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Introduction to Bond Portfolio Management

by Frank J. Fabozzi

PowerPoint Slides by David S. Krause, Ph.D., Marquette University

Copyright 2007 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express permission of the copyright owner is unlawful. Request for futher information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.

Chapter 16

Introduction to Bond Portfolio Management

Major learning outcomes:
Identify the activities in the investment management process (setting the investment objectives, developing and implementing a portfolio strategy, monitoring the portfolio, and adjusting the portfolio). Explain the two types of benchmarks (liability structure and bond index) used to identify an investment objective.

Key Learning Outcomes

Define liabilities. Classify different types of liabilities.

Define what a funded investor is and the investment objective of a funded investor. Identify the major broad-based bond market indexes.

Key Learning Outcomes

Describe what performance risk is. Identify some of the risks associated with liabilities.

Explain what the economic surplus of an entity is and how its exposure to changes in interest rates is assessed.
Define what the duration of a liability is.

Key Learning Outcomes

Identify the types of constraints imposed on managers and/or investors. Identify the elements in developing and implementing a portfolio strategy (writing an investment policy, selecting the type of investment strategy, formulating the inputs for portfolio construction, and constructing the portfolio). Distinguish between active and passive strategies. Explain how the degree of departure of a managed portfolio from the benchmark index determines the degree of active management.

Key Learning Outcomes

Explain the role of forward rates in formulating the inputs for constructing a portfolio. Explain what is involved in the monitoring activity phase of the investment management process. Distinguish between performance measurement and performance evaluation.

The Investment Management Process

The investment management process involves the following activities:
1) setting the investment objectives 2) developing and implementing a portfolio strategy 3) monitoring the portfolio 4) adjusting the portfolio

Investment Objectives
Specified in terms of return and risk Expressed quantitatively in terms of a benchmark - benchmark in terms of the investors liability structure - benchmark as a particular bond market index The benchmark should reflect the clients investment need from a risk, return, and cash flow perspective.

Liabilities as the Investment Objective

Two categories of investors 1) Investors borrow the funds and invest those funds funded investors (banks, savings and loan associations, credit unions, hedge funds, insurance companies)
Objective: earn a return on the funds borrowed that is greater than the cost of borrowing Spread: the difference between the return on the funds invested and the cost of borrowing

2) Institutional investors who must satisfy a liability structure but did not borrow the funds that created the liability (a pension sponsor)

Liabilities as the Investment Objective

Liability a potential cash outlay at a future date to satisfy the contractual terms of an obligation.
- amount of the liability - timing of the liability

Classification of Liabilities
Liability Type Amount of Outlay Timing of Cash Outlay Example

Type I
Type II Type III Type IV

known uncertain uncertain

uncertain known uncertain

Fixed-rate CD
Life insurance policy Floating-rate CD Auto (home) insurance policy

Bond Market Index as the Investment Objective

Basic characteristics of a benchmark
- Unambiguous: clearly identifiable names and weights of the securities - Investable: buy-and hold the benchmark vs. actively managed funds - Measurable: return can be calculated on a frequent basis - Appropriate: consistent with the managers investment style - Reflective of current investment opinions: knowledge of the securities included - Specified in advance

Bond Market Index as the Investment Objective

1) Broad-based U.S. bond market indexes
- Lehman Brothers U.S. Aggregate Index - Salomon Smith Barney Broad Investment-Grade Bond Index - Merrill Lynch Domestic Market Index These are computed daily and are market-value weighted The securities in the indexes are trader priced or model priced Intra-month cash flows reinvested in different ways

2) Specialized U.S. bond market indexes 3) Global and international bond market indexes

Performance risk the inability to satisfy an investment objective 1) Risk associated with managing relative to a bond market index 2) Risks associated with managing against a liability structure

Risk Associated with Managing Relative to a Bond Market Index

Portfolio relative performance the difference between the risk profile of the benchmark index and the risk profile of the portfolio Tracking error a measure that allows the manager to incorporate all of the major risks associated with a portfolio relative to a benchmark index The larger the tracking error, the greater the likelihood that the portfolios performance will differ from performance of the benchmark index

Risks Associated with Managing Against a Liability Structure

Managing relative to a liability structure is referred to as asset-liability management Call risk for liabilities Similar to call risk but at this case, a depository institution is concerned with the premature withdrawal of funds when interest rates rise Cap risk the risk that the funding cost will exceed the rate earned on a floating-rate bond Interest rate risk Economic surplus = market value of assets present value of liabilities If the duration of the assets is less than the duration of the liabilities, the economic surplus will decrease (increase) if interest rates fall (rise). Convexity should also be considered when analyzing interest rate sensitivity.

Client-imposed constraints should be realistic and consistent with the investment objective Constraints by the regulators of stateregulated institutions Tax implications

Developing and Implementing a Portfolio Strategy

1) Writing an investment policy 2) Selecting the type of investment strategy 3) Formulating the inputs for portfolio construction 4) Constructing the portfolio

Developing and Implementing a Portfolio Strategy

1) Writing an Investment Policy
- Links the investors investment objectives and the types of strategies to reach those objectives - Should specify the permissible risk and the way the performance risk is measured - Investment guidelines consistent with the investment policy and the investment philosophy of the manager

Developing and Implementing a Portfolio Strategy

2) Selecting the type of Investment Strategy
- Active strategies forecasts of interest rates; changes in the term structure of interest rates, interest rate volatility, yield spreads - Passive strategies indexing replicates the performance of a designated bond market index. - Structured portfolio strategies designing a portfolio to achieve the same performance as a designated benchmark

Developing and Implementing a Portfolio Strategy

2) Selecting the type of Investment Strategy
- comprehensive analysis of the risk profile of the benchmark index risk characteristics - passive vs. active management - use of derivatives

Developing and Implementing a Portfolio Strategy

3) Formulating the inputs for Portfolio Construction two tasks:
Forecast of the inputs that are expected to impact the performance of the portfolio: forecasting changes in interest rates, changes in interest rate volatility, changes in credit spreads. Extrapolate the markets expectations from market data: the portfolio managers view is relative to what is priced into the market, or the forward rates and the view of future rates relative to the rates built into todays prices of the securities.

Developing and Implementing a Portfolio Strategy

4) Constructing the portfolio
Bases on his forecasts and market-derived information, the manager assembles the portfolio with specific issues. Active bond portfolio management involves identifying opportunities to enhance return relative to the benchmark Determining the relative value of the securities as the ranking of foxed-income investments by sectors, structures, issuers, and issues in terms of their expected performance during some future interval.

Monitoring the Portfolio

Monitoring the portfolio involves two activities:
Assessment of whether there have been changes in the market that might suggest any of the key inputs used may not be realized. Monitor the performance of the portfolio: - performance measurement: calculation of the return realized by a manager over a specific time interval - performance evaluation: has the manager added value by outperforming the established benchmark and how he achieved the observed return? - Return attribution analysis decomposition of the performance results to explain why those results were achieved.

Adjusting the Portfolio

The activities involved in monitoring the portfolio indicate whether adjustment is needed.
The manager also determines whether to revise the inputs used in the construction of the portfolio. Adjusting the portfolio includes analysis if trading costs: transaction costs and any adverse tax or regulatory consequences.