NBS8336 Portfolio Management

Lecture 6
Fixed-income investment strategies
Module leader: Dr. Minh Nguyen

The fundamentals

This class

Outline
After this lecture, you would be expected to perform the following tasks:
Explain bond passive investment strategies:
Bond indexing
Bond portfolio immunisation
Describe active strategies:
Riding the yield curve
On and Off-the-run arbitrage
Swap spread arbitrage

Further readings:
Bodie, Kane & Marcus, Chapter 16

Fixed Income Fundamentals

T CFt
P
t 1 (1y )t

Bond Price
Modified Duration

P
D * y
P

Duration and convexity approximation

P
1
2
D * y CX y
P
2

Return: bond return,+1 =

+1 +possible

+1 (+1 )

coupon

Fixed income strategies

Passive bond portfolio managers track a
benchmark portfolio or match liabilities
Active bond portfolio managers seek profits
from their views about the evolution of
interest rates and yield spreads

Passive Management
Two passive bond portfolio strategies:
1.Indexing
2.Immunization
Both strategies see market prices as being
correct, but the strategies have very different
risks.

Bond indexing
Objective:
Track the returns of an index (indexing) as closely as
economically feasible or structure a portfolio to meet specific
liabilities over time (liability funding)
Rationale:
Markets are assumed to be efficient enough that research
cannot produce extra returns beyond its cost. Therefore a
portfolio is run either to track a chosen benchmark index or to
meet specific requirements over time whilst keeping expenses
(management, transaction costs) to a minimum

Choosing a Bond Index

There are broad based indices and specialist indices
1. Broad based examples (all highly correlated, 98% annual)
Lehman Brothers Aggregate Index
Salomon Brothers Broad Investment Grade Bond Index
Merrill Lynch Domestic Market Index
Each contain more than 5000 issues, mostly from US issuers.
All are investment grade and with medium to long term
maturities
2. Specialized examples (still correlated, 90% annual)
Morgan Stanley actively traded (MBS) index
First Boston high yield index
DL&J High Yield Index
Ryan Labs Treasury Index

16-10

Immunization
Immunization is a way to control interest rate
risk.
Widely used by pension funds, insurance
companies, and banks.

Immunization
Immunize a portfolio by matching the interest
rate exposure of assets and liabilities.
This means: Match the duration of the assets and
liabilities.
Price risk and reinvestment rate risk exactly cancel
out.

Result: Value of assets will track the value of

liabilities whether rates rise or fall.

Immunization: an example
Suppose an insurance company must make a single payment
of 19,487 in 7 years
Suppose the current market interest rate is 10%. What is the
present value of the obligation?
What is the present value of the obligation if interest rate is
reduced by 50 basis points (i.e. 9.5%)?
The company wishes to fund the obligation using 3-year zerocoupon bonds. How can the manager immunize the
obligation?

Immunization: an example
1.

Calculate the duration of the liability: as it is a single payment, the

duration of the obligation is 7 years. PV of the liability = 19,487/1.107
=10,000
2. Calculate the duration of the assets:
The duration of the zero coupon bonds = maturity = 3years
If w is the weight in zero bond. Match the duration of the asset and
liability
3w=7, thus w=7/3
As the PV of the obligation = 10,000 thus the manager needs to buy
23,333 (=7/3*10000) zero coupon bond
4. If the interest rate instantly dropped to 9.5%, the PV of the liability =
10,323. Thus the obligation increase by 323.
However, the PV of the zero coupon = 23333*1.103/1.0953=23,654,
making a profit = 23,654-23333=321. Thus offset the loss

Active Bond Strategies

Objective:
Take positions and rebalance positions actively to take
advantage of differences between the consensus market view,
as reflected in market equilibrium security prices, and the the
fund managers view
Rationale:
Assumes that the fund manager has some better views or
makes better analyses than the average trader in the market,
or has privileged access to some instruments that other
agents find difficult to trade, or benefits from special
circumstances (taxation, regulation, etc) that allow the
manager to cover his management cost (research, systems,
etc.) and still outperform his benchmark

Types of Active Strategies

Active strategies are based on views about one or several of the
following factors:
1. Changes in level of interest rates
Stable yield Yield curve ride
Shift up or down of all rates market-timing (shortening
and lengthening of duration)
2. Changes in shape of the discount curve

3. Changes in yield spreads (e.g. Corporate Treasury yields)

NB: For these strategies it is important to design portfolios that will
benefit if the expected change takes place but will be largely immune
to other changes

Term Structure of Interest

YTM

maturity

Yield to Maturity (YTM)

YTM = internal rate of return if you hold the bond to maturity
Yield as carry:
Simple carry = return if the yield on this bond stays the same = YTM holding period
YTM

Yield on this bond

maturity

Riding the Yield Curve

Riding the yield curve is a technique that xed-income portfolio
managers traditionally use in order to enhance returns.
When the yield curve is upward sloping and is supposed to remain
unchanged, it enables an investor to earn a higher rate of return by
purchasing xed-income securities with maturities longer than the
desired holding period, and selling them to prot from falling bond
yields as maturities decrease over time.
We give below an example of riding the yield curve.

Riding the Yield Curve

We consider at time t = 0 the following zero-coupon curve and ve bonds
with the same $1,000,000 nominal value and a 6% annual coupon rate.
The prices of these bonds are given at time t = 0 and 1 year later at time t
= 1, assuming that the zero-coupon yield curve has remained stable (see
table below).

What happens if the portfolio manager buys the 5-year bond at time 0 and
sell it one year later?

Riding the Yield Curve

A portfolio manager who has $1,020,770 cash at disposal for 1 year buys 1
unit of the 5-year bond at a market price of 102.077%, and sells it 1 year
later at a price of 102.848%. The total return, denoted by TR, of the buyand-sell strategy is given by the following formula:
Return

102.848 6
102.077

1 6.633%

Over the same period, the 1-year investment (i.e. 1-year zero coupon)
would generate a return of 3.9%. Thus the surplus profit = 2.7333%
Of course, the calculation is based on the assumption that future interest
rates are unchanged. If rates had risen, then the investment would have
returned less than 6.633% and might even have returned a loss
Reciprocally, the steeper the curves slope at the outset, the lower the
interest rates when the position is liquidated, and the higher the return on
the strategy.

Fixed Income Arbitrage

Relative value among fixed-income securities to
exploit price differences
Examples
On-the-run vs. off-the-run Treasuries
Swap spreads
Others: Mortgage trades, volatility trades, etc.

Trading on fixed income arbitrage is like picking up

nickels in front of a steamroller

On-the-Run vs. Off-the-Run

On-the-run Treasuries:
New issued securities
Most liquid, i.e. easy to buy and sell at low
transaction costs
Easy to fund: special repo rate

Off-the-run Treasuries
Old securities
Worse market and funding liquidity
As a result, often cheaper

On-the-Run vs. Off-the-Run

Typical trade:
Buy the cheap off-the-run Treasury
Sell short the expensive on-the-run

Reversing the trade:

Short the off-the-run, long to on-the-run
Betting that their yield-spread will widen is the
near term

Time Series of On-the-Run vs. Off-theRun Spread

Spread of on-the-run vs. off-the-run 10-year U.S.
Treasuries:

Swap Spreads
Swap spread
The difference between the YTM on the Treasury and the fixed
rate of the comparable maturity swap
SS = YTMswap YTMTreasury

If the swap spread will narrow in the near/medium term

then:
long swap, short Treasury

If the swap spread will be wider in the near/medium term

then:
sell swap, buy Treasury

Swap and Treasury Curves: October

2004

30

Swap and Treasury Curves: September

28, 2006

31

Swap and Treasury Curves: October 2,

2008

32

Swap and Treasury Curves: October 5,

2010

33

Summary
Fixed income strategies can be classified as passive and active
strategies
Passive strategies do not involve any views about the
evolution of the interest rates. Passive managers simply track
a benchmark portfolio or match their investments with their
liabilities
Active managers aim to generate higher returns from their
views. Strategies such as riding the yield curve, off/on-the-run
trading and swap spreads are examples of active bond
strategies