Fixed Income Portfolio Management

MFIN5600- Week 7

MFIN 5600 -Fall 2023 1

 Introduction to Fixed Income Investments

• Fixed income investments are securities that pay investors fixed interest or dividend
payments until maturity. Upon maturity, investors are repaid the principal amount invested.
Non-Publicly Traded
Commercial Paper: Notes and Bonds:
Instruments:
• Short-term unsecured • Medium to long-term • Loans: Direct lending to
promissory notes. investments. borrowers, often with
• Issued by corporations to • Can be traded on exchanges customizable terms.
fund short-term liabilities. or Over-The-Counter • Private Placements: Debt
• Maturities typically less than (OTC). securities not offered to the
270 days. • Include government, public, typically held by a
corporate, and municipal small number of select
bonds. investors.

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 The Significance of Fixed-Income in Diverse
Portfolios
Diversification:
• Balances a portfolio by reducing overall volatility.
• Fixed-income securities often have a low correlation with equities, leading to risk mitigation.

Regular Cash Flows:

• Provides consistent and predictable income streams.
• Especially beneficial for retirees or those seeking regular income from their investments.

Inflation Hedging:
• Certain fixed-income securities, like inflation-linked bonds, can offer protection against inflation.
• Helps maintain purchasing power and real returns over time.

MFIN 5600 -Fall 2023 3

 Diversification Benefits of Fixed-Income
Investments

Correlation and Diversification: Correlation with Equities:

• Combining assets with returns not • Correlations between fixed-income
perfectly correlated (correlation and equity securities vary.
coefficient < +1.0) results in risk • Fixed-income typically provides
diversification. effective diversification to portfolios
• The goal: Find assets with with equities
correlations much lower than +1.0
for optimal diversification.

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 Diversification Benefits of Fixed-Income
Investments
• Correlation between S&P 500 and various fixed-income categories over 20 years

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 Diversification Benefits of Fixed-Income
Investments
• Correlation between S&P 500 and various fixed-income categories over 5 years

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Diversification Benefits of Fixed-Income
Investments

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Diversification Benefits of Fixed-Income
Investments

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 Inflation Hedging with Fixed-Income
Investments
Floating Rate Coupons: Inflation-Linked Bonds (ILBs):
Protecting the real value of assets
against the erosion of purchasing • Bonds whose interest payments are • Definition: Bonds where the
adjusted periodically according to a principal or interest is adjusted by
power caused by inflation. reference interest rate, typically tied an inflation index, such as the
to a benchmark like LIBOR. Consumer Price Index (CPI).
Importance: Ensuring that the • Inflation Hedging Role: As inflation • Inflation Hedging Role: Directly ties
real return (nominal return rises, central banks may increase the bond's return to an inflation
reference rates to combat inflation. measure, ensuring that the bond's real
adjusted for inflation) of Consequently, the interest payments return stays aligned with inflation
investments remains positive, on floating rate bonds may rise with rates. As inflation rises, so does the
inflation, providing a natural hedge. interest or principal of the ILB,
preserving the real value of assets maintaining the investor's purchasing
power.

MFIN 5600 -Fall 2023 9

Approaches to Fixed-Income Portfolio
Management
Fixed-Income
Portfolio
Management

Liability based Total return

Cash flow Duration Enhanced

Pure indexing
matching matching indexing

Derivatives Contingent Active

overlay immunization management

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 Approaches to Fixed-Income Portfolio Management
Liability-Based Approaches

Tailored to meet specific liabilities or future cash flow requirements.

Cash Flow Matching: Duration Matching: Derivatives Overlay: Contingent Immunization:

• Definition: Investing in • Definition: Adjusting the • Definition: Using financial • Definition: A hybrid
bonds that generate cash duration of a portfolio to derivatives, like interest strategy that combines
flows matching the timing match the duration of rate swaps or futures, to active management with
and magnitude of an liabilities adjust the risk profile of a immunization.
investor's expected portfolio without altering Immunization plus active
liabilities. • Advantage: Protects the the underlying bond management for the surplus.
• Advantage: Reduces the portfolio from interest rate positions.
risk of not meeting changes, minimizing the • Advantage: Provides • Advantage: Allows for
liabilities, especially when impact on both assets and flexibility in managing active management while
reinvestment rates are liabilities. interest rate risk and ensuring a safety net against
uncertain. achieving desired portfolio adverse market movements.
characteristics.

MFIN 5600 -Fall 2023 11

 Approaches to Fixed-Income Portfolio Management
Liability-Based Approaches

Cash Flow Matching: Duration Matching: Derivative Overlay: Contingent Immunization:

Example: The California Example: The Canada Pension Example: The Dutch pension Example: Insurance companies
Public Employees' Plan Investment Board fund PGGM is known for its like Prudential Financial
Retirement System (CPPIB) manages the sophisticated risk management employ contingent
(CalPERS) is one of the investments for the Canada strategies. They have used immunization strategies. They
largest public pension systems Pension Plan. CPPIB employs derivative overlays, such as set specific return thresholds
in the United States. CalPERS duration matching to match interest rate swaps and and adjust their investment
uses cash flow matching the duration of its investments currency hedges, to manage strategy accordingly. If returns
strategies to ensure it has the with the long-term nature of risks within their portfolio and fall below a certain level, they
necessary funds to meet the its pension liabilities. This align their investments with shift to a more conservative
pension benefit payments to helps them manage interest their long-term pension approach to ensure they can
its retired members. They rate risk and ensure the fund's obligations. meet policyholder obligations.
invest in fixed-income long-term sustainability.
securities with maturities that
align with their expected
pension payout schedule.

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 Approaches to Fixed-Income Portfolio Management
Total Return Approaches

Pursuing Returns in Fixed-Income Portfolios

Pure Indexing: Enhanced Indexing: Active Management:

• Definition: Replicating the • Definition: A strategy that • Definition: A discretionary

performance of a specified closely tracks a bond index approach where the manager
bond index. but allows for small makes investment decisions
• Advantage: Low-cost, deviations in an attempt to to outperform a benchmark.
transparent, and provides outperform the index. • Advantage: Potential for
performance in line with the • Advantage: Offers potential higher returns, flexibility in
market. for slight outperformance strategy, and ability to
while maintaining the capitalize on market
benefits of indexing. inefficiencies.

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 Approaches to Fixed-Income Portfolio Management
Total Return Approaches

Pure Indexing: Enhanced Indexing: Active Management:

iShares Core U.S. Aggregate Bond PIMCO Enhanced Low Duration DoubleLine Total Return Bond Fund
ETF (AGG) Active ETF (LDUR) (DLTNX)

is an ETF that employs pure indexing. It is an ETF that uses enhanced indexing is a mutual fund managed by
aims to track the Bloomberg Barclays strategies. PIMCO, known for its DoubleLine Capital. This fund utilizes
U.S. Aggregate Bond Index, which is a active fixed income management, active management strategies. Jeffrey
broad and widely followed benchmark of employs an enhanced indexing Gundlach, the fund's renowned
the U.S. investment-grade bond market. approach in LDUR. While it aims to manager, makes active decisions
AGG holds a representative sample of track the Bloomberg Barclays U.S. regarding asset allocation, duration,
bonds from the index, attempting to
Aggregate Bond Index, it also and security selection to seek
replicate its performance. The
management style is passive, and the incorporates active management opportunities and manage risk in the
fund seeks to provide investors with techniques to enhance returns and fixed income market. DLTNX is not
returns that closely mirror the index's manage risk. The fund may deviate constrained by tracking an index and
performance. from the index selectively based on aims to generate alpha (excess returns)
PIMCO's research and analysis. through active management.

MFIN 5600 -Fall 2023 14

Pure Indexing vs. Enhanced Indexing vs.
Active Management
Portfolio Weight vs.
Strategy Objective Turnover
Benchmark

Replicate benchmark Closely aligned with benchmark Low (mainly due to index
Pure Indexing
performance weights rebalancing)

Slight outperformance over the Small deviations allowed from Moderate (some active
Enhanced Indexing
benchmark benchmark decisions)

Significant outperformance over Large deviations permitted from High (active trading &
Active Management
the benchmark benchmark positioning)

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Understanding Performance & Risk in Fixed-
Income Pure Indexing
Active Return:
• Definition: The difference between the portfolio's return and the benchmark's (index) return.
• Context: In pure indexing, the active return should be close to zero, as the goal is to replicate the benchmark's performance.

Active Risk:
• Definition: The risk (standard deviation) of the active return.
• Context: Represents the potential volatility of the portfolio's return relative to the benchmark. Ideally minimized in pure indexing.

Tracking Risk:
• Definition: Another term for active risk. It quantifies how consistently a portfolio follows its benchmark.
• Context: In pure indexing, tracking risk should be minimized to ensure the portfolio closely mirrors the index.

Tracking Error:
• Definition: Often used interchangeably with tracking risk, but can also refer to the square root of the average squared deviation
between portfolio returns and benchmark returns.
• Context: A measure of how closely the portfolio's returns match the benchmark's returns over time. Lower tracking error indicates
better replication of the index in pure indexing.

MFIN 5600 -Fall 2023 16

 Yield Metrics in Fixed-Income

Yield to Maturity (YTM) Yield Spread Credit Spread

• Definition: The total return anticipated • Definition: The difference in yield • Definition: The difference between the
on a bond if it is held until it matures. between two bonds, usually of similar yield of a corporate bond and a
YTM is expressed as an annual maturity but different credit quality. government bond of similar maturity.
percentage rate (APR). • Calculation: Subtract the YTM of one • Calculation: Subtract the YTM of a
• Calculation: It equates the present bond from the YTM of another bond. risk-free government bond from the
value of bond future cash flows (coupon • Use: Assesses the relative value of two YTM of a riskier corporate bond.
payments and return of principal) to its bonds. A larger yield spread indicates a • Use: Indicates the additional yield an
current price. higher compensation for the risk taken. investor expects to earn for the added
• Use: Helps investors compare the return credit risk of the corporate bond
of different bonds and ascertain if a compared to a risk-free government
bond is fairly priced. bond

MFIN 5600 -Fall 2023 17

 Bond Risk and Return Measures
Macaulay Duration: Modified Duration: Effective Duration:

1.Definition: The weighted average time 1.Definition: A measure of the sensitivity of 1.Definition: Measures a bond's sensitivity
until a bond's cash flows are received. It a bond's price to changes in interest to changes in interest rates, taking into
calculates the time-weighted present rates. It is an adjustment to the Macaulay account that expected cash flows can
value of future bond cash flows. Duration to make it a more direct measure change as interest rates change.
2.Formula: The present value of each cash of interest rate sensitivity. Particularly useful for bonds with
flow is multiplied by the time until that 2.Formula: Macaulay Duration divided by embedded options, like callable or putable
cash flow occurs, and then the sum of these (1 + (YTM/n)), where YTM is the bond's bonds.
products is divided by the bond's current yield to maturity, and n is the number of 2.Calculation: It considers how bond prices
price. compounding periods per year. change in response to a parallel shift in the
3.Use: Mainly an academic or theoretical 3.Use: Widely used by portfolio managers yield curve.
measure. While it gives an idea of the and analysts to gauge the price sensitivity 3.Use: Essential for analyzing bonds with
average time it takes to receive bond of fixed-income securities to changes in embedded options. As interest rates
cash flows, it's not directly useful for interest rates. For instance, a bond with a change, the expected cash flows of these
assessing interest rate risk. However, it modified duration of 5 years will see its bonds might change (e.g., a bond might be
serves as the foundation for the more price rise by about 5% for a 1% drop in called early if rates drop). Effective
practical modified duration. interest rates, and vice versa. duration captures this potential change in
cash flows.

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 Bond Risk and Return Measures
Key Rate Duration: Empirical Duration: Money Duration:

1.Definition: Measures the sensitivity 1.Definition: Calculated based on 1.Definition: Represents the change in
of a bond's price to changes in observed changes in bond prices and a bond's price (in monetary terms)
interest rates at specific points (or their relationship to changes in for a 1% change in yield. It's the
maturities) along the yield curve, interest rates, rather than based on product of the bond's modified
rather than a parallel shift. theoretical models. duration and its price or principal.
2.Use: Enables portfolio managers to 2.Use: Valuable when real-world, 2.Use: Crucial for portfolio managers
assess and hedge against the interest observed data is preferred over desiring a direct measure in
rate risk associated with specific theoretical models. Especially monetary terms of how much the
maturities on the yield curve. If one relevant in periods of market value of their holdings might change
believes that certain parts of the anomalies or distortions when with interest rate fluctuations.
yield curve will move more than traditional models might not fully Knowing the potential dollar change
others, key rate durations can guide capture market behaviors. for a 1% rate shift aids in risk
portfolio adjustments. management and strategy
implementation.

MFIN 5600 -Fall 2023 19

Bond Risk and Return Measures

• Macaulay focuses on weighted average time of cash flows, while Modified and Effective
Durations focus on price sensitivity to interest rate changes. Key Rate Duration narrows this
sensitivity to specific maturities on the yield curve.
• Effective Duration is more appropriate for bonds with embedded options, while Modified
Duration works well for option-free bonds. Key Rate Duration is used when non-parallel shifts
in the yield curve are of concern.
• Empirical Duration is based on observed changes, making it distinct from the other model-based
durations.

MFIN 5600 -Fall 2023 20

 Bond Risk and Return Measures

Price Value of a Basis Point (PVBP) Convexity Effective Convexity

• Definition: Measures the change in the • Definition: Measures the rate of change • Definition: Measures the convexity of a
price of a bond for a one basis point of a bond's duration as yields change, bond with embedded options (like
(0.01%) change in yield. reflecting the bond's price sensitivity to callable or putable bonds) considering
• Calculation: Difference between the interest rate changes. potential changes in interest rates.
bond's price at its original yield and its • Calculation: Second derivative of the • Calculation: Evaluates price changes
price at a yield changed by one basis bond's price with respect to its yield. for two parallel shifts in the bond's yield
point. • Use: Helps refine duration-based curve (one up and one down).
• Use: Useful for assessing the interest predictions. Positive convexity means • Use: Essential for bonds with embedded
rate risk of bonds. The higher the PVBP, bond prices rise more for a rate drop options, as they may not have constant
the more sensitive the bond's price is to than they fall for a rate increase of the cash flows. Helps investors understand
changes in yields. same magnitude. the bond's price sensitivity in different
interest rate scenarios.

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 Bond Portfolio Metrics
Effective Duration of Bond Bond Portfolio Modified
Bond Portfolio Duration Portfolio Convexity
Portfolio Duration
• Definition: Weighted • Definition: Measures the • Definition: Measures the • Definition: Measures the
average time until a bond's expected percentage change expected percentage change rate of change of portfolio
fixed cash flows are in the bond portfolio's price in a bond's price for a 1% duration as yields change.
received. for a parallel shift in the change in yield. • Calculation:
• Calculation: yield curve. • Calculation:
• Calculation:

• Use: Refines predictions of

• Weights are typically the bond price sensitivity,
proportion of each bond's • Use: Essential for portfolios especially for larger changes
market value in the containing bonds with in yields.
portfolio. embedded options, as it
• Use: Gauges the interest rate accounts for changes in cash
• Use: Indicates the portfolio's
risk of the entire bond flow due to rate changes.
overall sensitivity to
portfolio. changes in interest rates.

MFIN 5600 -Fall 2023 22

 Bond Portfolio Metrics

Spread Duration Duration Times Spread (DTS) Portfolio Dispersion

• Definition: Measures the sensitivity of a • Definition: A risk measure that • Definition: Measures the diversity of
bond's or bond portfolio's price to combines both interest rate risk bond maturities or durations within a
changes in credit spread. (duration) and credit risk (spread). portfolio.
• Calculation: • Calculation: • Calculation:
• The estimated percentage change in a • Often quantified as the average
bond's price for a 1% (or 100 basis DTS=Duration × Credit Spread difference between each bond's
points) change in its credit spread. duration and the portfolio's average
• Use: Useful for gauging the potential • It provides an estimate of the potential duration.
impact of credit spread changes on the loss in value for a given increase in • Use: Provides insights into the interest
bond's or portfolio's value, especially in credit spreads. rate risk of the portfolio. A portfolio
portfolios with varying credit qualities. • Use: Helps investors understand the with high dispersion has bonds with a
combined effect of interest rate and wide range of sensitivities to interest
credit spread changes on a bond or rate changes, while a portfolio with low
portfolio. dispersion is more uniformly sensitive.

MFIN 5600 -Fall 2023 23

Active Bond Portfolio Management:
Managing Portfolio Duration

Overview: Adjusting portfolio duration based on economic forecasts and interest rate expectations.
Implementation:
Use a combination of top-down (macroeconomic factors) and bottom-up (individual security selection)
approaches.
Adjust the exposure to longer-dated bonds relative to the benchmark based on interest rate expectations.

Example:
If expecting a rise in interest rates and a steepening yield curve, reduce exposure to longer-dated bonds, lowering
the portfolio duration.

Outcome:
Aligning portfolio duration with market expectations can lead to outperformance and active excess returns when
predictions materialize.
MFIN 5600 -Fall 2023 24
Active Bond Portfolio Management:
Managing Spread Duration or Credit Exposure

Overview: Using spread duration measures to adjust portfolio sensitivity to credit spread
changes.
Strategies:
Increase spread duration if expecting credit spreads to narrow.
Adjust the average credit rating of the portfolio (e.g., shifting from A rated to BBB rated bonds).

Constraints:
Be mindful of investment mandate constraints such as target duration, rating-based restrictions, and
derivatives use limits.

Tools:
Utilize "duration times spread" measure for a comprehensive view of potential portfolio value changes.

MFIN 5600 -Fall 2023 25

 Active Bond Portfolio Management:
Utilizing Relative Value

Overview: Selecting the most attractive individual securities based on a comprehensive analysis.
Approach:
Analyze and rank securities across sectors, issuers, and individual bonds based on valuation, issuer fundamentals, and
market technical conditions.
Establish a time horizon for the relative value analysis.

Implementation:
Use bond characteristics like key rate duration and duration times spread to express active positions relative to the
benchmark.
Select securities that optimize the expected return for a given level of risk, ensuring the best relative value.

Diversification:
Ensure idiosyncratic risks are within acceptable parameters while pursuing relative value opportunities.

MFIN 5600 -Fall 2023 26

Pure Indexing vs. Enhanced Indexing vs. Active Management
Example

MFIN 5600 -Fall 2023 27

Pure Indexing vs. Enhanced Indexing vs. Active Management
Example

MFIN 5600 -Fall 2023 28

Pure Indexing vs. Enhanced Indexing vs. Active Management
Example

MFIN 5600 -Fall 2023 29

Pure Indexing vs. Enhanced Indexing vs. Active Management
Example

MFIN 5600 -Fall 2023 30

 Understanding Liquidity Issues in Fixed Income

• Liquidity impacts Over-the-Counter

On-the-Run vs. Off-
bond pricing, (OTC) Dealer Search Cost: Price Transparency: Liquidity Premium:
the-Run Bonds:
Market:
trading strategies,
and portfolio • Unlike centralized • The time and • In equities, price • On-the-Run: Newest • Extra yield
exchanges, fixed resources required to information is readily bond issues, highly demanded by
management. income securities are find the best bond available due to liquid due to high investors for holding
• Investors need to often traded OTC. price or a willing centralized demand. less liquid bonds.
• Interactions are counterparty. exchanges. • Off-the-Run: Older • Compensates for the
balance the trade- mainly between • Higher in fixed • Fixed income bond issues replaced potential difficulty
off between yield dealers and income due to the securities, especially by newer ones. Less and cost of selling
and liquidity. institutional OTC nature, OTC trades, lack liquid as they're less the bond before
investors. resulting in less real-time price actively traded. maturity.
• A deep • This decentralized standardized prices transparency, leading • Liquidity differences • Bonds with higher
structure can lead to and terms. to information can lead to pricing liquidity risk will
understanding of asymmetry.
fragmented disparities between generally have a
market structure and information and the two. higher liquidity
liquidity nuances is varying prices. premium
essential for
effective fixed
income investing.
MFIN 5600 -Fall 2023 31
 Understanding Liquidity Issues in Fixed Income

Exchange-Traded Funds Exchange-Traded

Mutual Funds: OTC Derivatives:
(ETFs): Derivatives:
• Overview: Pooled investment • Overview: Similar to mutual • Overview: Financial • Overview: Customized
vehicles that aggregate capital funds, but trade on stock contracts, such as futures and contracts between two parties,
from multiple investors to buy exchanges like individual options on bond indices, that like interest rate swaps or
a diversified portfolio of stocks. are traded on organized credit default swaps.
bonds. • Liquidity Benefit: Real-time exchanges. • Liquidity Benefit: While
• Liquidity Benefit: Provides trading and price transparency. • Liquidity Benefit: individually tailored and
daily liquidity, enabling Acts as a bridge between the Centralized exchanges ensure potentially less liquid, they
investors to enter or exit bond market and stock standardization and typically can be structured to address
positions without directly exchanges, enhancing higher liquidity than OTC specific liquidity needs or time
transacting in individual liquidity. markets. horizons.
bonds. • Implications: Can be more • Implications: Useful for • Implications: Flexibility to
• Implications: Can offer cost-effective than mutual hedging, speculation, or design specific terms, but
diversification benefits and funds and offer intraday achieving synthetic exposure comes with counterparty risk
professional management, but liquidity. to fixed income assets without and may lack standardization.
may come with management directly holding them.
fees.

MFIN 5600 -Fall 2023 32

 Decomposing Expected Return of Fixed
Income
Views on Views on Yield Views on Currency
Coupon Income: Rolldown Return:
Benchmark Yield: Spread: Value Changes:

1.Definition: The 1.Definition: Gains 1.Definition: 1.Definition: 1.Definition: For bonds

periodic interest generated when a bond Anticipations about Expectations about the denominated in foreign
payment made to "rolls down" the yield future movements in changes in the currencies, expectations
bondholders during the curve as it approaches the general level of difference between the about future exchange
life of the bond. maturity. interest rates. bond's yield and a rate movements matter.
2.Impact on Return: As 2.Impact on Return: If a benchmark yield 2.Impact on Return: If a
2.Impact on Return: time passes, a bond manager expects a (usually a government manager expects the
Represents a may move to a shorter decline in benchmark bond). bond's currency to
predictable income maturity bucket on the yields, they may 2.Impact on Return: A appreciate relative to
stream, usually the yield curve, potentially increase duration to narrowing yield spread the home currency, this
largest component of resulting in capital capture capital gains, due to improving credit can add to returns for
expected return for appreciation if the yield and vice versa. quality or other factors international bond
investment-grade curve is upward can boost bond returns. holdings
bonds. sloping.

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