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The Journal of Performance Measurement, Vol. 13 No. 3 (2011)

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Table of Contents

Vol. 15, #3 - Spring 2011

Properties of the IRR Equation with Regard to Ambiguity of Calculating the Rate of Return and a Maximum

Number of Solutions

Yuri Shestopaloff, Ph.D., SegmentSoft and

Wolfgang Marty, Ph.D., Credit Suisse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 8

The IRR equation is widely used in financial mathematics for different purposes, such as computing the rate of return on in-

vestments, calculation of implied volatility, yield to maturity, calculation of interest rates for mortgages and annuities, etc.

However, in general, the IRR equation may have several solutions, which restricts its application. Thus, the knowledge of how

to find these solutions and choose the right one is important. Our understanding of properties of the IRR equation is not com-

plete.

Stephen Campisi, CFA, Intuitive Performance Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 23

Fixed income requires a unique approach to attribution since much of its return is driven by structural risk factors that are

specific to the bond market. The challenge in terms of performance attribution is to create a robust model that evaluates the

investment process fairly without introducing too much complexity. Otherwise, the results may be meaningless to clients who

may get lost in the details while missing the key performance messages. To develop the right performance model we need to

answer a few key questions: Which structural factors should be included? How can we leverage the existing performance at-

tribution methodologies where they are appropriate? And how can we balance simplicity, clarity and understandability with

rigor and accuracy?

Dean LeBaron, CFA, Batterymarch Financial Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 43

The Performance Measure You Choose Influences the Evaluation of Hedge Funds

Valeri Zakamouline, Ph.D., University of Agder . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 48

It is widely accepted that, when return distributions are non-normal, the use of the Sharpe ratio can lead to misleading con-

clusions. It is well documented that deviations of hedge fund return distributions from normality are statistically significant.

The literature on performance evaluation that takes into account the non-normality of return distributions is a vast one. How-

ever, there is another stream of research that advocates that the choice of performance measure does not influence the eval-

uation of hedge funds.

Larry Campbell, AIF, Morgan Keegan & Company . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 65

Among the topics most frequently discussed between financial advisors and portfolio performance analysts, time-weighted

and dollar-weighted performance returns have to be at the top of the list. Primarily, financial advisors want to know why

there are differences between time-weighted and dollar-weighted returns for a portfolio for the same time period.

John C. Stannard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 71

Measuring rates of return for derivatives offers many challenges. Despite some bad press such products have generated,

these securities wont disappear. Our author discusses the unique problems of these securities and offers a methodology for

measuring performance results.

This article has been reprinted with the permission of The Journal of Performance Measurement.

Spring 2011. For more information on this publication or to become a subscriber, visit

www.SpauldingGrp.com or contact Christopher Spaulding at

(732)873-5700 or CSpaulding@SpauldingGrp.com.

With offices in the New York City and Los Angeles metropolitan areas, The Spaulding Group, Inc is the

leader in investment performance measurement products and services. TSG offers consulting services;

publishes The Journal of Performance Measurement, a quarterly publication we launched in 1996; and

hosts the Performance Measurement Forum. The firm also sponsors the annual Performance Measure-

ment, Attribution and Risk (PMAR) conference and PMAR Europe which have come to be recognized

as the leading performance measurement conferences in the industry. TSGs Institute of Performance

Measurement offers performance measurement training, including a fundamentals course on performance

measurement, a course on performance attribution, and two CIPM exam preparation courses. Additional

details about TSGs services may be found on our website www.SpauldingGrp.com.

A Sector Based Approach to Fixed Income

Performance Attribution

Fixed income requires a unique approach to attribution since much of its return is driven by structural risk factors

that are specific to the bond market. The challenge in terms of performance attribution is to create a robust model

that evaluates the investment process fairly without introducing too much complexity. Otherwise, the results may

be meaningless to clients who may get lost in the details while missing the key performance messages. To develop

the right performance model we need to answer a few key questions: Which structural factors should be included?

How can we leverage the existing performance attribution methodologies where they are appropriate? And how

can we balance simplicity, clarity and understandability with rigor and accuracy? This article addresses these

challenges by employing a sector-based approach where market weightings are adjusted by the systematic risk of

bonds, where the income component of bond return is recognized and where the true drivers of price volatility are

included. The result is an attribution model that reflects the active bond management process with rigor, accuracy

and clarity and which accomplishes this with straightforward calculations that are easy to grasp and to commu-

nicate to clients.

is a practicing portfolio manager for endowments, foundations, and pension plans and serves as a consultant to

institutional portfolio managers in the areas of asset allocation, risk management, manager selection, and per-

formance measurement. He is also Principal of Intuitive Performance Solutions, a consulting firm specializing in

performance analysis and investment education. He has over twenty-five years of investment experience including

eight years as a bond portfolio manager within the insurance industry. He spent fifteen years as Adjunct Professor

of Finance for the Graduate School of Business of Western New England College, and for more than a decade he

has taught CFA Review classes for the Hartford CFA Society, for which he is a past president. He is a frequent

speaker at investment conferences and a current participant in the CFA Institutes Speaker Program, addressing

CFA Societies throughout the United States. He is a member of the Advisory Board of The Journal of Performance

Measurement, which published several of his articles including Primer on Fixed Income Performance Attribution

and Long Term Risk Adjusted Performance Attribution which won the Peter Dietz award. He holds an MBA

from the University of Connecticut and an MA in Music from Montclair State University.

OVERVIEW ital in bonds, since these provide the income and safety

that they require, especially at retirement.

Fixed income investments are an important part of many

investment portfolios. In fact, many believe that fixed Just as investors needs for bonds are increasing, we see

income investments are increasing in importance due to that fixed income performance attribution methodolo-

increasing worldwide demand for the liquidity, stability gies also continue to evolve. Beginning with the use of

and diversification that bonds provide. Insurance com- simple equity models, bond attribution models have

panies have always been bond investors, since their pro- moved through several stages. Overly general models

jected claims payments are easily matched against their based on the Security Market Line dominated the early

bond portfolios principal and interest payments. Simi- stages. Subsequent innovations included modified eq-

larly, pension funds seek to match projected liabilities uity models that simply subtracted an impact from

with the predictable cash flows that bond portfolios pro- changes in Treasury rates and then employed the famil-

vide. And, as the worlds population ages, individual iar equity model, treating the remaining return as a price

investors tend to invest a greater proportion of their cap- residual. These simplistic models were inadequate be-

cause they failed to identify the structural factors that Only a representative benchmark can evaluate the port-

represented the bond portfolio managers active invest- folios risk-adjusted return and provide the basis for

ment process. Most recently we have seen a swing to evaluating the impact of the managers tactical alloca-

the other extreme of complexity, with several versions tion shifts. After explaining the return due to these struc-

of highly mathematical, multi-factor models that incor- tural factors, the residual return legitimately represents

porate both structural and complex issue-specific fac- the remaining active return, which is generally due to

tors. By mixing risk factors with issue selection idiosyncratic risk. This residual term is usually referred

parameters, these models produced results that were to as a selection effect. In a bond portfolio, this se-

often incomprehensible due to their complexity and lack lection effect is relatively small, since bonds are homog-

of intuitiveness sometimes even for bond portfolio enous investments after adjusting for differences in risk

managers! The cost and complexity of these recent and style. Unlike equities, where individual companies

models have put them out of the reach of smaller com- reflect a high degree of differentiation (even when they

panies and prevented them from gaining broad accept- belong to the same industrial sector) bonds with com-

ance in the marketplace. In addition, there is some doubt mon characteristics tend to sell at comparable prices and

as to whether these models are simply mathematical ab- have equivalent returns. As a result, we can see that dif-

stractions or are truly representative of the bond man- ferences in performance between bond portfolios tend

agement process. to be the result of different structural characteristics. A

good bond performance methodology will control for

This paper outlines a reasonable balance between the these structural factors and will produce a relatively

simple intuition of the familiar sector-based approach small selection effect.

and the inclusion of those unique, structural factors that

are the key drivers of fixed income investing. The result A REVIEW OF BOND BASICS

is a straightforward approach to attribution that is truly

representative of the fixed income portfolio managers The bond market is significantly larger than the stock

decision process. It explains the results of the active market, both in terms of number of securities as well as

management of the portfolios structural factors and money value. Stocks are only issued by public compa-

identifies the active residual or selection effect. Of nies, whereas bonds are issued by both public and pri-

critical importance is the benefit of a highly practical vate companies, and by all levels of government (as well

and intuitive model that is easy to explain to non-tech- as by agencies of the government.) And where a com-

nical users and especially to clients. In addition, the pany usually issues only a single series of common

model requires a minimum of data to represent the port- stock, that same company may issue several (and some-

folio and to customize the benchmark, bringing this ro- times dozens of) series of bonds, each with its own

bust approach within the grasp of smaller firms that may unique characteristics. It has been said that one counts

have limited resources to devote to performance attri- stocks by the thousands and counts bonds by the mil-

bution. lions. Notwithstanding their importance as investments,

bonds rarely make the news, whereas equities dominate

GUIDELINES FOR PERFORMANCE the nightly news. This is understandable, since equities

ATTRIBUTION METHODOLOGIES are leading indicators of an economy. Given their rela-

tive unfamiliarity compared with stocks, and given the

The purpose of performance attribution is to explain the emerging awareness of the drivers of bond performance,

relative benefits of the investment managers active de- it is prudent to begin with a review of a few fundamental

cision process. Therefore, any valid performance attri- bond concepts and to compare bonds with stocks. This

bution methodology must reflect the investment process will help to explain why bonds require their own attri-

of the manager. Simply stated, the managers decisions bution model, and will also help to define the founda-

must be the basis for the attribution model. Second, the tions of the bond performance model.

methodology must allow for the creation of a benchmark

that represents the systematic risk and style characteris- Bonds are distinguished from stocks by five factors:

tics of the managers long-term investment strategy. their investment horizon, their return potential, their

markets, their risk factors and their opportunity for a true the price sensitivity with respect to changes in market

selection return. We will provide a brief review of each yields. Where the idiosyncratic selection effect in stock

of these characteristics. A more in-depth discussion of portfolios may be relatively large, the selection effect in

bonds can be found in many investment texts, some of bond portfolios is generally relatively small.

which are devoted exclusively to bonds.

DECOMPOSING BOND RETURN

1. Bonds are usually issued with a fixed term to matu-

rity, at which time the amount borrowed has been The return for any investment may be stated as its in-

fully repaid. By comparison, stocks are permanent come return plus its price return. For a stock, this is rep-

investments. resented by its dividend yield plus the return from its

change in market price over the performance period.

2. Bonds provide a fixed return from required interest For a bond, this is represented by its coupon return and

payments to the bondholders who are simply its return from price change (where price change is

lenders. When companies prosper, this increased driven by yield change.) The coupon return is simply

value goes to stockholders, who bear the risks of stated as the periodic coupon rate divided by the begin-

ownership. Where stocks have an unlimited upside, ning period bond price. This periodic coupon rate is cal-

bonds have a limited return potential that is gener- culated as the annual coupon rate divided by the horizon

ally in line with their interest rates. of the performance period. For example, the monthly

income return for a 6% coupon bond selling at $105.25

3. Bonds are often buy and hold investments, mean- would be:

ing that once purchased, they are held until maturity.

As a result, the secondary market for bonds is quite Income return = Coupon/Frequency Price =

limited. Aside from Treasury bonds, only a small [6 12] 105.25 = 0.50 105.25 = 0.475%

proportion of bonds are bought and sold on a given

day. As a result, bonds are less liquid than stocks, The price return for any investment is driven by the ratio

and they reflect a lower degree of reliability regard- of ending price to beginning price. If this bonds price

ing their true market prices, especially for any indi- increased from 105.25 to 107.25 during the month, its

vidual bond. By comparison, stocks enjoy a highly price return would be:

active secondary market and reliable pricing.

Price return = [Ending Price Beginning Price] 1

4. Bond returns are driven by their expected interest = 107.25 105.25 1 = 1.90%

income and also by changes in market yields. As

market yields rise above a bonds stated income The total monthly return for our bond would be:

yield, the bond becomes relatively unattractive and

its price falls. The opposite effect happens when Total return = Income return + Price return =

market yields fall. Therefore, the main risk factor 0.475% + 1.900% = 2.375%

for a bond is its sensitivity to yield changes. By

comparison, stock returns are driven by the perform- However, to understand the sources of bond price

ance of the markets economic sectors, and the main change, an understanding of bond yield and the sensi-

risk for a stock is its sensitivity to the overall market, tivity of a bond to this yield change is required.

measured by its beta statistic.

REVIEW OF BOND YIELD

It is clear that the performance of bonds and stocks are

driven by different factors, and that both bonds and A bonds yield has two components:

stocks require their own performance attribution models.

Stock performance is explained by general market sen- 1. A risk free interest rate, usually represented by a

sitivity, sector exposure and issue selection, whereas Treasury bond. Interest rates generally increase with

bond performance is explained by interest income and the maturity of the bond, implying that longer-term

bonds carry greater price volatility then shorter-term found in Mortgage Backed bonds where the price of

bonds. When we plot the graph of yields relative to the bond can only rise to a ceiling level of the price

their maturities, this curve is usually upward slop- at issue ($100 or Par.) Without a corresponding

ing to compensate investors for the higher risk in- increase in price to compensate for lower future in-

herent in longer maturity bonds. come levels, prepayment risk results in losses for

bondholders.

2. A risk premium that compensates investors for any

uncertainties related to the receipt of interest and Equity or Idiosyncratic risk: The risk inherent in

principal payments, as well as changes in this risk below investment grade bonds (junk bonds) where

premium that could cause a decline in bond price. the probability of default is significantly higher than

This premium is usually called a Spread over for investment grade bonds. Examples include low-

Treasuries or simply a Spread. An increase in rated corporate bonds as well as sovereign bonds

spread is called a widening while a decrease in from emerging economies. Ratings for speculative

spread is called a tightening. grade bonds are BB, B, CCC and D. These bonds

share the idiosyncratic nature of equity because

Bonds may carry any of four types of risk and each risk company-specific or country-specific issues domi-

provides its own risk premium. nate their pricing. For example, market yields may

decline, causing general bond prices to rise, and yet

Interest rate risk: This is the risk that bond prices an individual company may slip into bankruptcy and

will fall as Treasury rates rise. As current Treasury see a severe decline in the price of its bonds. There-

rates rise above the yields of existing bonds, these fore, these lower-rated bonds reflect a higher likeli-

bonds become relatively undesirable. This lower hood of default, higher potential price volatility and

demand results in a lower bond price. All bonds a greater selection effect than investment grade

have interest rate risk, since all yields are based on bonds.

the Treasury rate.

Bond yield is therefore the combination of three com-

Credit risk: This is the risk that either the borrower ponents:

will default on payments or that the market will de-

mand a higher risk premium for the existing risks of A short-term risk free rate that compensates the in-

the bond. Bond risk is evaluated by rating agencies vestor for inflation and provides a small real return

that assign bond ratings using a letter system. In-

vestment grade bonds have a high likelihood of pay- A maturity premium to compensate for potential

ing their interest and principal payments and are losses from unanticipated inflation.The sum of the

rated AAA, AA, A and BBB (in declining order of risk free rate and the maturity premium is the Treas-

creditworthiness.) Credit risk is found in Corporate ury rate.

bonds, Asset Backed bonds (bonds backed by pools

of card loans, credit card loans and home equity A risk premium to compensate for potential losses

loans) and Commercial Mortgage Backed bonds from defaults and/or prepayments

(bonds backed by pools of mortgages on apartment

houses, hotels, retail stores and other commercial BOND DURATION: THE LINK BETWEEN

buildings.) YIELD AND PRICE

Prepayment risk: This is essentially the risk of a loss As stated, a bonds price changes inversely with changes

of expected income. As market yields fall, investors in yields. As yields rise, bond prices fall; as yields fall,

tend to refinance their existing bonds at lower rates, bond prices rise. The degree of price change depends

thereby lowering their interest costs. This leaves on the bonds sensitivity to yield change. This sensitiv-

lenders to reinvest the proceeds at lower rates than ity is referred to as the bonds Duration or more pre-

their original bonds. Prepayment risk is primarily cisely its Modified Effective Duration. In practical

terms, a bonds price will change approximately by its small for most bonds. Fortunately, any estimation error

Duration for every 1% change in yield. For example, a with regard to the Treasury component of price change

5-year duration bond will see its price rise approxi- will be reflected in the Spread component of price

mately 5% if yields decline by 1% (100 basis points or change.

100 bps.) Conversely, this same bond will see its price

decline by approximately 5% if yields increase by 100 Therefore, the general form for bond price change is:

bps. Bond Duration is the systematic risk measure for

bonds. It is comparable to Beta for stocks. Just as mar- Change in Bond Price = -Duration x Change in Yield

ket risk cannot be diversified away for equities, the risk

of price declines from rising yields cannot be diversified Two things are worth noting in this calculation. First,

away in a bond portfolio. we employ the negative of Duration so that the inverse

relationship between Price and Yield is preserved. Sec-

The calculation of bond duration is beyond the scope of ond, we see that a bonds yield may change due to

this article, but this can be found in many investment changes in the Treasury rate, changes in the Risk Pre-

textbooks. However, for definitional purposes a bonds mium or both. We can decompose bond price return

duration can be calculated as the weighted average tim- into its two components, Treasury return and Spread re-

ing of its cash flows, using the present value of each turn, where:

cash flow as the weighting factor. This result is then di-

vided by (1 + Yield) which creates a measure of the Treasury return = -Duration x Treasury change

bonds price sensitivity. There is a small and generally Spread return = -Duration x Spread change

immaterial error in this price change estimate, since the

graph of bond price at each yield level is a curve rather DECOMPOSING BOND RETURN

than a straight line. Essentially, duration is the first de-

rivative of the bonds price/yield curve and therefore a Bond total return can be decomposed into its main struc-

linear estimate of price change. The use of this linear tural components: Income return, Treasury return and

estimate of price change implies a tendency to slightly Spread return. Any residual return not explained by

overestimate price declines and slightly underestimate these structural components is considered a Selection

price increases. However, this estimation error is quite return, where:

Selection return = Total return Treasury return cial Mortgage Backed, High Yield, Foreign and Emerg-

Spread return ing Markets. Each sector has a given maturity, making

it more or less responsive to changes in yields. Addi-

Therefore, the attribution model for bonds is: tionally, each sector also has a rating. Collectively, these

parameters fully describe or classify each bond. The

Total return = Income return + Treasury return + potential for numerous groupings of bonds is potentially

Spread return + Selection return. problematic. Therefore, it is essential to group the

bonds in the way that best represents the managers in-

The components of the attribution methodology are rep- vestment process.

resented in Figure 1.

Some analysts choose to view yield curve exposure (the

The data and general calculation process of the model weightings to the different points along the Treasury

are represented in Figure 2. curve) as the primary investment decision factor, with

the sector weightings taking a secondary position in the

A SECTOR-BASED VIEW OF FIXED INCOME decision process. Others view the sector weightings as

PERFORMANCE the primary investment decision, with yield curve expo-

sure seen as a secondary decision that may be the result

Describing the sector groupings in a bond portfolio is of active bets, issue selection or simply the availability

more involved than for an equity portfolio. Since bonds of bonds in an illiquid market. A reconciliation of these

are described using a set of structural factors and risk positions is sometimes reflected in the cell based ap-

factors that occur simultaneously, it is possible to de- proach to sectors, where each intersection of sector and

scribe these bond sectors by several characteristics and risk is treated as a unique cell. Here, the portfolios

to arrange these characteristics in any order of priority. sectors are represented by the matrix of sector and yield

For example, each bond belongs to a given market or curve exposures. Unfortunately, such schemes usually

issuer sector, which may be described as Governments, result in an incomprehensible array of dozens of indi-

Corporates, Mortgage Backed, Asset Backed, Commer- vidual cells without any clear and cohesive message.

In the straightforward model presented here, the dura- decisions are made simultaneously, rather than in the bi-

tions of the various sectors are the basis for the portfo- furcated manner implied by the arbitrary selection of

lios yield curve exposures. Rather than select the key rate durations. We conclude that using sector dura-

portfolios yield curve exposures through arbitrary tions to represent Treasury curve exposure provides a

points (1-year, 2-year, 3-year, 5-year, 7-year, 10-year, methodology that is representative in its design and both

30-year) we will consider the sector durations to repre- practical and efficient in its implementation.

sent these key rate durations for the portfolio. There

are two important reasons for this. First, a portfolios CALCULATIONS AND CASE STUDY

yield curve distribution is a critical aspect of its structure

and its return attribution, and so the values used to rep- We will explain and illustrate the bond attribution model

resent this curve distribution should be the result of ob- in the context of an analysis of an actual portfolio rela-

servable decisions, rather than arbitrary points chosen tive to its benchmark. Typical of most active bond

for the convenience of data gathering. The portfolio strategies, this portfolio reflects significant tactical

manager selects bonds with specific durations to imple- structural differences from its benchmark. These in-

ment the sector strategy. Therefore, each sectors dura- clude different sector weightings, different levels of sys-

tion is the result of specific manager decisions and tematic risk in each sector (measured by duration) and

specific bond purchases. It is a delightful curiosity that a different set of exposures along the yield curve and a

it is easy to gather the durations of the portfolios sectors different level of overall systematic risk when compared

and the corresponding sectors in the benchmark using with the benchmark. Not surprisingly, this reflects a dif-

readily available public data. However, it is difficult to ferent level of interest income and differences in the

gather all of the benchmark data sorted by the set of ar- price risk resulting from different exposures to the driv-

bitrarily chosen yield curve points. In fact, such an ap- ers of yield change, namely Treasury rate and spread

proach may require having access to all of the changes. We will evaluate the differences in perform-

benchmarks constituent bond holdings, which often ance caused by these structural differences and explain

number in the thousands or tens of thousands of bonds. the remaining selection return.

This places such a model out of the reach of smaller

firms. And so, the relevant, decision-based set of sector DATA REQUIREMENTS

durations is more representative, less costly and less dif-

ficult to implement, while the arbitrary set of duration We begin by gathering and calculating the basic data re-

exposures is less relevant while involving higher cost quired for the model. This data will form the basis for

and difficulty in implementation. the attribution analysis. While this model can be ana-

lyzed at any level of granularity (down to the issue

The second reason for joining the portfolios sector du- level) we will proceed at the sector level. It is worth

rations and its yield curve exposures is because this ap- noting that since this is a linear model, the attribution

proach reflects how bond managers determine sector results will be the same whether the model is imple-

weightings. A bonds weighting includes aspects of mented at the issue level or any other level of aggrega-

both money and time, so that the true weighting of a tion. The basic data for the model includes:

bond is not simply its market weighting, but rather the

combined effect of weighting and duration, which bond Market value weighting (%)

managers refer to as Contribution to Duration. There- Return

fore, sector exposures can only be understood in terms Coupon

of the simultaneous consideration of both weighting and Beginning price

duration. Since sector weightings cannot be separated Beginning duration

from their durations, then sector durations must be a Treasury curve at beginning and end of performance

critical component of the portfolios yield curve expo- period

sure. At a more practical level, a portfolio manager can

only gain exposure to the yield curve through the pur- Using the basic data in Tables 1 and 2 we will calculate

chase of bonds and so the yield curve and sector/issue the remaining data needed for the attribution analysis:

Par value weighting (%) the published Treasury returns (in bold font) we used

Treasury change at the point matching each sector linear interpolation to calculate the intermediary points

duration (Duration Matched Treasury) along the curve in 1/8 year increments. The changes in

Spread change for each benchmark sector rates are simply the differences between the two Treas-

ury curves. The final step in identifying the basic data

IDENTIFYING THE APPROPRIATE is to find the Treasury change that most closely matches

WEIGHTING FACTORS each sectors duration for each sector. (One may also in-

terpolate to find the yield curve point to match each sec-

Risk and return values are weighted by market value tors duration exactly; this is a matter of personal

weightings. However, by definition coupon and price judgment and will not have a material effect on the at-

values are weighted by par value. So, for each sector tribution results.)

we calculate the par value in money terms and then find

the percentage weighting of each sectors par value CALCULATING THE COMPONENT RETURNS

where:

Now that we have the required data for the benchmark,

Par value = Market value Price we will calculate each of the component returns (Ef-

fects) that sum to the total return for each sector. We

We also note that Yield changes (Treasury, spread and will illustrate each calculation using the data from the

total yield) are weighted by the compound factor of benchmarks Corporate sector.

Market Percentage x Duration (or Duration Contribu-

tion) and this weighted product is then divided by the Income Effect or Interest earned on Market

average Duration. We will also express the Duration Value Invested = Periodic Coupon Price

Contribution of each sector as a percentage of total Du-

ration. Therefore, there are three relevant weighting 0.49 105.57 = 0.4641% or 0.46% (result ex-

factors for fixed income attribution: Market, Par and pressed to one bps of precision)

Duration Contribution.

Treasury Effect or Price change from Treasury

Table 3 contains the Treasury curves and the rate change = - Duration x Treasury change

changes over the performance period. Beginning with

Table 3: Yield Curves at Beginning and End of Performance Period

-5.82 x -0.2735% = 1.5918% or 1.59% Portfolio Spread Effect = - Duration x Bench-

mark Spread Change

Spread Effect or Price change from change in

Spread Tables 4 and 5 include the data for the benchmark and

the portfolio including the totals for each of the factors

Since benchmarks contain a fixed set of securi- (return, coupon, price, duration, Treasury change, spread

ties there is no selection effect. Therefore, all change.)

remaining return is the result of spread change.

So, for the benchmark: Before preparing the analysis of return and excess return

(or contribution to return and attribution analysis)

Spread Effect = Total return minus Income we will first examine the relative exposures in terms of

effect minus Treasury effect both money and risk (see Figures 3 and 4). This will

provide significant guidance to the subsequent analysis.

1.52% 0.4641% 1.5918% = -0.5359% or

-0.54% Sector exposure is also determined by degree of system-

atic risk, measured by duration. For bond managers, the

Spread Change = Spread Effect - Duration more meaningful exposure is in terms of both market

value and systematic risk, or contribution to duration.

-0.5359 -5.82 = +0.0921% or 9 bps

This Benchmark Sector Spread Change is the The sector durations also illustrate the yield curve ex-

relevant market data that we will use in calcu- posures. That is, the sector durations represent the key

lating the Spread Effect for the corresponding rate duration exposures of the benchmark and the port-

sector in the portfolio, where: folio. This graph provides additional insight into the

managers decisions as to where to take interest rate risk common bond management technique. This is illus-

and spread risk. Clearly the portfolio and the benchmark trated in Figure 5.

have different average durations, and different exposures

along the yield curve. In terms of spread exposure, the CALCULATING THE RETURN

manager has a greater weighting to the most of the DECOMPOSITION

spread sectors but takes less price risk by using shorter (CONTRIBUTION TO RETURN)

durations relative to the benchmark. In contrast, the

manager takes greater price risk in the Treasury sector, Using the data and calculations above, we can now pre-

which is also used to align the portfolios duration more pare an analysis of the return of each sector in the

closely with the duration of the benchmark. This is a benchmark and in the portfolio. We also provide the

Benchmark Sector Weights Portfolio Sector Weights

ABS CMBS

MBS 1.3% 8.0%

34.4%

CMBS

3.5% ABS Corporates

6.5% 42.0%

Corporates

24.3%

MBS

23.0%

Governments

Governments 20.5%

36.5%

Benchmark by Contribution to Duration Weighting Portfolio by Contribution to Duration Weighting

Governments

Corporates 30.5%

32.1%

Governments

39.5% Corporates

41.2%

CMBS

3.6%

ABS MBS

0.9% 15.6%

CMBS ABS

MBS 8.8% 3.9%

23.8%

summary return for each model factor (Income, Treas- gard to groupings by sector or any other combination of

ury, Spread, and Selection.) These are illustrated in Ta- relevant factors.

bles 6 and 7.

The totals for each return component can be calculated

The linear nature of this model allows for unlimited drill in either of two ways. First, these may be derived by

down capability. That is, each sector can be further bro- simply taking the weighted average of the sector effects

ken out into its meaningful subcomponents or sub-sec- using market value as the weightings. Or they may be

tors and then rolled up to the aggregate sector level. For calculated directly using the total values at the portfolio

example, Governments can be broken out into Treasur- level for the basic data. Bear in mind that each compo-

ies vs. Agencies, and Corporates can be broken out by nent of return has its own weighting factor. Coupon and

industrial sectors. Customizing the benchmark is a sim- price are weighted by percentage of par value. Duration

ple matter of rearranging the data and calculating is weighted by percentage of market value. Treasury

weighted average factor values for the revised group- change and spread change are weighted by percentage

ings. The flexibility of the model is unlimited with re- contribution to duration, or stated differently, they are

Corporate

MBS Corporate

Government

CMBS

Table 8: Total Values for Benchmark and Portfolio

weighted by the product of percentage market times du- would have ignored the significant income component

ration, and the sum is then divided by the average dura- of return, and we would have ignored the differences in

tion. These total values are shown in Table 8. risk that were the key drivers of the changes in price.

Whenever risk is incorrectly specified the attribution re-

Using these summary statistics, we can now calculate sults will be incorrect and we will reward or punish

the contribution to return for each component, and then managers for differences in risk and style rather than for

simply subtract the benchmark value from the portfolio their skill. We see this clearly in our example, where

value to calculate the contribution to excess return for the use of the equity method produces a negative selec-

each component. We illustrate these summary-level cal- tion effect instead of a significant positive effect. This

culations for the benchmark: is illustrated in Table 10.

Benchmark Treasury Effect = - 4.40 x - 0.2583 = 1.14% SECTOR LEVEL

Benchmark Spread Effect = - 4.40 x 0.0669 = -0.29%

(this is also the residual value) We can extend our analysis to show each sectors con-

Total Return 1.26% tribution to excess return. In fact, we can analyze each

(difference due to rounding of display) sectors contribution to the excess return from every re-

turn effect: Income, Treasury, Spread and Selection.

PREPARING THE ATTRIBUTION ANALYSIS AT This process is a simple matter of treating each return

THE PORTFOLIO LEVEL effect as its own entity. (We can visualize each return

effect as though it were a total portfolio return.) We then

Once the return decomposition has been prepared for apply the standard equity attribution model to derive

the benchmark and the portfolio, we simply subtract the each sectors contribution to that return effect. Since

values to produce the attribution results. This is illus- the return effects have already been created using the

trated in Table 9. proper income and risk factors, we are free to apply the

equity model to these results as a means of assigning the

What if we had used the traditional equity method to excess return already calculated. To do this, we will

prepare the attribution analysis? Simply stated, we make the familiar references to an allocation compo-

Table 10: Attribution Results Using the Equity Method

nent and a selection component. The allocation Sector Opportunity: Benchmark sector return

component will be driven by the portfolios differences minus Benchmark total return (this is stated for each

in sector weighting (relative to the benchmark) and the fixed income return component)

relative advantage that each sector brings within the

benchmark return for the respective fixed income factor. Portfolio Opportunity: Portfolio sector return

The selection component is calculated as the portfolio minus benchmark sector return

weighting times the difference in return between the

portfolio sector and its corresponding benchmark sector. Using these terms, we can create the allocation and

We will illustrate by calculating each sectors contribu- selection components for each sectors contribution

tion to excess return from exposure to the Treasury to the excess return for each respective fixed income

curve. factor (Income, Treasury, and Spread.) We note that the

allocation portion measures the impact from differ-

We note that the standard attribution ingredients are ences in money weighting, while the selection com-

used to assign the contributions to excess return to each ponent measures the impact from risk or otherwise

of the fixed income return factors: Income, Treasury and differently structured investments. When these two

Spread. These ingredients include: components are added together they sum to each sec-

tors contribution to excess return for each fixed income

Weighting Difference: Portfolio weighting factor. Of course, the sum of all of the sectors excess

minus Benchmark weighting return contributions equals the total contribution to ex-

Table 11: Assigning Contributions to Excess Return using Brinson Equity Approach

cess return. In our example illustrating the Treasury re- tion is that, as previously stated, the corporate bonds in

turn, we can see that this sum (- 6 bps) is equal to the the portfolio had a lower duration than the correspon-

difference in the Treasury return for the portfolio and ding bonds in the benchmark. The manager made a de-

for the benchmark (as illustrated in Table 9.) With all liberate decision to have less spread duration and as a

this in mind, we can now complete the analysis for each result, the portfolio was somewhat shielded from the

of the fixed income return factors within all of the sec- price decline experienced in the benchmark. An addi-

tors. This provides a robust and granular explanation of tional insight can be gained by examining the alloca-

the sources of excess return. For example, we may ex- tion and selection components of this detailed sector

amine the portfolios contribution to excess return either analysis. In the case of corporates, we can see that the

by fixed income effect (Income, Treasury, Spread and allocation effect (driven simply by market exposure)

Selection) or by sector (Governments, MBS, ABS, was negative, since we overweighted a sector that ex-

CMBS and Corporates) or by both. These results are il- perienced a negative return from spread widening.

lustrated in Table 12. However, the lower duration produced a smaller price

decline that is reflected in the selection effect. The

SOME INSIGHTS INTO THE ATTRIBUTION positive selection component of about 6 bps (reflecting

ANALYSIS lower risk) dominated the negative allocation compo-

nent of about 4 bps (reflecting higher market weighting)

Some of these attribution results may seem obvious, to produce an overall positive impact of 2 bps on the rel-

while others may seem somewhat counter-intuitive. For ative performance of the portfolio. Once again, this

example, it seems obvious that the portfolio should have shows that exposure in a bond portfolio is the result of

underperformed the benchmark with regard to its Treas- both weighting and risk, and that if risk is ignored then

ury return. Given a decline in rates accompanied by a attribution results will be incorrect (especially with re-

lower duration relative to the benchmark, we would ex- gard to sector allocation effects.)

pect a smaller price increase in the portfolio than in the

benchmark. This intuition is confirmed by the 6 bps of SUMMARY AND CONCLUSIONS

underperformance caused by the mismatch of duration

in the portfolio, most of which was caused by the shorter Bonds are a significant part of almost every investment

duration of the Corporate sector. portfolio and clients require an understanding of the ab-

solute and relative performance of their bond portfolios.

However, given the increase in spreads and given the While equities have enjoyed a general consensus on

portfolios higher allocation to corporate bonds, we how to analyze relative performance, bonds have begun

might have expected to see a corresponding degree of their evolution toward an attribution methodology that

underperformance in the bond sectors contribution to is representative of the managers investment process,

excess return from Spread Effect. Instead, we see that robust in its results, reasonable in its cost and responsive

corporate bonds made a positive contribution to relative to clients information needs. Above all, the model must

spread effect. How could this be? The simple explana- deliver answers to clients questions in an intuitive man-

ner that is easy to understand. bonds with specific durations as chosen by the man-

ager.)

This straightforward bond attribution model meets all We have calculated the impact of this distribution of du-

of these requirements. It identifies the key structural rations or curve exposure in terms of the price return

drivers of bond performance and of the managers active due to changes in Treasury rates along the curve, where

investment process. These drivers include income, yield each sectors (negative) duration is multiplied by the

curve positioning and relative duration, sector exposure corresponding yield curve change to compute the re-

and spread management, and bond selection. Given the spective price change. This price change can be further

linear characteristic of its design, the model is unlimited broken out into the change attributed to parallel and

in its flexibility in adapting to various sector breakouts non-parallel yield curve movements. That is, we can

and any sector/sub-sector hierarchies that drive the in- evaluate the impact in a general change in the level of

vestment process. rates (the parallel or shift effect) as well as the im-

pact of changes of different magnitude at the short end

Equally important, this method allows complete cus- vs the long end of the curve (the non-parallel or

tomization of the relevant benchmark, so that differ- twist effect.)

ences of risk and style are incorporated into the

attribution analysis. Additionally, the attribution analy- To calculate the parallel yield curve effect, we must first

sis may be calculated and presented in a variety of ways, identify the point on the yield curve that will be used to

using either granular factors at the sector/sub-sector represent the parallel change in rates. This is sometimes

level or at the total portfolio level. This ability to drill treated as an arbitrary decision, often selecting the 10-

down or roll up the analysis is key to satisfying the year point as the most representative measure of yield

needs of the various constituencies that will use this at- curve change. Others simply select the 10-year point

tribution analysis. As a result, this model can be used because it is widely quoted, producing a readily avail-

to provide meaningful results that are a critical part of able number. However, our viewpoint is that it is wise

the investment management process. to select a widely-quoted point on the yield curve that

corresponds closely to the long term average duration

APPENDIX: ADDITIONAL INSIGHTS of the bond portfolio. For example, many diversified

bond portfolios have durations closer to the 5-year point

A) Calculating parallel vs. non-parallel than to the 10-year point, and so we feel that, for these

Treasury effects portfolios, the 5-year point on the curve is the more rep-

resentative and therefore a better estimate for a parallel

We had already noted that each sectors economic ex- change in rates. Notwithstanding, any point selected

posure is described in terms of both money and risk. along the curve will do, so long as one realizes that the

That is, a sectors true weighting is essentially the prod- split between parallel and non-parallel return is

uct of its market value percentage and its duration. This largely driven by the selection of the point on the yield

distribution of sector durations also forms the effective curve chosen to represent the parallel change in rates.

Treasury curve distribution, and this curve distribution (To visualize this, imagine a flattening non-parallel

is then consolidated into a single duration statistic. yield curve shift where short rates rise and long rates

Stated differently, each portfolio or benchmark has an decline, and where the 5-year point is the pivot point

average duration around which its sector durations are for this yield curve movement. If the 5-year point is se-

distributed. This approach unifies the sector weighting lected to represent the amount of parallel movement,

and the yield curve distribution decisions and ensures then all of the Treasury curve impact will be considered

that the partial durations along the yield curve are the non-parallel in nature. However, if the 10-year point is

result of deliberate decisions rather than arbitrarily cho- selected to represent the parallel shift, then the majority

sen points. (These decisions include both the money of the Treasury impact will be parallel in nature.)

weighting of each sector as well as the amount of sys-

tematic risk in the sector resulting from the selection of We recall that the Treasury return is calculated as:

Treasury return = - Duration x Treasury Change (at the Benchmark Sector Shift Return =

point of the yield curve matching that duration) -4.76 x +0.26 = +1.2376

We then define the following additional terms which de- Portfolio Sector Twist Return =

compose the Treasury change: -6.31 x -0.0020 = +0.0126

Key Rate Duration Change or KRD is the Benchmark Sector Twist Return =

Treasury change corresponding to the selected -4.76 x +0.0025 = - 0.0119

parallel shift point (the 5-year point)

We can now sum these effects to the total Treasury re-

Duration Matched Treasury Change or turn as previously stated:

DMT is the Treasury change corresponding to

the sector duration Portfolio Treasury Return =

+1.6406 + 0.0126 = +1.6532

With these terms in mind, we can calculate the parallel

return (Shift) and the non-parallel return (Twist) as Benchmark Treasury Return =

follows: +1.2376 + (-0.0119) = +1.2257

Shift return = - Duration x Change in Key Rate We can calculate the parallel and non-parallel effects for

Duration or [ -D x KRD ] each sector, and then calculate each sectors contribution

to excess return from the shift and twist components

Twist return = - Duration x (Change in Duration of the Treasury return, using the same attribution

Matched Treasury minus Change in Key Rate methodology we applied to the other performance fac-

Duration) or [ -D x ( DMT KRD) ] tors. These return and attribution results are outlined in

Tables 13 and 14.

We can easily see that these calculations consolidate into

the total Treasury Return calculation as previously B) Additional commentary on the Spread Effect

stated.

The three return components identified in this model are

Lets demonstrate the breakout of the Treasury return complete in describing the active decisions of the man-

for the Governments sector. ager in terms of how bond portfolios are structured and

Duration DMT 5yr KRD [DMT- KRD] managed. These components include income, price sen-

Portfolio 6.31 -0.2620 -0.2600 -0.0020 sitivity to changes in the risk free rate through a portfo-

Benchmark 4.76 -0.2576 -0.2600 +0.0025 lios exposure to the yield curve (Treasury effect or

Duration effect) and the price change from exposure

Portfolio Sector Shift Return = to risk premia through the Spread effect. The sum of

-6.31 x -0.26 = +1.6406 these return effects produces the explained return. The

Table 14: Treasury Return Attribution Analysis

residual of the observed return compared with the ex- reach of all but the largest investor shops, since their

plained return is the Selection effect. In a valid fixed in- cost in terms of required data and analytical rigor is so

come model where a representative benchmark is used high.

so that risks are clearly identified, this selection effect

should be small, given the homogenous nature of indi- As a result, we may be confident that the true decision

vidual bonds within each sector category. process of the investment manager is adequately and ac-

curately represented in this fixed income attribution

It is important to note that the risk for each unique sector model. Further, we may be assured that the impact of

(credit, prepayment and equity) is the primary these minor additional factors is represented identically

driver of the Spread effect. However, it is also important in both the benchmark and the portfolio. We know this

to note that there are certain other factors that contribute because the impact that these factors have on each of

to the models Spread effect. These factors tend to have the benchmark sectors spread change is translated ex-

a minor, inconsequential and sometimes even barely actly to the portfolio: after all, the spread change for the

perceptible impact on return, especially in the short run. benchmark sector is used for the corresponding portfolio

They also share a common characteristic of being dif- sector. Any difference in the portfolios minor factors

ferent from the structural decisions that drive the port- will appropriately be reflected in the selection effect

folio management process. Rather, they tend to be where it belongs.

related more to issue selection, rather than to deliberate

decisions around the structure of the portfolio relative C) The Issue of Convexity in Fixed Income

to the benchmark. And finally, these factors increase in Attribution

complexity relative to the key active decision factors in-

cluded in this model. For these reasons, these incidental We understand that the duration measure assumes that

factors are summarized and included in the Spread ef- price changes resulting from changes in yield may be

fect and are part of the change in spread for each sector. estimated via a linear relationship. This estimation is

These factors include roll, prepayment impact, amorti- usually very close to the actual price change, so long as

zation impact and changes in option volatility. the change in yield is relatively small. However, the es-

timated price change using only duration will tend to

These additional factors reflect the inherent error in overstate losses and understate gains, because the true

complex fixed income models: they confuse issue se- relationship between price and yield is not linear, but

lection factors with structural factors. As a result, these rather is represented by a yield curve that is convex in

models are unrepresentative of the portfolio manage- nature (with both duration and gains increasing at an in-

ment process and bring a complexity, cost and confusion creasing rate as yields fall and both duration and losses

that severely limit the intuitiveness and understandabil- decreasing at a decreasing rate as rates rise.) To address

ity of the output, therefore rendering the output unusable this estimation error, some include a measure of con-

to any but the most knowledgeable fixed income in- vexity in the calculation of estimated price change, not-

vestors. Additionally, these models are generally out of ing that this convexity adjustment improves the

estimated price change, but still leaves a very small lection effect.

residual error.

While the impact of convexity is small, the effect of its

In this model, convexity is addressed by its contribution inclusion in the model is significant: it turns a flexible

to spread change. This is especially evident in Mortgage and highly intuitive model into a severely limited one

Backed Securities (MBS) where negative convexity that actually produces less useful information about the

drives price down for any change in yield. This negative investment process. It is important to note that one can-

convexity is expressed through an additional widening not apply the breakout of yield change into its price

of spread in the MBS sector, and this wider spread pro- components using a duration + convexity approach,

duces the same negative price impact that one would since there is no mathematical equivalence when these

achieve using a duration + convexity construct. In components of yield change are separated. This is

positively-convex sectors (such as corporates) the con- clearly demonstrated in the following calculation:

vexity impact is reflected in a slight tightening of spread

change, reconciling to the slightly higher price change (-D x Y + C/2 x Y2) [-D x T + C/2 x T2] +

observed for that sector. Therefore, we can see that the [-D x S + C/2 x S2]

models spread change already conveys information

about each benchmark sectors convexity impact to the Where: Y = Yield Change, T = Treasury Change,

corresponding sector in the portfolio. Differences in S = Spread Change

convexity between the portfolio and the benchmark are

therefore reflected in the Portfolio Selection effect. Including convexity in the attribution model means that

However, this impact will generally be quite small, since the critical breakout of a managers decisions around

a) the portfolio and its appropriate benchmark will have both Treasury yield curve positioning and spread expo-

convexities that are not materially different from each sure would be lost in the hopes of pursuing a purely ac-

other and b) the impact of convexity is a very small ademic argument for precision that is clearly

component of price, as indicated in the following cal- immaterial in its impact. Since including convexity into

culation: the core attribution model results in a significant loss of

information, convexity should be evaluated only at the

Estimated Price Change = - Duration x Yield Change + total yield level as a means of understanding its contri-

.5 x Convexity x Yield Change Squared bution to the selection effect. Although this can be ac-

complished at the sector level, we recommend analyzing

Given the squaring of yield change for the convexity the impact of convexity at the total portfolio level. Table

impact, the result is always quite small. In the sample 15 illustrates the impact of convexity at the total port-

portfolio used here, the impact of the greater portfolio folio level.

convexity resulted in about of one basis point, clearly

an immaterial impact that is already reflected in the Se- We see clearly that the impact of differences in convex-

Table 16: Impact of Convexity on Spread Change

ity is a mere 2/10ths of a bps and this is already reflected difference is a mere basis point. Table 16 illustrates

in the portfolio selection effect. As a result, we would the impact of including convexity in the calculation of

note that the portfolios previously stated selection re- spread change at the sector level, as well as at the total

turn of 5.7 bps (.057%) contains a positive convexity portfolio level.

impact of 0.2 bps, or that the true Selection effect is

5.5 bps (.055%) which nonetheless rounds to a 6 bps This demonstrates that convexity is already accounted

impact. for adequately within this model by making a widening

adjustment for negatively convex sectors, and making

For those wishing to calculate the exact impact from a corresponding tightening adjustment in positively con-

convexity for each sector, and to roll this information vex sectors. Since both the benchmark and the portfolio

up to the portfolio level, this can be accomplished by a are treated identically in the calculation of spread

two-step process: change, the impact of spread change on the difference

in resulting price returns is as accurate for the duration-

a) Using the known total return and income return, only approach as it is for the duration + convexity

calculate the implied total price change. approach. However, with the duration-only approach

of this model, we have the significant added benefit of

b) Using the implied total price change, solve for the gaining the ability to separate differences in price

implied total yield change using the Duration + change to decisions around both yield curve positioning

Convexity model. This implicitly calculates the im- and spread exposure through sector exposure. Clearly,

plied spread change, given the known change in the convexity impact is sometimes of interest and this can

Treasury rate for each sector. be calculated explicitly and most appropriately as an ad-

ditional analysis to supplement the critical results of this

We can show that the impact on spread change resulting model.

from including convexity in the model is quite small,

even for the MBS sector, where negative convexity is

most evident. The spread change for the duration +

convexity approach is quite close to the spread change

derived using only duration, as stated earlier in the arti-

cle. For the total portfolio, the difference in spread

change is a mere 2/100ths of a basis point (the difference

between a 6.71 bps widening vs a 6.69 bps widening.)

Even in the highly negatively convex MBS sector the

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