chapter 4 portfolio management of bonds viewing recommendations for windows: use the arial truetype...
TRANSCRIPT
Chapter 4
Portfolio Management of Bonds
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Major Sectors of U.S. Dollar Bond Market
As % of total nominal value outstanding at year-end 2000 $16,192 billion
Source: Federal Reserve Flow of Funds; Salomon Smith Barney
Corporate28%
US government21%Mortgage-
backed15%
Other government
agencies11%
Foreign10%
Municipal10%
Asset-backed5%
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Basic Characteristics of Bonds
• Stated characteristics of par value, coupon maturity, and optional features (if any) are all related to current price
• An example: bond with 5 years remaining to maturity; paying 6% annual coupon on par (face) value of $1,000
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End of Period
Year 1 Year 2 Year 3 Year 4 Year 5
Interest (coupon) payment
$60 $60 $60 $60 $60
Principal repayment
$1000
Current price
Basic Characteristics of Bonds (cont.)
• Cash flows
Discounted at effective yield (YTM)
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Yield (rates)
Bond Prices
Bonds: Relationship Between Yield and Price
• There is an inverse relationship between yield and price
• Value of the bond today– Depends on the interest rate (yield) used to discount each
year’s cash flows back to the present– Will change as the yield demanded by investors changes
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• Yield required increases as risks increase– In general
bond yield = risk-free yield + risk premium= treasury yield + yield (risk)
spread
Yield Spreads
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4.13
10.33
4.35
11.10
5.00
25.00
0
5
10
15
20
25
30
5-year bonds 25-year bonds
9% coupon bond
6% coupon bond
Zero coupon bond
Calculated Duration
(stated maturity) (stated maturity)
Duration as a Measureof Comparability
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Risks of Bond Investment
• Market risk– Addresses inverse relationship between interest
rates and bond prices
• Reinvestment risk– Relates to variability in bond returns that result
from fluctuations in the interest rate at which interim cash flows are invested
• Credit risk– Threat that the issuer of a bond may default
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Risks of Bond Investment (cont.)
• Call risk
– Relates to risk an investor faces when buying a bond with an embedded call option attached
• Event risk
– Involves circumstances unforeseen at the time of purchase that can have a large adverse effect on bond prices
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Passive versus Active Investment Strategies
• Passive management
– Buy and hold: objective is to achieve a specific return
– Indexing: objective is to match the performance of the bond market
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Passive versus Active Investment Strategies (cont.)
• Active management– Objective is to beat the return of the
market, defined as• A market index and/or• A competitive universe of funds with similar
objectives
– Portfolio manager is buying and selling securities based on his or her expectations about interest rates, credit risks, etc.
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Impact Chance of Success
Duration management (Interest rate anticipation)
High Low
Yield curve positioning
Sector analysis
Issuer credit selection Low High
*Other strategies include: using credit derivatives to manage credit risk, predicting prepayments, and using option adjusted spreads
Major Fixed Income Investment Strategies*
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• If managers anticipate a rise in rates, they may “shorten the maturity” of the bond fund– Long maturity bonds are very price sensitive to changes in rates– Holding shorter maturity bonds reduces the amount that the
fund’s price may fall if rates increase– Examples
Interest Rate Anticipation: Rising Rates
ratesmaturity length
bond price
bond price
ratesmaturity length
Longer Maturity Bond Shorter Maturity Bond
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Shorter Maturity Bond Longer Maturity Bond
• If managers anticipate a fall in rates, they may “lengthen the maturity” of the bond fund– Long maturity bonds are very price sensitive to changes in rates– Holding longer maturity bonds increases the amount that the
fund’s price may rise if rates decrease– Examples
Interest Rate Anticipation: Falling Rates
ratesmaturity length
bond price
rates
bond price
maturity length
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Prospective Total Return of Municipal Bonds Insured Revenue, Horizon = 365 days
Duration
0%
1%
2%
3%
4%
5%
6%
1 3 5 7 9 11 13
Yield
6-year maturity
12-year maturity
Yield Curve Example
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Sector Exposure Example
Sector Fund Index Difference
Corporates 10.1% 21.6% –11.5%
Mortgages 18.4% 4.8% 13.6%
Asset-backed securities
8.9% 1.4% 7.5%
Treasuries 32.4% 43.0% –10.6%
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BKB = Bank of BostonROA = return on assetsNPA = non-performing assetsOREO = other real estate owned
Issuer CreditAnalysis Example
CREDIT SUMMARY NOTE
Credit Comment
Continued improvements. BKB posted an ROA of .89% (.97% excl. a $16.4MM restructuring charge) compared with .76% in 2Q93. NPAs are down to 2.76% of loans and OREO from 3.06 YE93.
Sector Issuer Analyst Agency Rating Date
Bank Bank ofBoston
MWO Moody Baa1 8/22/xx
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A Manager’s Steps in the Investment Process
1. Understand the fund’s objective and compliance requirements
2. Develop a fund strategy
3. Work with analysts and traders to find value (e.g., individual security selection)
4. Review liquidity, risk, diversification requirements
5. Execute portfolio transactions
6. Evaluate performance attribution; return to step 2
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Other Key Players in Bond Fund Management
• Credit analyst– Actively analyzes financial condition of issuers
– Utilizes ratio analysis
– Determines the credit risk/return profile of bond issuers
– Note: some differences in corporate versus municipal analysts
• Quantitative analyst– Builds mathematical models to help identify potential
opportunities
– Examines analytical building blocks of bonds
– Produces valuation and risk parameters
– Quantifies and rewards of strategies under various scenarios