Transcript Presentation Title Goes Here with room for three lines of text if

FIXED-INCOME PORTFOLIO
MANAGEMENT—PART II
CHAPTER 12
© 2016 CFA Institute. All rights reserved.
TABLE OF CONTENTS
06 OTHER FIXED-INCOME STRATEGIES
07 INTERNATIONAL BOND INVESTING
08 SELECTING A FIXED-INCOME MANAGER
09 SUMMARY
2
6. OTHER FIXED-INCOME STRATEGIES
• Frequently, a manager is permitted to use leverage as a
tool to help increase the portfolio’s return.
Example: Assume that a manager has $40 million of funds to
invest. The manager then borrows an additional $100 million at
4% interest. All of the funds can be invested at a 4.5% rate of
return. Calculate the returns on the portfolio’s components:
Borrowed Funds
Amount invested
Equity Funds
$100,000,000
$40,000,000
Rate of return at 4.5%
4,500,000
1,800,000
Less interest expense at 4%
4,000,000
0
500,000
1,800,000
Net profitability
3
OTHER FIXED-INCOME STRATEGIES
Example (continued).
• Rate of return on borrowed funds
$500,000
= 𝟎. 𝟓𝟎%
$100,000,000
• Rate of return on equity funds (without leverage)
$1,800,000
= 𝟒. 𝟓𝟎%
$40,000,000
• Rate of return on equity funds (with leverage)
$1,800,000 + $500,000
= 𝟓. 𝟕𝟓%
$40,000,000
The return on equity increased by 1.25% with leverage. The larger the
amount of borrowed funds, the larger the magnification will be (positive
or negative).
4
LEVERAGE
• If E = amount of equity; B = amount of borrowed funds; k = cost
of borrowing; rF = return on funds invested; and RB, RE, and RP
are returns on borrowed funds, equity, and portfolio, then:
𝑹𝑩 = 𝒓𝑭 − 𝒌
𝑹𝑬 = 𝒓𝑭
𝑹𝑷 = 𝒓𝑭 + 𝑩 𝑬 × (𝒓𝑭 − 𝒌)
• The duration of the levered equity portfolio is:
𝑫𝑨 𝑨 − 𝑫𝑳 𝑳
𝑫𝑬 =
𝑬
where A = assets (bond portfolio); L = liabilities (borrowed funds);
and DA, DL, and DE = durations of assets, liabilities, and equity.
5
REPURCHASE AGREEMENTS
Among investment managers’ favorite instruments to increase
the leverage of their portfolios is the repo.
A repurchase agreement is a contract involving the sale of such
securities as Treasury instruments coupled with an agreement to
repurchase the same securities on a later date.
The repo market presents a low-cost way for managers to
borrow funds by providing Treasury securities as collateral.
The repo agreements typically have short terms to maturity.
6
REPURCHASE AGREEMENTS
Quality of
the
collateral
Seasonal
factors
Prevailing
interest
rates in the
economy
Term of the
repo
A variety of
factors will
affect the repo
rate, including:
Delivery
requirement
Availability
of collateral
7
PORTFOLIO RISK MEASURES
Portfolio risk can be described by the following statistical
measures:
Standard
deviation
measures the dispersion of data from its
mean, assuming a normal distribution.
Semi
variance
measures the dispersion of return
outcomes that are below the target return.
Shortfall
risk
is the probability of not achieving some
specified return target.
Value at
risk (VAR)
is an estimate of the $ loss that the
portfolio manager expects to be
exceeded with a given level of
probability over a specified time period.
8
PORTFOLIO RISK MEASURES
The deficiencies of the statistical measures are:
Standard
deviation
• has an unrealistic assumption of a normal
distribution of returns, especially for portfolios
having securities with embedded options.
Semivariance
• is computationally challenging for large
portfolios, adds no value for the symmetric
returns, is difficult to forecast for asymmetric
returns, and uses only half of observations,
which reduces its statistical accuracy.
Shortfall risk
• does not account for the magnitude of losses
in money terms.
VAR
• does not indicate the magnitude of the very
worst possible outcomes.
9
INTEREST RATE FUTURES
• A futures contract is a contract between a buyer (seller)
and an established exchange or its clearinghouse in which
the buyer (seller) agrees to take (make) delivery of the
underlying asset at a specified price at the specified time.
• There are a number of advantages to using futures
contracts rather than the cash markets for purposes of
portfolio duration control:
+
• Liquidity and cost-effectiveness
• Shorting (selling) the contract for effective
duration reduction
10
DURATION MANAGEMENT
A portfolio’s dollar duration can be changed with futures contracts
so that it equals a specific target duration.
Portfolio’s target
dollar duration
Dollar duration of
futures
Current portfolio’s
dollar duration
without futures
Dollar duration of
each futures
contract
Dollar duration of
the futures
contracts
Number of
futures contracts
(𝐷𝑇 −𝐷𝐼 )𝑃𝐼
alternatively,
Dollar duration per futures contract
𝐷𝑇 −𝐷𝐼 𝑃𝐼
× Conversion factor for the CTD bond
𝐷𝐶𝑇𝐷 𝑃𝐶𝑇𝐷
𝑵𝑭 ≈
𝑵𝑭 ≈
where DT, DI, and DCTD = target, initial, and cheapest-to-deliver (CTD)
bond durations; PT and PCTD = market value of the portfolio and the price
of the CTD bond.
11
DURATION MEASUREMENT WITH FUTURES
Example: The market value of a UK pension fund’s bond
portfolio is £50 million. The portfolio’s duration is 9.52.
Expecting an increase in interest rates, the pension fund
decided to reduce duration to 7.5 by using a futures contract
priced at £0.1 million that has a duration of 8.47. Assume a
conversion factor of 1.1. Calculate the number of contracts
required for the change in duration.
7.5 − 9.52 × 50,000,000
𝑁𝐹 ≈
× 1.1 = −𝟏𝟑𝟏. 𝟕
8.47 × 100,000
The pension fund would need to sell 131 futures contracts.
12
DURATION HEDGING
• Hedging with futures contracts involves taking a futures
position that offsets an existing interest rate exposure.
The key to minimizing risk in a cross hedge is to choose the right
hedge ratio.
𝐇𝐞𝐝𝐠𝐞 𝐫𝐚𝐭𝐢𝐨 =
𝐇𝐞𝐝𝐠𝐞 𝐫𝐚𝐭𝐢𝐨 =
Factor exposure to be hedged
Factor exposure of futures contract
𝐷𝐻 𝑃𝐻
𝐷𝐶𝑇𝐷 𝑃𝐶𝑇𝐷
alternatively,
× Conversion factor for the CTD bond
where DH and PH = duration and price of the bond to be hedged.
13
DURATION HEDGING
A hedger can use regression analysis to capture the
relationship between yield levels and yield spreads.
Yield on bond to be hedged = a + b(Yield on CTD bond) + Error term
where the estimate of b, called the yield beta, is the expected
relative change in the two bonds.
The hedge ratio with yield beta is
𝑯𝑹 =
𝐷𝐻 𝑃𝐻
𝐷𝐶𝑇𝐷 𝑃𝐶𝑇𝐷
× Conversion factor for the CTD bond × Yield beta
14
INTEREST RATE SWAPS
An interest rate swap can be used to alter the
cash flow characteristics of an institution’s
assets or liabilities so as to provide a better
match between assets and liabilities.
An interest rate swap is a contract between
two parties to exchange periodic interest
payments based on a specified dollar amount
of principal.
The traditional swap has one party making
periodic payments at a fixed rate in return for
the counterparty making periodic payments
based on a benchmark floating rate.
For a floating-rate payer, the dollar duration (DD) of a swap is:
𝐃𝐃 𝐬𝐰𝐚𝐩 = DD fixed rate bond − DD floating rate bond
15
BOND AND INTEREST RATE OPTIONS
Options can be used to hedge a bond portfolio.
Options on futures give the buyer the right to buy
from or sell to the writer a designated futures
contract at the strike price at a specified time
during the life of the option.
The price of a bond option will depend on the
price of the underlying instrument, which
depends in turn on the interest rate on the
underlying instrument.
The duration of an option (Do) is:
𝑫𝒐 = δ × 𝐷𝑢 ×
𝑃𝑢
𝑃𝑜
where Du and Pu = duration and the price of the underlying; δ
and Po = delta and the price of the option.
16
HEDGING WITH OPTIONS
There are two hedging strategies in which options are
used to protect against a rise in interest rates:
Protective put buying
establishes a minimum value for
the portfolio but allows the
manager to benefit from a decline
in rates.
In covered call writing,
the covered call writer sells outof-the-money calls against an
existing bond portfolio to generate
premium income that provides
partial protection in case rates
increase.
Interest rate caps and floors can assist in setting the ceiling
and the floor for short-term borrowing rates.
17
CREDIT RISK INSTRUMENTS
Derivatives can help with hedging credit risks.
• There are three types of credit risk:
Default risk is the risk that the issuer may fail to meet its
obligations.
Credit spread risk is the risk that the spread between
the rate for a risky bond and the rate for a default riskfree bond (like US Treasury securities) may vary after
the purchase.
Downgrade risk is the risk that one of the major rating
agencies will lower its rating for an issuer based on its
specified rating criteria.
18
CREDIT OPTIONS
• There are variety of credit derivatives, including the following:
Credit
options
• The triggering events of credit options can be based
either on: (1) the value decline of the underlying asset or
(2) the spread change over a risk-free rate.
• For the latter, the credit spread option can be used.
Credit spread options are call options in which the payoff
is based on the spread over a benchmark rate. The
payoff (for a call option) is:
𝐏𝐚𝐲𝐨𝐟𝐟 = Max Spread at maturity − 𝐾 × 𝑁 × 𝑅𝐹, 0
Credit
forward
• The buyer of a credit forward contract benefits from a
widening credit spread, and the seller benefits from a
narrowing credit spread. Payoff for the buyer is:
𝐏𝐚𝐲𝐨𝐟𝐟 = Spread at maturity − Contracted credit spread × 𝑁 × 𝑅𝐹
where N = notional amount; RF = risk factor; K = strike spread.
19
CREDIT OPTIONS
- Credit swaps. A number of different products can be classified
as credit swaps. The credit default swap is the most popular.
- A credit default swap is a contract that shifts credit exposure of
an asset issued by a specified reference entity from one
investor (protection buyer) to another investor (protection
seller).
- The protection buyer usually makes regular payments — the
swap premium payments (default swap spread) — to the
protection seller.
Swap premium
Protection buyer
Payment on credit event
Protection seller
20
7. INTERNATIONAL BOND INVESTING
• The motivation for international bond investing (i.e., investing in
nondomestic bonds) includes portfolio risk reduction and return
enhancement.
The opportunities for active
management are created by
inefficiencies that may be
attributed to the following:
• Differences in tax treatment
• Local regulations and
coverage by fixed-income
analysts
• Differences in how market
players respond to similar
information
The active manager seeks to
exploit those inefficiencies through
the following:
• Superior bond market selection
• Currency selection
• Duration management/yield
curve management
• Sector selection
• Credit analysis of issuers
• Investing outside the benchmark
index
21
RELATIONSHIP BETWEEN DURATION OF
FOREIGN BOND AND INVESTOR’S PORTFOLIO
• Thomas and Willner (1997) suggested the following
methodology for computing the contribution of a foreign
bond’s duration to the duration of a portfolio:
∆ 𝑽𝑭𝑩 = −Duration × ∆Yield𝐹 × 100 or
∆ 𝑽𝑭𝑩 = −Duration × ∆Yield𝐹 given ∆Yield𝐷 × 100
The relationship between ∆𝐘𝐢𝐞𝐥𝐝𝑭 and ∆𝐘𝐢𝐞𝐥𝐝𝑫 is estimated
∆𝐘𝐢𝐞𝐥𝐝𝑭,𝒕 = α + β∆Yield𝐷,𝑡
where ∆ 𝑽𝑭𝑩 = change in value of the foreign bond; ∆𝐘𝐢𝐞𝐥𝐝𝑭,𝒕 and
∆𝐘𝐢𝐞𝐥𝐝𝑫,𝒕 = changes in values of foreign and domestic yields at
time t; 𝛃 = correlation (∆Yield𝐹,𝑡 , ∆Yield𝐷,𝑡 ) × σ𝐹 /σ𝐷 .
22
CURRENCY RISK
Every investor in foreign markets can either remain exposed
to this currency risk or hedge it.
- Unhedged return is equal to:
𝑹 ≈ 𝒓𝒍 + 𝒆
- Hedged return is equal to:
𝑯𝑹 ≈ 𝒓𝒍 + 𝒇 ≈ 𝒓𝒍 + 𝒊𝒅 − 𝒊𝒇 = 𝒊𝒅 + (𝒓𝒍 − 𝒊𝒇 )
where 𝒓𝒍 = local currency return of the foreign bond; 𝒆 = the
currency return; 𝒊𝒅 and 𝒊𝒇 = domestic and foreign risk-free rate.
23
BREAKEVEN SPREAD ANALYSIS
Breakeven spread
analysis can be used to
quantify the amount of
spread widening required
to diminish a foreign yield
advantage.
The breakeven spread
widening analysis must
be associated with an
investment horizon (e.g.,
3 months) and must be
based on the higher of
the two countries’
durations.
Duration plays an
important role in
breakeven spread
analysis.
The analysis ignores the
impact of currency
movements.
24
EMERGING MARKET DEBT
• Emerging market debt (EMD) includes sovereign bonds
as well as debt securities issued by public and private
companies in those countries.
• Recently, emerging market debt has matured as an asset
class and now frequently appears in many strategic asset
allocations because of:
• High return potential
• Favorable diversification properties
25
EMERGING MARKET DEBT
Risks do exist in the EMD sector:
• Volatility in the EMD market is high.
• EMD returns are frequently characterized by significant
negative skewness.
• The EMD market does not offer the degree of transparency,
court-tested laws, and clear regulations found in established
markets.
• There is less protection from interference by the governments.
• Emerging countries tend to over borrow.
• Recovery against sovereign states can be very difficult.
• There is little standardization of covenants.
26
8. SELECTING A FIXED-INCOME MANAGER
• When funds are not managed entirely in-house, a search for outside
managers must be conducted.
• The due diligence for selection of managers is satisfied primarily by
investigating the following:
• Managers’ investment process
• Types of trades the managers are making
• Managers’ organizational strengths and
weaknesses.
• The aim is to find managers who can produce consistent positive styleadjusted alphas.
• Then, a combination of managers is optimized based on their styles
and exposures.
27
9. SUMMARY
Effect of leverage on duration and investment returns
• Leverage has a magnifying effect on a portfolio’s risk and
return.
Repurchase agreements
• The repurchase agreements market is an important and
cost-effective source of funds to finance bond purchases.
• Factors affecting the repo rate are quality of the collateral,
term of the repo, delivery requirement, availability of
collateral, prevailing interest rates in the economy, and
seasonal factors.
Statistical measures of fixed-income portfolio risk
• Standard deviation, target semivariance, shortfall risk, and
value at risk have all been proposed as appropriate
measures of risk for a portfolio. However, each has its own
deficiency.
28
SUMMARY
Advantages of using futures
• The primary advantages to using futures to alter a portfolio’s
duration are increased liquidity and cost-effectiveness.
Immunization strategy based on interest rate futures
• Futures contracts can be used to shorten or lengthen a
portfolio’s duration.
• The contracts may also be used to hedge or reduce an
existing interest rate exposure.
Use of interest rate swaps and options
• Interest rate swaps and options can also be used to hedge
interest rate risk.
• Swaps are flexible and cost-effective instruments.
29
SUMMARY
Use of credit derivative instruments
• Credit options are structured to offer protection against both
default risk and credit spread risk; credit forwards offer
protection against credit spread risk; and credit default
swaps help in managing default risk.
Sources of excess return for an international bond
portfolio
• The sources of excess return for an international bond
portfolio include bond market selection, currency selection,
duration management/yield curve management, sector
selection, credit analysis, and investing in markets outside
the benchmark index.
30
SUMMARY
Effect of change in value for a foreign bond
• For a change in domestic interest rates, the change in a
foreign bond’s value may be found by multiplying the
duration of the foreign bond times the country beta.
• Because a portfolio’s duration is a weighted average of the
duration of the bonds in the portfolio, the contribution to the
portfolio’s duration is equal to the adjusted foreign bond
duration multiplied by its weight in the portfolio.
Hedging of a currency risk
• The decision about how much currency risk to hedge—from
none to all—is important because currency movements can
have a dramatic effect on the investor’s return from
international bond holdings.
31
SUMMARY
Breakeven spread analysis
• Breakeven spread analysis is used to estimate relative
values between markets by quantifying the amount of
spread widening required to reduce a foreign bond’s yield
advantage to zero.
Advantages and risks of investing in emerging market debt
• The quality of sovereign bonds has increased to the point
that they now have similar frequencies of default, recovery
rates, and ratings transition probabilities compared with
corporate bonds with similar ratings.
• Emerging market debt is still risky, however, and is
characterized by high volatility and returns that exhibit
significant negative skewness. Moreover, emerging market
countries frequently do not offer the degree of transparency,
court-tested laws, and clear regulations found in established
markets.
32
SUMMARY
Criteria for selecting a fixed-income manager
• When funds are not managed entirely in-house, a search for
outside managers must be conducted.
• The due diligence for selection of managers is satisfied
primarily by investigating the managers’ investment process,
the types of trades the managers are making, and their
organizational strengths.
33