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CFA Level 3 Fixed Income
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CFA Level 3 Fixed Income
Fixed Income 2
Using Leverage to enhance returns
Repurchasing agreements (Repo or RP)
The logic behind a PM doing this is that inhopes of capturing a higher return than theborrowing cost.
Dealers are the individuals we would lendour security to and who would provide usthe funds to lever up.
The 6 factors that
a more attractive/lower rates for
repos.
Physical delivery
Seasonal factors affecting supply &demand
Demand for the underlying security
Term to maturity
Transfer of Securities
Using Derivatives to manage risksassociated with bond portfolio management
Derivative enabled strategies
Interest rate futures
When to buy vs. sell interest rate futurescontracts.
Think of this as a form of increasing risk ordecreasing risk. If rates go up you want tolower risk by selling interest rate futures.
Advantages of using interest rate futures vs.using cash market. (aka outright buying andselling bonds)
Interest Rate Swaps
How to alter duration (interest rate risk) ofa portfolio using swaps.
Swap duration
Interest Rate Options
Bond Options and duration
CALL DURATION: is always positivebecause the delta is positive for Calls
PUT Duration: Is negative because delta'sare negative for puts.
Hedging with options
2 Hedging Strategies in which options areused to PROTECT against RISING interestrates.
Buy a Protective Put
Write a covered call.
You would not use this strategy if youbelieve rates are going to go up a lot. Rather this would be used if you believerates will remain stable.
Protect against REINVESTMENT risk if ratesDECLINE
Buy a Call option.
Write a put.
Structured Products
What to do based on interest rate outlook.
If not sure where rates will be.
If you believe rates will not move much ineither direction.
If you strongly believe rates will drop
If you strongly believe rates will increase
Credit Risk and 5 methods for managing
Credit Risk
Credit Derivatives
Credit Default "Swap"
Credit "Options"
Binary Credit Option
Credit Spread Options
Credit "Forward" Contract
Payoff for a "buyer" of a credit forward
contract.
Other risk meausres
Semivariance
Measures dispersion of returns below atarget return
Disadvantage
Shortfall Risk
It is appropriate for analyzing risk that is
not normally distributed.
Disadvantage
Measures only the "probability" of notachieving some specified return target.
VaR
Gives an estimated probability that losses
will exceed a certain level over a specifiedtime period.
Disadvantage
International Bond Investing
Which international bond to invest in?
Proxy Hedge
Currency Risk
Comparing Hedged Returns acrossmarkets BB
To hedge or not hedge (you'll notice thatall the examples say "assuming IRP holds") I don't think they give an example whereIRP does not hold. So don't worry/think tomuch about what IRP means.
Example 1 BB
Example 2 BB
Marlet is the French based investor
Jones is the UK based investor.
EOC FI 2
Which bond will have the highestHEDGED return assuming rates DON'Tchange?
Answer
Which bond will have the highest expectedUNHEDGED return?
Answer
Example from 2016 morning essay(scenario)
Question
Answer (notice there are 3 ways to arrive atan answer)
Do we pursue active or passivemanagement?
Active management decisions on where
value can be added.
Currency: To hedge currency risk or not.
Watch FI(2) video starting at 1:38:13 wherehe covers hedged and unhedged returnand draws out backwardation andcontango.
Duration: Foreign bond duration
contribution to portfolio and using Hedge
Ratio
Example:
Country Beta formula.
Example from 2017 CFA afternoon itemset. (Deals with a UK manager owningboth German & US bonds.
Country beta between US bond andGerman bond is .62.
Question
Answer
Within intl. bonds themselves, where doopportunities lie.
Yield Curve: Breakeven yield curve analysis.
Sector Selection: Govts, corporates...
Credit: ability to anticipate credit upgradesand downgrades.
Investing outside the bond benchmark.
Breakeven Spread Analysis
Sample BB
Sample EOC 22
Answer
Scenario
Question
Answer
Notice that when dividing the yieldadvantage by duration, the yld advantageis converted from .7375% to 73.75
Sample EOC 8
Question
Answer
Emerging Market Debt (Investing in)
Pro
Have access to IMF if they need moneywhich provides a secondary source ofliquidity.
They can react quickly to negative events
Cut spending or raise taxes and interestrates
Many possess large FX reserves.
Con
Returns exhibit negative skewness
Lack transparency and court tested lawsthat a developed country offers.
Less protected from political influence to aEMD investors disadvantage. (corruptgovt)
Analyzing EMD
Political Risk
Does the country have sound ways tocollect revenue via taxes. Export/Importfriendly.
Relative Value Methodologies
What is relative value analysis in the bondworld?
2 approaches to Global Credit bondportfolio Management (or acombination of both approaches)
TopDown
Goal: form views on largescale economicand industry developments.
Which then:
Macro picture drives asset allocationdecisions
Bottom Up
Goal: hope to outperform their benchmarkdue to superior security selection, whilemaintaining neutral weightings to thevarious sectors in the benchmark
Notice: they maintain neutral weightings tothe various sectors in the benchmark.
Find good bond investments based onprice of that issue relative to another peerbonds issue.
"Classic Relative Value Analysis" combinesboth bottom up and top down approaches.
9 Methods to add value using RelativeValue approach (RV Methodologies)during the portfolio constructionprocess.
Total Return Analysis
Primary Market Analysis
New Issues coming to market causesecondary issue bond prices to go up (yldsdown) due to price validation from the newissues.
Secondary Trading rationales andconstraints analysis.
8 Common reasons to trade in thesecondary market.
Yield/spread pick up trade
Two bonds look the same yld but I found a3rd peer comparable bond that is offeringa slightly higher yld. all else being equal.
Credit Upside trade
Do not say anything about how lowercredit quality bonds are less sensitive tointerest rate movements. (it does not sayanything about this in the CFAI material)
Hoping that a lower credit quality bondgets upgraded.
Swapping out old issue and replacing with
new issue (New issue swap trades)
Industry/Sector rotation trade
Curve Adjustment trade
Forcasting rates to rise would favor PM'sswitching out of zero coupon bonds andinto relatively HIGH coupon paying bonds.
Structure Trade
Cash Flow reinvestment trades
Credit Defense trade
Trading constraints and the IPS
Portfolio Constraints.
Story Disagreement
Buy & Hold
Seasonality
Liquidity and Trading Analysis
less liquid securities offer a higher yld butincur higher costs as a result of illiquidity.
Large corporate bond issues will be moreliquid than small private placementissuances.
Spread Analysis
Mean Reversion Analysis Trades
Upon computing the results you say "XYZbond is the appropriate bond to purchasebecause its credit spread is the largestnumber of standard deviations above themean. It's spread is more likely to contractthan the spreads on the other two bonds".
Structural Analysis
Credit Curve Analysis
Credit Analysis
Asset Allocation/Sector Analysis
Relative Value
Relative Value Analysis
The Fixed Income Portfolio ManagementProcess
Fixed Income 1
Managing funds agains a liability usingALM
Dedication Strategies
Immunization
Strategies
(Classical) SinglePeriod Immunization
Not really used by pension plans since
you have employees retiring over various
years.
3 assumptions of Classical Immunization
These 3 assumptions need to hold in orderfor Classical Immunization to beconsidered effective as a "riskminimizing"strategy.
4 Extensions of Classical Immunizations that
address the nonrealistic assumptions of CI.
Multifunctional Duration
allows for non parallel shifts in yld curve
Multiple Liability Immunization
Allows for multiple time horizons.
Return Maximization for ImmunizedPortfolios
relaxes target return
Contingent Immunization
If rates rise
If rates rise high enough and dollar safetymargin goes to zero, active managementmust be stopped and assets must beimmunized immediately.
If rates fall
To minimize the risk that non parallel shiftsin the yield curve will have.
Immunized Return
Cushion Spread
Immunization for General Cash Flows
Hybrid of Immunization and Cash FlowMatching
Say a manager wants to immunize againstmultiple future liabilities but does not havethe "cash in hand" to pay those liabilities atthis point. He could consider usingImmunization for General Cash Flowstrategy.
Cash Flow Matching Strategy
Structuring Cash Flows of assets/portfolio tomatch up with liability Cash Flows.
Work backwards when matching cash flowpayments to liability payments.
Limitations of Cash Flow Matching
Extensions of CF Matching
Symmetric Cash Flow Matching
Combination Matching/Horizon Matching
Contrasting an Immunization strategy to aCash Flow Matching strategy
Applying any dedication strategy, a PM isconcerned with:
Universe Selection
Optimization
Monitoring
Transaction Costs
Classes of Liabilities
Principal Repayment: Amount & Timing ofLiability are known
Life Insurance payment: Known amount butunknown timing.
Floating rate annuity payout: Unknownamount but known timing liability
Postretirement health care benefits:Unknown timing & amount of liability.
Rebalance ratio
Managing Funds against a bond marketindex
Classification of Fixed Income
Strategies
Passive Strategies
Indexing: Pure & Enhanced
Pure Bond Indexing (full replication)
Bad:
Goal:
Enhanced Indexing by small risk factors
Goal:
Small mismatch/tilt with 1) sectors 2)quality 3) maturity
Mismatches are small and intended tosimply enhance return/risk profile enoughto overcome the difference in admin. costsbetween the portfolio and index.
Enhanced Indexing by matching primary
risk factors.
Uses sampling to attempt match primaryrisk factors. Tries to achieve higher returnthan pure indexing.
Reduces construction cost when comparedto Full Replication
By matching primary risk factors theportfolio is affected by broad marketmoving events.
Matching primary risk factors is done bystratified sampling
Primary Risk factors are Changes in int.
rate levels, twists in yld. curve, changes in
spreads to the same degree as the index.
3 Techniques to align Risk Exposure withBond Index
Full Replication
Purest form of indexing
Cons
Stratified Sampling
Done to reflect the "risk factors" of theindex.
taking account of each cells relativeimportance to the index.
Multifactor Model
7 important PRIMARY RISK FACTORS thata manager will focus on. (In order to keepTRACKING RISK as low as possible)
Duration/Effective Duration (measuresSMALL Parallel Shifts aka Interest RateRisk)
As it relates to TRACKING RISK
Deals with Parallel Shifts
aka Interest Rate Risk
Duration only measures SMALL interestrate shifts. For larger shifts, apply aConvexity Adjustment.
Key Rate duration & PV distribution of cashflows. Measures NON PARALLEL shifts(Yield Curve RISK)
As it relates to TRACKING RISK
Deals with Non Parallel Shifts
aka Yield Curve Risk
BIGGEST Realistic Risk to a bondmanagers portfolio is Yld Curve Risk
Key Rate Duration approach
Analyze interest rate affect on one KEY ratematurity at a time holding all othermaturities constant.
Particularly effective with Barbell & bulletStrategies
PV of distribution of Cash Flows approach
Sector and quality percent (weighting)
As it relates to TRACKING RISK
Sector would be like MBS
Credit Quality would be like AA bonds
"Sector" Duration Contribution
As it relates to TRACKING RISK
"Quality Spread" Duration Contribution
As it relates to TRACKING RISK
Sector/Coupon/Maturity cell weights
As it relates to TRACKING RISK
Issuer Exposure
As it relates to TRACKING RISK
Interpreting Tracking Risk
Target Tracking risk is 1% (example)
Active Strategies
Active mgmt by larger risk factormismatches
The difference between this and enhancedindexing is one of degree.
PM deliberately makes larger mismatcheson primary risk factors
PM actively pursues opportunities in themarket to increase return.
Examples would be 1) Overweightcorporate vs. treasuries 2) Position port totake advantage of anticipated twist. 3)slightly adjust duration away from BMduration. 4) Overweight Arated andunderweight AAweighted bonds.
Full Blown active management
Aggressive mismatches on duration, sectorweights, & other factors.
Does not give much thought to underlyingindex composition.
Goal: To construct a portfolio w/ superiorrisk/return characteristics.
Extra Activities required by active managers
1)Identify which index mismatches are to beexploited.
2) Extapolate the markets expectations orinputs from the market data
3) Independently forecast the necessaryinputs and compare these with the marketsexpectations
4) Estimate the relative values of securitiesin order to identify areas of under orovervaluation.
Choosing a BM for AO or ALM approach
If choosing to go with an INDEX (passive)approach
Benchmark selection: 4 characteristicsto match your INDEX fund against thebenchmark with.
1) Market Risk
As the the term of the maturity andduration increase, the "market risk" of thebond portfolio increases.
2) Income Risk
If stability and dependability of risk aremost important to an investor than heshould go with a LT bond fund vs STbond fund.
3) Credit Risk
Level of diversification
Minimum credit quality level
4) Liability Framework Risk
If Liabilities are important than thebenchmark duration should match thebond durations. (Think ALM for bothindividuals and institutations)
If Liabilities are not a critical part of theinvestors objectives than the fund managerhas quite a bit more latititude
In addition: Returns and Risk need to beevaluated on after tax basis.
BB example of index benchmark selectionbased on what is important to the investor.
Risk in Detail: Risk Profile
A major source of risk for most bonds:Yield Curve
Yld Curve changes include
Parallel Shifts
Twists
Other curvature changes
The BUMs problem
A cap weighted index is made up of highlyleveraged issuers which, as a result, run therisk of being downgraded.
Definitions
Economic Surplus
ALM uses the Liability Relative Approachto build a Liability Mimicking Portfolio.
Liability Relative Approach coversmatching the liabilities of a pension with "alike" asset. Nominal bonds to non inflationadjusted benefit payments....
ALM just explains the need approach thatmatches the assets duration to theliabilities duration.
ALM vs. MVO
Liability Mimicking Portfolio is one that isdesigned relative to
Durations
Effective Duration
Key Rate Duration
Convexity
