
Yield
Change
-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
Parallel
Shift
-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
Nonparallel
Shift
-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
Nonparallel
Shift (%)
-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
23-43

Lets focus on the second column of Exhibit 23-9, 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.
23-44

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.
As can be seen from the second column of Exhibit 23-9, 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. (The
truncated version of Exhibit 23-9 was in Overhead 23-41.)
23-45

Approximating the Exposure of a Portfolios 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.
23-46

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 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.
23-47
Importance of Dollar Duration Weighting of

Yield Spread Strategies (p. 539)
Par Value
Price
Bond X
100
80
Modified
Duration
5
Bond Y
100
90
Par Value
Market
Value
Modified
Duration of
1%
Bond X
10 million 8 million
Bond Y
(400,000/4
%) * (9/10)
400,000
400,000/4% 400,000
23-48

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
i. its yield is higher than that of comparably rated issues, or
ii. 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.
23-49

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 23-10 (see Overhead 23-48) shows a one-year rating
transition matrix (table) based on a Moodys study for the
period 19701993.
Exhibit 23-11 (see Overhead 23-49) shows the expected
incremental return estimates for a portfolio consisting of only
three-year Aa-rated bonds.
Exhibit 23-12 (see Overhead 23-50) shows expected
incremental returns over Treasuries assuming the rating
transition matrix given in Exhibit 23-10 and assuming that the
horizon spreads are the same as the initial spreads.
23-50
Exhibit 23-10 One-Year Rating

Transition Probabilities (%)
Aaa
Aa
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
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.
23-51
23-51
Exhibit 23-11 Expected Incremental Return

Estimates for Three-Year Aa-Rated Bonds over a
One-Year Horizon
Initial Horizon Horizon
Spread Rating Spread
30
30
30
30
30
Aaa
Aa
A
Baa
Ba
25
30
35
60
130
Return over Transition Contribution to

Treasuries Probability
Incremental
(bp) X
(%) =
Return (bp)
38
30
21
24
147
1.13
91.26
7.09
0.31
0.21
0.43
27.38
1.49
0.07
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.
23-52
Exhibit 23-12 Expected Incremental Returns over Treasuries When

Rating Transitions Match Historical Experience (One-Year Horizon, bp)
Initial
Spread
Incremental
Return
Incremental
Return
Incremental
Return
Aaa
25
24.2
30
28.4
Aa
30
28.9
35
31.4
35
31.1
45
37.3
Baa
60
46.3
70
39.9
Initial
Spread
Incremental
Return
Incremental
Return
Incremental
Return
Aaa
35
31.7
45
34.6
Aa
40
30.3
55
34.8
55
37.9
75
42.7
Baa
85
21.9
115
27.4
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.
23-53
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.
23-54
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.
23-55

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.
23-56

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 found as
follows:
(ratio computed in Step 3) x [100/(rate change in Step 2 in bps)]
x 100
23-57

Duration of a Leveraged Portfolio
Suppose that the initial value of the un-levered portfolio is

$100 million and the leveraged portfolio is $400 million
($100 million equity plus $300 million borrowed):
Step 1: Calculate & find the duration of the levered portfolio: 3.
Step 2: If the duration of the levered portfolio is 3, then the
dollar duration for a 50-basis-point change in interest rates
is: 3 x 0.5% x 400 millions, or 6 millions.
Step 3: The ratio of the dollar duration for a 50-basis-point
change in interest rates to the $100 million initial market
value of the un-levered portfolio is 0.06 ($6 million divided
by $100 million).
Step 4: The duration of the un-levered portfolio is then found as
follows: (0.06) x [100/(50)] x 100, or 12.
23-58

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.
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..
Despite the fact that there may be high-quality collateral underlying
a repo transaction, both parties to the transaction are exposed to
credit risk.
23-59
Dollar interest on a repo transaction

Dollar interest = (dollar amount borrowed) x
(repo rate) x repo term / 360
For example, at a repo rate of 6.5% and a
repo term of one day (overnight), the dollar
interest is $1,805 as shown below:
$9,998,195 x 0.065 x 1/360 = $1,805
The advantage to the dealer of using the
repo market for borrowing on a short-term
basis is that the rate is lower than the cost
of bank financing.
23-60

How to Create Leverage Via the Repo Market
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.
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.
23-61
Homework from Chapter 23

Question #16 on page 552.
Question #20 on page 552.
23-62
All rights reserved. No part of this publication may be reproduced,

stored in a retrieval system, or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording, or otherwise, without
the prior written permission of the publisher. Printed in the United
States of America.
23-63

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Chapter 23

Active Bond Portfolio

Copyright 2010 Pearson Education, Inc.

Learning Objectives (continued)

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Overview of the Investment

Overview of the Investment

The first step in the investment management process is setting

Establishing Investment Policy

The second step in investment management process is

Copyright 2010 Pearson Education, Inc.

Overview of the Investment

Overview of the Investment

Overview of the Investment

Copyright 2010 Pearson Education, Inc.

Overview of the Investment

Pricing efficiency is taken to describe a market where

Copyright 2010 Pearson Education, Inc.

Overview of the Investment

Copyright 2010 Pearson Education, Inc.

Overview of the Investment

Tracking Error and Bond

Tracking Error and Bond

Tracking Error and Bond

Exhibit 23-1 Calculation of Tracking Error for Two Hypothetical Portfolios:

Standard Deviation = Tracking error

Tracking error (in basis points)

Copyright 2010 Pearson Education, Inc.

Exhibit 23-1 Calculation of Tracking Error for Two Hypothetical Portfolios:

Standard Deviation = Tracking error

Tracking error (in basis points)

Copyright 2010 Pearson Education, Inc.

Exhibit 23-2 Calculation of Tracking Error for Two Hypothetical Portfolios:

Standard Deviation = Tracking error

Tracking error (in basis points)

Copyright 2010 Pearson Education, Inc.

Exhibit 23-2 Calculation of Tracking Error for Two Hypothetical Portfolios:

Copyright 2010 Pearson Education, Inc.

Tracking Error and Bond Portfolio

Copyright 2010 Pearson Education, Inc.

Tracking Error and Bond Portfolio

Copyright 2010 Pearson Education, Inc.

Tracking Error and Bond Portfolio

Tracking Error and Bond Portfolio

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Exhibit 23-3 Summary of Risk Factors for a Benchmark

Tracking Error and Bond

Tracking Error and Bond

Nonsystematic factor risks are classified as nonsystematic risks

Tracking Error and Bond

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Active Portfolio Strategies

A money manager who pursues an active strategy will position

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Active Portfolio Strategies (continued)

A money manager who believes that he or she can accurately

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Active Portfolio Strategies (continued)

The yield curve for U.S. Treasury securities shows the

Copyright 2010 Pearson Education, Inc.

Active Portfolio Strategies (continued)

Copyright 2010 Pearson Education, Inc.

Active Portfolio Strategies (continued)