Practice investment management pim3 ch19

CHAPTER NINETEEN MANAGING THE FIXED INCOME PORTFOLIO Practical Investment Management Robert A Strong Outline  Fixed Income Security Risk  Default Risk  Reinvestment Rate Risk  Interest Rate Risk  Duration  Duration Measures  Applying Duration South-Western / Thomson Learning © 2004 19 - Outline  Convexity     Problems with Duration Simple Convexity An Example Using Convexity  Management Strategies      Active vs Passive Management Classic Passive Management Strategies The Risk of Barbells and Ladders Indexing Active Management South-Western / Thomson Learning © 2004 19 - Fixed Income Security Risk  Default risk, or credit risk, is the possibility that a borrower will be unable to repay principal and interest as agreed upon in the loan document  Reinvestment rate risk refers to the possibility that the cash coupons received will be reinvested at a rate different from the bond’s stated rate  Interest rate risk refers to the chance of loss because of adverse movements in the general level of interest rates South-Western / Thomson Learning © 2004 19 - Interest Rate Risk : Malkiel’s Theorems  Malkiel’s theorems are a set of relationships among bond prices, time to maturity, and interest rates  Theorem One : Bond prices move inversely with yields  Theorem Two : Long-term bonds have more risk  Theorem Three : Higher coupon bonds have less risk South-Western / Thomson Learning © 2004 19 - Interest Rate Risk : Malkiel’s Theorems  Theorem Four : The importance of theorem two diminishes with time  Theorem Five : Capital gains from an interest rate decline exceed the capital loss from an equivalent interest rate increase South-Western / Thomson Learning © 2004 19 - Interest Rate Risk : Malkiel’s Theorems Insert Table 19-1 here South-Western / Thomson Learning © 2004 19 - Interest Rate Risk : Malkiel’s Theorems  Bond A : matures in years, 9.5% coupon Bond B : matures in 15 years, 11% coupon Which price will rise more if interest rates fall?  Apparent contradictions can be reconciled by computing a statistic called duration South-Western / Thomson Learning © 2004 19 - Duration  For a noncallable security, duration is the weighted average time until a bond’s cash flows are received  Duration is not limited to bond analysis It can be determined for any cash flow stream  Duration is a direct measure of interest rate risk The higher it is, the higher is the risk  Thinking of duration as a measure of time can be misleading if the life or the payments of the bond are uncertain South-Western / Thomson Learning © 2004 19 - Duration Measures  Macaulay duration is the time-value-of-moneyweighted, average number of years necessary to recover the initial cost of the security N  D Ct t t 11  R  t P where D = duration       Ct = cast flow at time t       R = yield to maturity (per period)       P = current price of bond       N = number of periods until maturity       t = period in which cash flow is received South-Western / Thomson Learning © 2004 19 - 10 Using Convexity Insert Figure 19-6 here South-Western / Thomson Learning © 2004 19 - 25 Management Strategies  An active strategy is one in which the investment manager seeks to improve the rate of return on the portfolio by anticipating events in the marketplace  A passive strategy is one in which the portfolio is largely left alone after its construction Changes are made when securities mature or are called, but normally not for any other reason South-Western / Thomson Learning © 2004 19 - 26 par value Classic Passive Management Strategies maturity  A barbell strategy differs from the laddered strategy in that less investment is made in the middle maturities par value maturity  A laddered strategy distributes fixed income dollars throughout the yield curve  A credit barbell is a bond portfolio containing a mix of high-grade and low-grade securities South-Western / Thomson Learning © 2004 19 - 27 Classic Passive Management Strategies Insert Figure 19-7 here South-Western / Thomson Learning © 2004 19 - 28 Classic Passive Management Strategies Insert Figure 19-8 here South-Western / Thomson Learning © 2004 19 - 29 Classic Passive Management Strategies Insert Figure 19-9 here South-Western / Thomson Learning © 2004 19 - 30 Classic Passive Management Strategies Insert Figure 19-10 here South-Western / Thomson Learning © 2004 19 - 31 The Risk of Barbells and Ladders  If durationladdered portfolio > durationbarbell portfolio , interest rate risk reinvestment rate risk rising interest rate falling interest rate barbell ladder favored favored barbell favored ladder favored  Yield curve inversion means short-term rates are rising faster than long-term rates Duration as a pure measure of interest rate risk only works for parallel shifts in the yield curve South-Western / Thomson Learning © 2004 19 - 32 Passive Management Strategies  Indexing is predicated upon managers being unable to consistently predict market movements  Indexing involves attempting to replicate the investment characteristics of a popular measure of the bond market  The two best-known bond indexes are probably the Merrill Lynch Corporate Bond Index and the Lehman Brothers Bond Index South-Western / Thomson Learning © 2004 19 - 33 Active Management Strategies  Active management techniques frequently involve a bond swap, which is usually intended to one of four things:  increase current income  increase yield to maturity  improve the potential for price appreciation with a decline in interest rates  establish losses to offset capital gains or taxable income  Active management strategies fall into four broad categories South-Western / Thomson Learning © 2004 19 - 34 Strategy : Duration Management  Duration management techniques involve creating a structured portfolio - a collection of securities with characteristics that will accommodate a specific need or objective  A key concept is immunization - a technique that seeks to reduce or eliminate the interest rate risk in a portfolio  Bank immunization is achieved when the total dollar duration of a financial institution’s rate sensitive assets equals the total dollar duration of its rate sensitive liabilities South-Western / Thomson Learning © 2004 19 - 35 Strategy : Duration Management  Bullet immunization seeks to ensure that a specific sum of money will be available at a point or series of points in the future Cash matching is the special case when cash is generated exactly in line with cash demands  Another practice, known as duration matching, aims to get interest rate risk and reinvestment rate risk to cancel each other out  A dedicated portfolio is a separate portfolio that will generate cash equal to or greater than some required amount South-Western / Thomson Learning © 2004 19 - 36 Active Management Strategies  Strategy : Yield Curve Reshaping  If lower interest rates are expected, long-term premium bonds may be exchanged for longterm discount bonds, for example  Strategy : Sector Selection  Differences in market sectors sometimes cause otherwise similar bonds to behave differently in response to market changes  Strategy : Issue Selection  Analysts try to correctly anticipate bond rating changes or make profitable substitution swaps South-Western / Thomson Learning © 2004 19 - 37 Review  Fixed Income Security Risk     Default Risk Reinvestment Rate Risk Interest Rate Risk Duration   Duration Measures Applying Duration South-Western / Thomson Learning © 2004 19 - 38 Review  Convexity      Problems with Duration Simple Convexity An Example Using Convexity Management Strategies      Active vs Passive Management Classic Passive Management Strategies The Risk of Barbells and Ladders Indexing Active Management South-Western / Thomson Learning © 2004 19 - 39 ... Example Using Convexity  Management Strategies      Active vs Passive Management Classic Passive Management Strategies The Risk of Barbells and Ladders Indexing Active Management South-Western... dominates the competing investment South-Western / Thomson Learning © 2004 19 - 24 Using Convexity Insert Figure 19-6 here South-Western / Thomson Learning © 2004 19 - 25 Management Strategies... Learning © 2004 19 - 26 par value Classic Passive Management Strategies maturity  A barbell strategy differs from the laddered strategy in that less investment is made in the middle maturities par