Fixed Income Portfolio Management

MFIN5600- Week 7

MFIN 5600 -Fall 2023 1

 Introduction to Fixed Income Investments

• Fixed income investments are securities that pay investors fixed interest or dividend
payments until maturity. Upon maturity, investors are repaid the principal amount invested.
Non-Publicly Traded
Commercial Paper: Notes and Bonds:
Instruments:
• Short-term unsecured • Medium to long-term • Loans: Direct lending to
promissory notes. investments. borrowers, often with
• Issued by corporations to • Can be traded on exchanges customizable terms.
fund short-term liabilities. or Over-The-Counter • Private Placements: Debt
• Maturities typically less than (OTC). securities not offered to the
270 days. • Include government, public, typically held by a
corporate, and municipal small number of select
bonds. investors.

MFIN 5600 -Fall 2023 2

 The Significance of Fixed-Income in Diverse
Portfolios
Diversification:
• Balances a portfolio by reducing overall volatility.
• Fixed-income securities often have a low correlation with equities, leading to risk mitigation.

Regular Cash Flows:

• Provides consistent and predictable income streams.
• Especially beneficial for retirees or those seeking regular income from their investments.

Inflation Hedging:
• Certain fixed-income securities, like inflation-linked bonds, can offer protection against inflation.
• Helps maintain purchasing power and real returns over time.

MFIN 5600 -Fall 2023 3

 Diversification Benefits of Fixed-Income
Investments

Correlation and Diversification: Correlation with Equities:

• Combining assets with returns not
perfectly correlated (correlation
coefficient < +1.0) results in risk
diversification.
• The goal: Find assets with
correlations much lower than +1.0
for optimal diversification.
• Correlations between fixed-income
and equity securities vary.
• Fixed-income typically provides
effective diversification to portfolios
with equities

MFIN 5600 -Fall 2023 4

 Diversification Benefits of Fixed-Income
Investments
• Correlation between S&P 500 and various fixed-income categories over 20 years

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 Diversification Benefits of Fixed-Income
Investments
• Correlation between S&P 500 and various fixed-income categories over 5 years

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Diversification Benefits of Fixed-Income
Investments

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Diversification Benefits of Fixed-Income
Investments

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 Inflation Hedging with Fixed-Income
Investments
Protecting the real value of assets
against the erosion of purchasing
power caused by inflation.
Importance: Ensuring that the
real return (nominal return
adjusted for inflation) of
investments remains positive,
preserving the real value of assets
Floating Rate Coupons:
• Bonds whose interest payments are
adjusted periodically according to a
reference interest rate, typically tied
to a benchmark like LIBOR.
• Inflation Hedging Role: As inflation
rises, central banks may increase
reference rates to combat inflation.
Consequently, the interest payments
on floating rate bonds may rise with
inflation, providing a natural hedge.
MFIN 5600 -Fall 2023
Inflation-Linked Bonds (ILBs):
• Definition: Bonds where the
principal or interest is adjusted by
an inflation index, such as the
Consumer Price Index (CPI).
• Inflation Hedging Role: Directly ties
the bond's return to an inflation
measure, ensuring that the bond's real
return stays aligned with inflation
rates. As inflation rises, so does the
interest or principal of the ILB,
maintaining the investor's purchasing
power.
9
Approaches to Fixed-Income Portfolio
Management
Fixed-Income
Portfolio
Management

Liability based Total return

Cash flow Duration Enhanced

Pure indexing
matching matching indexing

Derivatives Contingent Active

overlay immunization management

MFIN 5600 -Fall 2023 10

 Approaches to Fixed-Income Portfolio Management
Liability-Based Approaches

Tailored to meet specific liabilities or future cash flow requirements.

Cash Flow Matching: Duration Matching: Derivatives Overlay: Contingent Immunization:

• Definition: Investing in
bonds that generate cash
flows matching the timing
and magnitude of an
investor's expected
liabilities.
• Advantage: Reduces the
risk of not meeting
liabilities, especially when
reinvestment rates are
uncertain.
• Definition: Adjusting the
duration of a portfolio to
match the duration of
liabilities
• Advantage: Protects the
portfolio from interest rate
changes, minimizing the
impact on both assets and
liabilities.
• Definition: Using financial
derivatives, like interest
rate swaps or futures, to
adjust the risk profile of a
portfolio without altering
the underlying bond
positions.
• Advantage: Provides
flexibility in managing
interest rate risk and
achieving desired portfolio
characteristics.
• Definition: A hybrid
strategy that combines
active management with
immunization.
Immunization plus active
management for the surplus.
• Advantage: Allows for
active management while
ensuring a safety net against
adverse market movements.

MFIN 5600 -Fall 2023 11

 Approaches to Fixed-Income Portfolio Management
Liability-Based Approaches
Cash Flow Matching:
Example: The California
Public Employees'
Retirement System
(CalPERS) is one of the
largest public pension systems
in the United States. CalPERS
uses cash flow matching
strategies to ensure it has the
necessary funds to meet the
pension benefit payments to
its retired members. They
invest in fixed-income
securities with maturities that
align with their expected
pension payout schedule.
Duration Matching:
Example: The Canada Pension
Plan Investment Board
(CPPIB) manages the
investments for the Canada
Pension Plan. CPPIB employs
duration matching to match
the duration of its investments
with the long-term nature of
its pension liabilities. This
helps them manage interest
rate risk and ensure the fund's
long-term sustainability.
MFIN 5600 -Fall 2023
Derivative Overlay:
Example: The Dutch pension
fund PGGM is known for its
sophisticated risk management
strategies. They have used
derivative overlays, such as
interest rate swaps and
currency hedges, to manage
risks within their portfolio and
align their investments with
their long-term pension
obligations.
Contingent Immunization:
Example: Insurance companies
like Prudential Financial
employ contingent
immunization strategies. They
set specific return thresholds
and adjust their investment
strategy accordingly. If returns
fall below a certain level, they
shift to a more conservative
approach to ensure they can
meet policyholder obligations.
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 Approaches to Fixed-Income Portfolio Management
Total Return Approaches

Pursuing Returns in Fixed-Income Portfolios

Pure Indexing: Enhanced Indexing: Active Management:

• Definition: Replicating the • Definition: A strategy that • Definition: A discretionary

performance of a specified
bond index.
• Advantage: Low-cost,
transparent, and provides
performance in line with the
market.
closely tracks a bond index
but allows for small
deviations in an attempt to
outperform the index.
• Advantage: Offers potential
for slight outperformance
while maintaining the
benefits of indexing.
approach where the manager
makes investment decisions
to outperform a benchmark.
• Advantage: Potential for
higher returns, flexibility in
strategy, and ability to
capitalize on market
inefficiencies.

MFIN 5600 -Fall 2023 13

 Approaches to Fixed-Income Portfolio Management
Total Return Approaches
Pure Indexing:
iShares Core U.S. Aggregate Bond
ETF (AGG)
is an ETF that employs pure indexing. It
aims to track the Bloomberg Barclays
U.S. Aggregate Bond Index, which is a
broad and widely followed benchmark of
the U.S. investment-grade bond market.
AGG holds a representative sample of
bonds from the index, attempting to
replicate its performance. The
management style is passive, and the
fund seeks to provide investors with
returns that closely mirror the index's
performance.
Enhanced Indexing:
PIMCO Enhanced Low Duration
Active ETF (LDUR)
is an ETF that uses enhanced indexing
strategies. PIMCO, known for its
active fixed income management,
employs an enhanced indexing
approach in LDUR. While it aims to
track the Bloomberg Barclays U.S.
Aggregate Bond Index, it also
incorporates active management
techniques to enhance returns and
manage risk. The fund may deviate
from the index selectively based on
PIMCO's research and analysis.
MFIN 5600 -Fall 2023
Active Management:
DoubleLine Total Return Bond Fund
(DLTNX)
is a mutual fund managed by
DoubleLine Capital. This fund utilizes
active management strategies. Jeffrey
Gundlach, the fund's renowned
manager, makes active decisions
regarding asset allocation, duration,
and security selection to seek
opportunities and manage risk in the
fixed income market. DLTNX is not
constrained by tracking an index and
aims to generate alpha (excess returns)
through active management.
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Pure Indexing vs. Enhanced Indexing vs.
Active Management
Portfolio Weight vs.
Strategy Objective Turnover
Benchmark

Replicate benchmark Closely aligned with benchmark Low (mainly due to index
Pure Indexing
performance weights rebalancing)

Slight outperformance over the Small deviations allowed from Moderate (some active
Enhanced Indexing
benchmark benchmark decisions)

Significant outperformance over Large deviations permitted from High (active trading &
Active Management
the benchmark benchmark positioning)

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Understanding Performance & Risk in Fixed-
Income Pure Indexing
Active Return:
• Definition: The difference between the portfolio's return and the benchmark's (index) return.
• Context: In pure indexing, the active return should be close to zero, as the goal is to replicate the benchmark's performance.

Active Risk:
• Definition: The risk (standard deviation) of the active return.
• Context: Represents the potential volatility of the portfolio's return relative to the benchmark. Ideally minimized in pure indexing.

Tracking Risk:
• Definition: Another term for active risk. It quantifies how consistently a portfolio follows its benchmark.
• Context: In pure indexing, tracking risk should be minimized to ensure the portfolio closely mirrors the index.

Tracking Error:
• Definition: Often used interchangeably with tracking risk, but can also refer to the square root of the average squared deviation
between portfolio returns and benchmark returns.
• Context: A measure of how closely the portfolio's returns match the benchmark's returns over time. Lower tracking error indicates
better replication of the index in pure indexing.

MFIN 5600 -Fall 2023 16

 Yield Metrics in Fixed-Income
Yield to Maturity (YTM)
• Definition: The total return anticipated
on a bond if it is held until it matures.
YTM is expressed as an annual
percentage rate (APR).
• Calculation: It equates the present
value of bond future cash flows (coupon
payments and return of principal) to its
current price.
• Use: Helps investors compare the return
of different bonds and ascertain if a
bond is fairly priced.
Yield Spread
• Definition: The difference in yield
between two bonds, usually of similar
maturity but different credit quality.
• Calculation: Subtract the YTM of one
bond from the YTM of another bond.
• Use: Assesses the relative value of two
bonds. A larger yield spread indicates a
higher compensation for the risk taken.
MFIN 5600 -Fall 2023
Credit Spread
• Definition: The difference between the
yield of a corporate bond and a
government bond of similar maturity.
• Calculation: Subtract the YTM of a
risk-free government bond from the
YTM of a riskier corporate bond.
• Use: Indicates the additional yield an
investor expects to earn for the added
credit risk of the corporate bond
compared to a risk-free government
bond
17
 Bond Risk and Return Measures
Macaulay Duration:
1.Definition: The weighted average time
until a bond's cash flows are received. It
calculates the time-weighted present
value of future bond cash flows.
2.Formula: The present value of each cash
flow is multiplied by the time until that
cash flow occurs, and then the sum of these
products is divided by the bond's current
price.
3.Use: Mainly an academic or theoretical
measure. While it gives an idea of the
average time it takes to receive bond
cash flows, it's not directly useful for
assessing interest rate risk. However, it
serves as the foundation for the more
practical modified duration.
Modified Duration:
1.Definition: A measure of the sensitivity of
a bond's price to changes in interest
rates. It is an adjustment to the Macaulay
Duration to make it a more direct measure
of interest rate sensitivity.
2.Formula: Macaulay Duration divided by
(1 + (YTM/n)), where YTM is the bond's
yield to maturity, and n is the number of
compounding periods per year.
3.Use: Widely used by portfolio managers
and analysts to gauge the price sensitivity
of fixed-income securities to changes in
interest rates. For instance, a bond with a
modified duration of 5 years will see its
price rise by about 5% for a 1% drop in
interest rates, and vice versa.
MFIN 5600 -Fall 2023
Effective Duration:
1.Definition: Measures a bond's sensitivity
to changes in interest rates, taking into
account that expected cash flows can
change as interest rates change.
Particularly useful for bonds with
embedded options, like callable or putable
bonds.
2.Calculation: It considers how bond prices
change in response to a parallel shift in the
yield curve.
3.Use: Essential for analyzing bonds with
embedded options. As interest rates
change, the expected cash flows of these
bonds might change (e.g., a bond might be
called early if rates drop). Effective
duration captures this potential change in
cash flows.
18
 Bond Risk and Return Measures
Key Rate Duration:
1.Definition: Measures the sensitivity
of a bond's price to changes in
interest rates at specific points (or
maturities) along the yield curve,
rather than a parallel shift.
2.Use: Enables portfolio managers to
assess and hedge against the interest
rate risk associated with specific
maturities on the yield curve. If one
believes that certain parts of the
yield curve will move more than
others, key rate durations can guide
portfolio adjustments.
Empirical Duration:
1.Definition: Calculated based on
observed changes in bond prices and
their relationship to changes in
interest rates, rather than based on
theoretical models.
2.Use: Valuable when real-world,
observed data is preferred over
theoretical models. Especially
relevant in periods of market
anomalies or distortions when
traditional models might not fully
capture market behaviors.
MFIN 5600 -Fall 2023
Money Duration:
1.Definition: Represents the change in
a bond's price (in monetary terms)
for a 1% change in yield. It's the
product of the bond's modified
duration and its price or principal.
2.Use: Crucial for portfolio managers
desiring a direct measure in
monetary terms of how much the
value of their holdings might change
with interest rate fluctuations.
Knowing the potential dollar change
for a 1% rate shift aids in risk
management and strategy
implementation.
19
Bond Risk and Return Measures

• Macaulay focuses on weighted average time of cash flows, while Modified and Effective
Durations focus on price sensitivity to interest rate changes. Key Rate Duration narrows this
sensitivity to specific maturities on the yield curve.
• Effective Duration is more appropriate for bonds with embedded options, while Modified
Duration works well for option-free bonds. Key Rate Duration is used when non-parallel shifts
in the yield curve are of concern.
• Empirical Duration is based on observed changes, making it distinct from the other model-based
durations.

MFIN 5600 -Fall 2023 20

 Bond Risk and Return Measures
Price Value of a Basis Point (PVBP)
• Definition: Measures the change in the
price of a bond for a one basis point
(0.01%) change in yield.
• Calculation: Difference between the
bond's price at its original yield and its
price at a yield changed by one basis
point.
• Use: Useful for assessing the interest
rate risk of bonds. The higher the PVBP,
the more sensitive the bond's price is to
changes in yields.
Convexity
• Definition: Measures the rate of change
of a bond's duration as yields change,
reflecting the bond's price sensitivity to
interest rate changes.
• Calculation: Second derivative of the
bond's price with respect to its yield.
• Use: Helps refine duration-based
predictions. Positive convexity means
bond prices rise more for a rate drop
than they fall for a rate increase of the
same magnitude.
MFIN 5600 -Fall 2023
Effective Convexity
• Definition: Measures the convexity of a
bond with embedded options (like
callable or putable bonds) considering
potential changes in interest rates.
• Calculation: Evaluates price changes
for two parallel shifts in the bond's yield
curve (one up and one down).
• Use: Essential for bonds with embedded
options, as they may not have constant
cash flows. Helps investors understand
the bond's price sensitivity in different
interest rate scenarios.
21
 Bond Portfolio Metrics
Bond Portfolio Duration
• Definition: Weighted
average time until a bond's
fixed cash flows are
received.
• Calculation:
• Weights are typically the
proportion of each bond's
market value in the
portfolio.
• Use: Gauges the interest rate
risk of the entire bond
portfolio.
Effective Duration of Bond
Portfolio
• Definition: Measures the
expected percentage change
in the bond portfolio's price
for a parallel shift in the
yield curve.
• Calculation:
• Use: Essential for portfolios
containing bonds with
embedded options, as it
accounts for changes in cash
flow due to rate changes.
MFIN 5600 -Fall 2023
Bond Portfolio Modified
Duration
• Definition: Measures the
expected percentage change
in a bond's price for a 1%
change in yield.
• Calculation:
• Use: Indicates the portfolio's
overall sensitivity to
changes in interest rates.
Portfolio Convexity
• Definition: Measures the
rate of change of portfolio
duration as yields change.
• Calculation:
• Use: Refines predictions of
bond price sensitivity,
especially for larger changes
in yields.
22
 Bond Portfolio Metrics
Spread Duration
• Definition: Measures the sensitivity of a
bond's or bond portfolio's price to
changes in credit spread.
• Calculation:
• The estimated percentage change in a
bond's price for a 1% (or 100 basis
points) change in its credit spread.
• Use: Useful for gauging the potential
impact of credit spread changes on the
bond's or portfolio's value, especially in
portfolios with varying credit qualities.
Duration Times Spread (DTS)
• Definition: A risk measure that
combines both interest rate risk
(duration) and credit risk (spread).
• Calculation:
DTS=Duration × Credit Spread
• It provides an estimate of the potential
loss in value for a given increase in
credit spreads.
• Use: Helps investors understand the
combined effect of interest rate and
credit spread changes on a bond or
portfolio.
MFIN 5600 -Fall 2023
Portfolio Dispersion
• Definition: Measures the diversity of
bond maturities or durations within a
portfolio.
• Calculation:
• Often quantified as the average
difference between each bond's
duration and the portfolio's average
duration.
• Use: Provides insights into the interest
rate risk of the portfolio. A portfolio
with high dispersion has bonds with a
wide range of sensitivities to interest
rate changes, while a portfolio with low
dispersion is more uniformly sensitive.
23
Active Bond Portfolio Management:
Managing Portfolio Duration

Overview: Adjusting portfolio duration based on economic forecasts and interest rate expectations.
Implementation:
Use a combination of top-down (macroeconomic factors) and bottom-up (individual security selection)
approaches.
Adjust the exposure to longer-dated bonds relative to the benchmark based on interest rate expectations.

Example:
If expecting a rise in interest rates and a steepening yield curve, reduce exposure to longer-dated bonds, lowering
the portfolio duration.

Outcome:
Aligning portfolio duration with market expectations can lead to outperformance and active excess returns when
predictions materialize.
MFIN 5600 -Fall 2023 24
Active Bond Portfolio Management:
Managing Spread Duration or Credit Exposure

Overview: Using spread duration measures to adjust portfolio sensitivity to credit spread
changes.
Strategies:
Increase spread duration if expecting credit spreads to narrow.
Adjust the average credit rating of the portfolio (e.g., shifting from A rated to BBB rated bonds).

Constraints:
Be mindful of investment mandate constraints such as target duration, rating-based restrictions, and
derivatives use limits.

Tools:
Utilize "duration times spread" measure for a comprehensive view of potential portfolio value changes.

MFIN 5600 -Fall 2023 25

 Active Bond Portfolio Management:
Utilizing Relative Value

Overview: Selecting the most attractive individual securities based on a comprehensive analysis.
Approach:
Analyze and rank securities across sectors, issuers, and individual bonds based on valuation, issuer fundamentals, and
market technical conditions.
Establish a time horizon for the relative value analysis.

Implementation:
Use bond characteristics like key rate duration and duration times spread to express active positions relative to the
benchmark.
Select securities that optimize the expected return for a given level of risk, ensuring the best relative value.

Diversification:
Ensure idiosyncratic risks are within acceptable parameters while pursuing relative value opportunities.

MFIN 5600 -Fall 2023 26

Pure Indexing vs. Enhanced Indexing vs. Active Management
Example

MFIN 5600 -Fall 2023 27

Pure Indexing vs. Enhanced Indexing vs. Active Management
Example

MFIN 5600 -Fall 2023 28

Pure Indexing vs. Enhanced Indexing vs. Active Management
Example

MFIN 5600 -Fall 2023 29

Pure Indexing vs. Enhanced Indexing vs. Active Management
Example

MFIN 5600 -Fall 2023 30

 Understanding Liquidity Issues in Fixed Income

• Liquidity impacts Over-the-Counter

On-the-Run vs. Off-
bond pricing, (OTC) Dealer Search Cost: Price Transparency: Liquidity Premium:
the-Run Bonds:
Market:
trading strategies,
and portfolio • Unlike centralized • The time and • In equities, price • On-the-Run: Newest • Extra yield
exchanges, fixed resources required to information is readily bond issues, highly demanded by
management. income securities are find the best bond available due to liquid due to high investors for holding
• Investors need to often traded OTC. price or a willing centralized demand. less liquid bonds.
• Interactions are counterparty. exchanges. • Off-the-Run: Older • Compensates for the
balance the trade- mainly between • Higher in fixed • Fixed income bond issues replaced potential difficulty
off between yield dealers and income due to the securities, especially by newer ones. Less and cost of selling
and liquidity. institutional OTC nature, OTC trades, lack liquid as they're less the bond before
investors. resulting in less real-time price actively traded. maturity.
• A deep • This decentralized standardized prices transparency, leading • Liquidity differences • Bonds with higher
structure can lead to and terms. to information can lead to pricing liquidity risk will
understanding of asymmetry.
fragmented disparities between generally have a
market structure and information and the two. higher liquidity
liquidity nuances is varying prices. premium
essential for
effective fixed
income investing.
MFIN 5600 -Fall 2023 31
 Understanding Liquidity Issues in Fixed Income
Mutual Funds:
• Overview: Pooled investment
vehicles that aggregate capital
from multiple investors to buy
a diversified portfolio of
bonds.
• Liquidity Benefit: Provides
daily liquidity, enabling
investors to enter or exit
positions without directly
transacting in individual
bonds.
• Implications: Can offer
diversification benefits and
professional management, but
may come with management
fees.
Exchange-Traded Funds
(ETFs):
• Overview: Similar to mutual
funds, but trade on stock
exchanges like individual
stocks.
• Liquidity Benefit: Real-time
trading and price transparency.
Acts as a bridge between the
bond market and stock
exchanges, enhancing
liquidity.
• Implications: Can be more
cost-effective than mutual
funds and offer intraday
liquidity.
MFIN 5600 -Fall 2023
Exchange-Traded
Derivatives:
• Overview: Financial
contracts, such as futures and
options on bond indices, that
are traded on organized
exchanges.
• Liquidity Benefit:
Centralized exchanges ensure
standardization and typically
higher liquidity than OTC
markets.
• Implications: Useful for
hedging, speculation, or
achieving synthetic exposure
to fixed income assets without
directly holding them.
OTC Derivatives:
• Overview: Customized
contracts between two parties,
like interest rate swaps or
credit default swaps.
• Liquidity Benefit: While
individually tailored and
potentially less liquid, they
can be structured to address
specific liquidity needs or time
horizons.
• Implications: Flexibility to
design specific terms, but
comes with counterparty risk
and may lack standardization.
32
 Decomposing Expected Return of Fixed
Income
Views on Views on Yield Views on Currency
Coupon Income: Rolldown Return:
Benchmark Yield: Spread: Value Changes:

1.Definition: The 1.Definition: Gains 1.Definition: 1.Definition: 1.Definition: For bonds

periodic interest generated when a bond
payment made to "rolls down" the yield
bondholders during the curve as it approaches
life of the bond. maturity.
2.Impact on Return: As
2.Impact on Return: time passes, a bond
Represents a may move to a shorter
predictable income maturity bucket on the
stream, usually the yield curve, potentially
largest component of resulting in capital
expected return for appreciation if the yield
investment-grade curve is upward
bonds. sloping.
Anticipations about Expectations about the
future movements in changes in the
the general level of difference between the
interest rates. bond's yield and a
2.Impact on Return: If a benchmark yield 2.Impact on Return: If a
manager expects a (usually a government
decline in benchmark bond).
yields, they may 2.Impact on Return: A
increase duration to narrowing yield spread
capture capital gains, due to improving credit
and vice versa. quality or other factors
can boost bond returns.
denominated in foreign
currencies, expectations
about future exchange
rate movements matter.
manager expects the
bond's currency to
appreciate relative to
the home currency, this
can add to returns for
international bond
holdings

MFIN 5600 -Fall 2023 33

MFIN 5600 -Fall 2023 34