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<!doctype html>
<html lang="en">
<head>
<meta charset="utf-8">
<title>Study Session 9 | Reading 23 | Fixed-Income Portfolio Management, Part 1</title>
<meta name="description" content="Chartered Financial Analyst Level 3 Study Materials">
<meta name="author" content="MacLane Wilkison">
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<div class="slides">
<section>
<h1>Reading 23</h1>
<h3>Fixed-Income Portfolio Management, Part 1</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">AlchemistsAcademy</a> by <a href="http://alchemistsacademy.com/about">MacLane Wilkison</a></small>
</p>
</section>
<section>
<h2>Fixed-Income Portfolio Management Framework</h2>
<ul>
<li>Four activities composing the investment management process:</li>
<ol>
<li>Setting investment objectives (with related contraints)</li>
<li>Developing and implementing a portfolio strategy</li>
<li>Monitoring the portfolio</li>
<li>Adjusting the portfolio</li>
</ol>
<li>**See reading 23, page 7 for a detailed diagram**</li>
</ul>
</section>
<section>
<section>
<h1>Managing Funds Against a Bond Market Index</h1>
</section>
<section>
<h2>Types of Strategies</h2>
<ol>
<li>Pure bond indexing (full replication) approach</li>
<li>Enhanced indexing by matching primary risk factors</li>
<li>Enhanced indexing by small risk factor mismatches</li>
<li>Active management by larger risk factor mismatches</li>
<li>Full active management</li>
</ol>
<aside class="notes">
1) Produces a portfolio that is a perfect match to the benchmark portfolio; 2) Uses a sampling approach in an attempt to match the primary index risk factors and achieve a higher return than under full replication; 3) Matches duration but allows manager to tilt the portfolio in favor of any of the other risk factors; 4) Makes deliberately large mismatches on the primary risk factors to increase return; 5) Allows aggressive mismatching of durations, sector weights, and other factors.
</aside>
</section>
<section>
<h2>General Considerations</h2>
<ul>
<li>Advantages:</li>
<ul>
<li>Lower fees than actively managed accounts</li>
<li>Difficult to outperforma a broad-based market index consistently after fees</li>
<li>Provides excellent diversification</li>
</ul>
<li>Primary risk considerations:</li>
<ul>
<li>Market value risk</li>
<li>Income risk</li>
<li>Credit risk</li>
<li>Liability framework risk</li>
</ul>
</ul>
<aside class="notes">
When constructing an indexed portfolio, manager's should choose an index containing characteristics that closely match those of the desired portfolio, giving particular consideration to market value risk, income risk, credit risk, and liability framework risk
</aside>
</section>
<section>
<h2>Risk Overview</h2>
<ul>
<li>Yield curve risk</li>
<ul>
<li>Parallel shifts, twists, and other curvature changes</li>
</ul>
<li>Spread risk - changes in the spread between Treasuries and non-Treasuries</li>
<li>Risk profile - detailed tabulation of an index's risk exposures</li>
<li>Cell-matching vs. mutifactor model technique</li>
</ul>
<aside class="notes">
There are various techniques a manager may use to align a portfolio's risk exposures with that of the benchmark. Cell-matching techniques (aka stratified sampling) divides the benchmark index into cells that represent qualities that should refelct the risk factors of the index. The manager then selects bonds from those in each cell to represent the entire cell taking account of the cell's relative importance in the benchmark index. The multifactor model techniques analyzes a set of factor that drive bond returns (i.e. (1) duration with convexity adjustment, (2) key rate duration and PV distribution of cash flows, (3) sector and quality percentage weight, (4) sector duration contribution, (5) quality spread duration contribution, (6) sector/coupon/maturity cell weighting, and (7) issuer exposure.
</aside>
</section>
<section>
<h2>Tracking Risk</h2>
<p><em>Definition: A measure of the variability with which a portfolio's return tracks the return of a benchmark index</em></p>
<ul>
<li>Tracking risk = Standard deviation of active returns</li>
<ul>
<li>Active return = Portfolio's return - Benchmark index's return</li>
</ul>
<li>Primary risk factors to match:</li>
<ol>
<li>Portfolio duration</li>
<li>Key rate duration and PV distribution of cash flows</li>
<li>Sector and quality percent</li>
<li>Sector duration contribution</li>
<li>Quality spread duration contribution</li>
<li>Sector/coupon/maturity cell weights</li>
<li>Issuer exposure</li>
</ol>
</ul>
</section>
<section>
<h2>Enhanced Indexing Strategies</h2>
<ol>
<li>Lower cost enhancements</li>
<li>Issue selection enhancements</li>
<li>Yield curve positioning</li>
<li>Sector and quality positioning</li>
<li>Call exposure positioning</li>
</ol>
<aside class="notes">
There are a variety of ways a manager might attempt to recoup the expenses associated with construction/rebalancing an indexed portfolio. These include (1) maintaining tight controls on trading costs and management fees; (2) identifying and selecting undervalued securities; (3) overweighting undervalued areas of the yield curve and underweighting overvalued areas; (4) maintaining a yield tilt toward short duration corporates or the periodic over-/underweighting of sectors or qualities
</aside>
</section>
<section>
<h2>Active Strategies</h2>
<ul>
<li>Steps:</li>
<ol>
<li>Identify which index mismatches are to be exploited</li>
<li>Extrapolate the market's expectations (or inputs) from the market data</li>
<li>Independently forecast the necessary inputs and compare these with the market's expectations</li>
<li>Estimate the relative values of securities in order to identify areas of under-/overvaluation</li>
</ol>
</ul>
</section>
</section>
<section>
<section>
<h1>Managing Funds Against Liabilities</h1>
</section>
<section>
<h2>Dedication Strategies</h2>
<p><em>Definition: Specialized fixed-income strategies that are designed to accomodate specific funding needs of the investor</em></p>
<img src="images/23/dedication-strategies.png" alt="dedication strategies" />
<aside class="notes">
Immunization aims to construct a portfolio that, over a specified horizon, will earn a predetermined return regardless of interest rate changes. Cash flow matching provides thae future funding of a liability stream from the coupon and matured principal payments of the portfolio.
</aside>
</section>
<section>
<h2>Types of Liabilities</h2>
<img src="images/23/classes-of-liabilities.png" alt="classes of liabilities" />
<aside class="notes">
The more uncertainty surrounding a liability, the more difficult it is to plan for
</aside>
</section>
<section>
<h2>Single Period Immunization</h2>
<p><em>Definition: The creation of a fixed-income portfolio that produces an assured return for a specific time horizon, irrespective of any parallel shifts in the yield curve</em></p>
<ul>
<li>Requires setting the duration of the portfolio equal to the specified portfolio time horizon to assure the offsetting of positive and negative incremental returns</li>
<li>Key characteristics:</li>
<ul>
<li>Specified time horizon</li>
<li>Assured rate of return during the holding period to a fixed horizon date</li>
<li>Insulation from the effects of interest rate changes on the portfolio value at the horizon date</li>
</ul>
</ul>
<aside class="notes">
As the duration of the portfolio inevitably changes over time, managers face a tradeoff between transaction costs or mismatches in duration.
</aside>
</section>
<section>
<h2>Dollar Duration</h2>
<p><em>Definition: A measure of the change in portfolio value for a 100 bps change in market yields</em></p>
<ul>
<li>Dollar duration = Duration × Portfolio value × 0.01</li>
<li>Rebalancing dollar duration steps:</li>
<ol>
<li>Move forward in time and include a yield curve shift then calculate the dollar duration of the portfolio using the new market values and durations</li>
<li>Calculate the rebalancing ratio (original dollar duration divided by new dollar duration) and subtract one to determine the percentage amount each position needs to be changed</li>
<li>Multiply new market value of the portfolio by desired percentage change to determine the amount of cash required for rebalancing</li>
</ol>
</ul>
</section>
<section>
<h2>Spread Duration</h2>
<p><em>Definition: A measure of how the market value of a risky bond will change with respect to a parallel 100 bps change in its spread above the comparable benchmark</em></p>
<ul>
<li>Spread types:</li>
<ul>
<li>Nominal spread - spread of a bond above the yield of a similar maturity Treasury</li>
<li>Static spread (zero-volatility spread) - constant spread above the Treasury spot curve that equates the calculated price of a security to its market price</li>
<li>Option-adjusted spread (OAS) - current spread over the benchmark yield less the spread component attributable to any embedded optionality</li>
</ul>
</ul>
</section>
<section>
<h2>Multiple Liability Immunization</h2>
<ul>
<li>Necessary conditions for successful immunization:</li>
<ol>
<li>PV of assets equals PV of liabilities</li>
<li>Composite duration of the portfolio equals composite duration of the liabilities</li>
<li>Distribution of durations of individual portfolio assets must have a wider range that that of the liabilities</li>
</ol>
</ul>
</section>
<section>
<h2>Cash Flow Matching Strategies</h2>
<p><em>Definition: The process of selecting securities to match the timing and amount of liabilities</em></p>
<ul>
<li>Conceptually simpler, yet technically inferior to immunization</li>
<ul>
<li>Requires a relatively conservative rate of return assumption for short-term cash and cash balances may be large</li>
<li>Funds must be available when each liability is due</li>
</ul>
<li>Symmetric cash flow matching</li>
<li>Combination matching</li>
</ul>
<aside class="notes">
Symmetric cash flow matching is an extension of cash flow matching that allows for the short-term borrowing of funds to satisfy a liability prior to its due date. Combination matching is a combination of multiple liability immunization and cash flow matching whereby a manager creates a duration-matched portfolio with the added constraint that it is cash flow matched for the first several years.
</aside>
</section>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
</section>
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