BOND

PORTFOLIO MANAGEMENT STRATEGIES

1. Passive Portfolio Strategy
- letting market forces prevail
- not exerting effort
Buy and Hold
- A manager selects a portfolio based on objectives and constraints of client with the intent
of holding these bonds to maturity
- Two prominent strategies under this approach are the laddered & barbell strategies
Indexing
- The objective is to construct a portfolio of bonds that will equal the performance of a
specified bond index (benchmarking)

Classic Passive Management Strategies

Laddered- distributes fixed income dollars throughout the yield curve
- tranches
Barbell- differs from laddered strategy in that less investment is made in middle securities
Credit barbell- contains mix of high grade and low grade securities

THE RISKS OF BARBELL AND LADDERS
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Rising Interest Rate Falling Interest Rate
Interest rate risk Barbell favored Ladder favored
Reinvestment rate risk Barbell favored Ladder favored

o Yield curve inversion: short term rates are rising faster than long term rates
- duration as a pure measure of interest rate risk only works for parallel shifts in the yield
curve

2. Active Management Strategies
Interest-rate anticipation
Risky strategy relying on uncertain forecasts of future interest rates, adjusting portfolio
duration
Ladder strategy staggers maturities
Barbell strategy splits funds between short duration and long duration securities
Valuation analysis
A form of fundamental analysis, this strategy selects bonds that are thought to be priced below
their estimated intrinsic value
Credit analysis
Determines expected changes in default risk
Try to predict rating changes and trade accordingly
Buy bonds with expected upgrades
Sell bonds with expected downgrades
Credit analysis models such as Altmans Z-score model may be useful for predicting changes in
ratings
High yield bonds may warrant special attention
Yield-spread analysis
Monitor spread within and across sectors, bond ratings, or industries
 Trade in anticipation of changing spreads
Bond swaps
Liquidating a current position and simultaneously buying a different issue with similar
attributes but having
Swaps to increase current yield or YTM, take advantage of shifts in interest rates or
realignment of yield spreads, improve quality of portfolio, or for tax purposes
Pure yield pickup swap: Swapping low-coupon bonds into higher coupon bonds
Substitution swap: Swapping a seemingly identical bond for one that is currently thought to be
undervalued
Tax swap: Swap in order to manage tax liability (taxable & munis)
Swap strategies and market-efficiency: Bond swaps by their nature suggest market inefficiency

INTEREST RATE DERIVATIVE INSTRUMENTS
Futures and Forward- marked to market

Forward Rate Agreement
- difference between the FRA rate and reference rate as a percentage of the notional sum,
paid by one party to another on the settlement date
`


+

where:
A- agreed rate
S- spot rate (?)

Example:
J.P Morgan sells 3 against 12 FRA for 1M at annualized rate of 4.75%. Three months after the
sale, interest rate have the following term structure.
Maturity (months) Rate (%)
3 4
6 4.5
9 5
12 5.5

Solution:

.!. ( )
, ,
= $1,807.23
(!.)( )

Cheapest to Deliver
highest implied repo rate; lowest cost bond among possible bond delivery options that can be used
to satisfy the short position contractual obligations on a bond futures contract, minimizes the
difference between the cost to acquire the bond less the proceeds from delivery bond
Repo rate: rate at which reserve banks lend to its clients generally against government securities.
The cheapest-to-deliver bond is the one for which
Quoted Price Futures Price Conversion Factor
is least.



Example:
The sample quoted futures price is 114:26. Which of the following 3 bonds is cheapest to deliver?

Bond Price Conversion factor
1 162:20 1.3987
2 138:31 1.2820
3 131:02 1.1273


Solution:
Bond 1= 162.625 114.8125 1.3987 = 2.0368
Bond 2= 138.96875 114.8125 1.2820 = 8.2209
Bond 3= 131.0624 114.8125 1.1273= 1.6343
*Bond 3 is the cheapest to deliver

Bond swaps

Example:
Your currently hold a 10 year, 7 percent coupon bond priced to yield 8 percent. As a swap
candidate you are considering a 10 year; 8 percent coupon bond priced to yield 9 percent. Assume
a reinvestment rate of 9 percent, semiannual compounding, and a one year workout period.

Current Bond Candidate Bond
Dollar investment 932.05 934.96
Coupon 70 80
Interest on One coupon 1.575 ?
(9% for 6 months)
Principal value at year end 936.70 ?
Total accrued 1008.28 ?
Realized Compound Yield= 8.018% ?

To get dollar investment:

%
+ ( + )!
= + = $.
% %
( + )
% !
+ ( + )
= + = $.
% %
( + )

Coupon:
= % = $
= % = $
Interest on One Coupon:
%
= = .


%
= = .

Principal Value at year end:

% !
+ +
= + = $.
% %
+

!
%
+ +
= + = $.
% %
+

Total accrued:
= . + + . = $, .
= . + + . = $, .
Current Bond:
$, . $.
= = .
$.
= ( + . )/ ) = . /. %

Candidate Bond:
$, . $.
= = .
$.
= ( + . )/ ) = . /%


* The value of the swap is 98.2 bps (9-8.018)*100

Core Plus Bond Portfolio Management
A combination approach of passive and active bond management styles
A large, significant part of the portfolio is passively managed in one of two sectors:
The U.S. aggregate sector, which includes mortgage-backed and asset-backed securities
The U.S. Government/Corporate sector alone
The rest of the portfolio is actively managed
Often focused on high yield bonds, foreign bonds, emerging market debt
Diversification effects help to manage risks

Matched Funding Management Strategies
- goal is simply to increase wealth of their overall portfolios while providing risk
diversification benefits across asset classes
- form of asset liability management whereby the characteristics of the bonds that are held
in the portfolio are coordinated with those of the liabilities the investor is obligated to
pay
- investors liabilities are predictable with some degree of precision
Dedicated Portfolios
- used to service a prescribed set of liabilities
Two alternatives:
Pure cash-matched dedicated portfolio: most conservative strategy
- objective is to develop a portfolio of bonds that will provide a stream of payments from
coupons, sinking funds, and maturing principal payments that exactly match the specified
liability schedule
 - example: pension system- the goal is to build a portfolio that will generate sufficient
funds in advance of each scheduled payment
Dedication with reinvestment: similar to pure cash matched technique except it allows
that the bonds and other cash flows do not have to exactly match the liability stream
- any inflow that precede liability claims can be reinvested at some reasonably
conservative rate

Bond Immunization
- instead of using dedicated portfolio technique, manager may decide to protect portfolio
from interest rate changes through immunization
- attempts to derive a specified rate of return (generally close to the current market rate)
during a given investment horizon, regardless of what happens to the future level of
interest rates)
- Immunize a portfolio from interest rate risk by keeping the portfolio duration equal to
the investment horizon
Duration strategy superior to a strategy based only a maturity since duration
considers both sources of interest rate risk

Components:
Net price risk
Duration> Investment Horizon
Net reinvestment risk
Duration < Investment Horizon

*Duration= Investment Horizon ( immuned)

If the term structure of interest rates were flat and market rates never changed between the time of
purchase and horizon date when funds were required, yor wealth postion would be:

Example:
Assume you acquire a 10-year, $1 million bond with an 8 percent coupon at its par value. If the
yield curve was flat with no changes, your wealth position at the end of your 10-year investment
horizon would be:

Solution:
$, , (+. ) = $, ,