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Reading 23 Fixed Income Portfolio Management – Part II www.irfanullah.co Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Contents Other Fixed-Income Strategies – – – Combination Strategies Leverage Derivatives Enabled Strategies International Bond Investing – – – – Active vs Passive Management Currency Risk Breakeven Spread Analysis Emerging Market Debt Selecting a Fixed-Income Manager – – – Historical Performance as a Predictor of Future Performance Developing Criteria for Selection Comparison with Selection of Equity Managers www.irfanullah.co Other Fixed Income Strategies • Combination Strategies – Active/Passive Combination – Active/Immunization Combination • Leverage – Leverage can be used to enhance portfolio returns – Works if investment return > funding cost – Interest rate sensitivity goes up www.irfanullah.co Example – Use of Leverage www.irfanullah.co Leverage cuts both ways… Borrow at 4% www.irfanullah.co E= B= k= rf = Amount of equity Amount of borrowed funds Cost of borrowing Return on invested funds Return on borrow funds: RB = rf – k Return on Equity: RE = rf Return on Portfolio, Rp = rf + (B/E) x (rf – k) www.irfanullah.co If portfolio has assets and liabilities, how you calculate the duration of equity… DE = (DAA – DLL) / E Bond Portfolio = $140 mil with DA = Borrowed funds = $100 mil with DL = Calculate DE www.irfanullah.co Repurchase Agreements (repo or RP) • Sale of security coupled with agreement to repurchase • Collateralized loan with price difference representing interest • Transfer of securities – – – – Physical delivery Credits/Debits to accounts of banks acting as clearing agents for customers Deliver to custodial account at seller’s bank (trustee for both parties) No delivery www.irfanullah.co Factors that Affect Repo Rate • Quality of collateral • Term of the repo • Delivery requirement • Availability of collateral • Prevailing interest rate in the economy • Seasonal factors www.irfanullah.co 5.3 Derivatives Enabled Strategies • Derivatives can create, reduce or magnify factor exposures – Factors: duration and convexity, credit, liquidity • This sub-section covers – – – – – – – Interest Rate Risk Other Risk Measures Bond Variance vs Duration Interest Rate Futures Interest Rate Swaps Bond and Interest Rate Options Credit Risk Instruments www.irfanullah.co 10 Credit Forward Payoff = (Credit Spread a Maturity – Contracted Spread) x NP x RF Symmetric Example 13 www.irfanullah.co 27 Example 14 Binary Credit Option Credit Spread Option Credit Spread Forward www.irfanullah.co 28 Credit Swaps Credit Default Swap (CDS) is the most popular credit swap Protection Buyer, Protection Seller, Reference Entity, Credit Event Example 15: You are bullish on long term debt issued by countries A, B and C Credit event = failure to make timely payments Will you sell protection or buy protection? A few months later, the government of Country A defaults on its debt obligations, the rating of debt issued by Country B is lowered by Moody’s from Baa to Ba because of adverse economic developments in that country, and the rating of debt issued by Country C is upgraded by Moody’s from Baa to A in view of favorable economic developments For each country indicate whether you’d suffer a loss www.irfanullah.co 29 International Bond Investing Diversification benefit because of low correlation across international bond markets www.irfanullah.co 30 6.1 Active vs Passive Management Active managers seek to add value through one or more of the following means: 1) Bond market selection 2) Currency selection 3) Duration management/yield management 4) Sector selection 5) Credit analysis of issuers 6) Investing in markets outside the benchmark www.irfanullah.co 31 When estimating the duration of a foreign bond you should consider the country beta Example 16 www.irfanullah.co 32 6.2 Currency Risk Currency risk can be hedged using forward contracts Interest Rate Parity: F = S x (1 + i ) / (1 + i) Forward premium, f = (F – S ) / S f is approximately = id - if Forward hedging use forward contracts Proxy hedging forward contract bet home currency and currency which is highly correlated with bond’s cur Cross hedging hedging using two currencies other than home currency www.irfanullah.co 33 Hedged return vs unhedged return R = rl + e HR = rl + f HR = www.irfanullah.co 34 www.irfanullah.co 35 www.irfanullah.co 36 6.3 Breakeven Spread Analysis Quantify amount of spread widening to required to diminish foreign yield advantage Example 20 www.irfanullah.co 37 6.4 Emerging Market Debt (EMD) EMD has matured as an asset class and frequently appears in many strategic asset allocations Important role in core-plus fixed income portfolios Advantages Risks Relatively low correlation with domestic bond portfolios Significant negative skewness Potential for consistent, attractive rates of return Sovereign EM govts can react quickly to negative economic events Access to IMF and WB Relatively high credit risk Less transparency Weak legal system Political risk Credit analysis is very important! Some EM countries have high FX reserves www.irfanullah.co 38 Selecting a Fixed-Income Manager Average institutional investor has 85% assets managed actively When funds are not managed in-house look for a fixed income portfolio manager Consider past performance (active return and active risk), but this should NOT be the only criteria Develop selection criteria 1) Style analysis 2) Selection bets 3) Organization’s investment process 4) Correlation of alphas www.irfanullah.co 39 Comparison with Selection of Equity Managers 1) In both cases a consultant is used to identify a universe of suitable investment managers 2) In both cases, past performance is not necessarily a guide to future results 3) Many qualitative factors are common: manager’s philosophy, experience, competitive advantages, etc 4) Management fees and expenses are more important in fixed income because they represent a higher percentage of returns Example 21: Due Diligence Questionnaire for a U.S Fixed Income Portfolio www.irfanullah.co 40 Conclusion • Learning objectives • Summary is exceptionally good • A Few examples… • … but lots of good practice problems www.irfanullah.co 41 ...Contents Other Fixed- Income Strategies – – – Combination Strategies Leverage Derivatives Enabled Strategies International Bond Investing – – – – Active vs Passive Management Currency Risk... Fixed- Income Manager – – – Historical Performance as a Predictor of Future Performance Developing Criteria for Selection Comparison with Selection of Equity Managers www.irfanullah.co Other Fixed. .. rf Return on Portfolio, Rp = rf + (B/E) x (rf – k) www.irfanullah.co If portfolio has assets and liabilities, how you calculate the duration of equity… DE = (DAA – DLL) / E Bond Portfolio = $140