CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 CFA 2018 r21 introduction to fixed income portfolio management IFT notes

R21 Introduction to Fixed-Income Portfolio Management IFT Notes Introduction to Fixed-Income Portfolio Management Introduction 2 Roles of Fixed-Income Securities in Portfolios 2.1 Diversification Benefits 2.2 Benefits of Regular Cash Flows 2.3 Inflation Hedging Potential 3 Fixed-Income Mandates 3.1 Liability-Based Mandates 3.1.1 Cash Flow Matching 3.1.2 Duration Matching 3.1.3 Contingent Immunization 3.1.4 Horizon Matching 3.2 Total Return Mandates 3.2.1 Pure Indexing 3.2.2 Enhanced Indexing 3.2.3 Active Management Bond Market Liquidity 4.1 Liquidity among Bond Market Sub-Sectors 10 4.2 The Effects of Liquidity on Fixed-Income Portfolio Management 10 4.2.1 Pricing 10 4.2.2 Portfolio Construction 11 4.2.3 Alternatives to Direct Investment in Bonds 11 A Model for Fixed-Income Returns 11 5.1 Decomposing Expected Returns 12 5.2 Estimation of the Inputs 13 5.3 Limitations of the Expected Return Decomposition 13 Leverage 13 6.1 Using Leverage 13 6.2 Methods for Leveraging Fixed-Income Portfolios 14 6.2.1 Futures Contracts 14 6.2.2 Swap Agreements 14 6.2.3 Structured Financial Instruments 15 6.2.4 Repurchase Agreements 15 6.2.5 Securities Lending 16 6.3 Risks of Leverage 17 Fixed-Income Portfolio Taxation 17 7.1 Principles of Fixed-Income Taxation 17 7.2 Investment Vehicles and Taxes 18 Summary from the Curriculum 19 Examples from the Curriculum 22 Example Adding Fixed-Income Securities to a Portfolio 22 Example Liability-Based Mandates (1) 23 IFT Notes for the Level III Exam www.ift.world Page R21 Introduction to Fixed-Income Portfolio Management IFT Notes Example Liability-Based Mandates (2) 23 Example The Characteristics of Different Total Return Approaches 23 Example Decomposing Expected Returns 25 Example Components of Expected Return 27 Example Managing Taxable and Tax-Exempt Portfolios 27 This document should be read in conjunction with the corresponding reading in the 2018 Level III CFA® Program curriculum Some of the graphs, charts, tables, examples, and figures are copyright 2017, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute IFT Notes for the Level III Exam www.ift.world Page R21 Introduction to Fixed-Income Portfolio Management IFT Notes Introduction Fixed-income markets include publicly traded securities (such as commercial paper, notes, and bonds) and non-publicly traded instruments (such as loans and privately placed securities) This reading discusses the role of fixed-income securities in portfolios, types of fixed-income portfolio mandates, bond market liquidity and its effects on pricing and portfolio construction, determining a model for fixed-income returns, use of leverage in fixed-income portfolios, and considerations in managing fixed-income portfolios for both taxable and tax-exempt investors This section addresses LO.a: LO.a: discuss roles of fixed-income securities in portfolios; ROLES OF FIXED-INCOME SECURITIES IN PORTFOLIOS Fixed-income securities play different important roles in investment portfolios, including diversification, regular cash flows, and possible inflation hedging 2.1 Diversification Benefits In general, fixed-income securities have low correlation with other asset classes (including equity securities, real estate, and commodities); hence, adding fixed-income securities to portfolios provide diversification benefits Refer to the table below There are various fixed income indexes and other asset classes, i.e., US S&P500 (which represents US equity) If we take Bloomberg Barclays US Aggregate (representing an overall index for US bonds), its correlation with S&P500 is -0.27 Source: Authors’ calculations for the period January 2003 to September 2015, based on data from Barclays Risk Analytics and Index Solutions; J.P Morgan Index Research; S&P Dow Jones Indices However, it is important to note that these correlations are not constant over time The correlation between the asset classes may increase or decrease, depending on the circumstances and capital market dynamics For example, during periods of market stress, the correlation between riskier assets IFT Notes for the Level III Exam www.ift.world Page R21 Introduction to Fixed-Income Portfolio Management IFT Notes such as equity securities and high-yield bonds may increase while at the same time, the correlation between government bonds and equity securities, as well as between government bonds and high-yield bonds may decrease Besides having a lower correlation with other asset classes, bonds are generally less volatile than other major asset classes and thus help in reducing the overall risk of a portfolio Like correlation, volatility (standard deviation) of asset class returns may also vary over time For example, if interest rate volatility increases, the near-term volatility of returns tends to increase relative to the average volatility over a long historical period Similarly, lower credit quality (high-yield) bonds may exhibit higher volatility of returns during times of financial stress, because a decline in credit quality leads to increase in the probability of default 2.2 Benefits of Regular Cash Flows Fixed-income investments play another important role in investment in the form of regular cash flows Regular and predictable cash flows help investors in meeting their known future obligations such as tuition payments, pension obligations, or payouts on life insurance policies Investors can select fixedincome securities whose timing and magnitude of cash flows match the timing and magnitude of the projected future liabilities For example, a 10-year coupon paying bond can be used to cover an investor’s living expenses over a 10-year horizon Sometimes, investors may create “ladder” bond portfolios which comprise bonds of different maturities Ladder portfolios help investors in balancing price and reinvestment risk Regular cash flows benefit relies on the assumption that no credit event (such as an issuer defaulting on scheduled interest or principal payment) or other market events (such as a decrease in interest rates increasing prepayments of mortgages underlying mortgage-backed securities) will occur 2.3 Inflation Hedging Potential Bonds with floating-rate coupons provide a hedge against inflation because the reference rate is adjusted for inflation However, the principal payment at maturity is unadjusted for inflation Inflationlinked bonds provide inflation hedging benefits as their coupon is directly linked to an index of consumer prices and the principal is also adjusted for inflation In inflation-linked bonds, the volatility of the returns depends on the volatility of real, rather than nominal, interest rates As a result, inflationlinked bonds exhibit lower return volatility than conventional bonds and equities Owing to lower volatility and inflation hedging benefits, adding inflation-indexed bonds to diversified portfolios of bonds and equities results in superior risk-adjusted real portfolio returns Exhibit below illustrates inflation protection provided by type of bond Exhibit Coupon Fixed-coupon bonds Principal Inflation unprotected Inflation unprotected Floating-coupon bonds Inflation protected Inflation unprotected Inflation-linked bonds Inflation protected Inflation protected Zero-coupon inflation-linked bonds Not applicable Inflation protected IFT Notes for the Level III Exam www.ift.world Page R21 Introduction to Fixed-Income Portfolio Management Capital-indexed inflation-linked bonds IFT Notes A fixed coupon rate is applied to a principal amount that is adjusted for inflation throughout the bond’s life Refer to Example from the curriculum This section addresses LO.b: b describe how fixed-income mandates may be classified and compare features of the mandates; FIXED-INCOME MANDATES There are two types of fixed-income mandates, i) liability-based mandates and ii) total return mandates 3.1 Liability-Based Mandates Liability-based mandates aim at matching or covering expected liability payments with future projected cash inflows They are also called structured mandates, asset/liability management (ALM), or liabilitydriven investments (LDI) Users of liability-based mandates include individuals funding specific cash flow and lifestyle needs as well as institutions such as banks, insurance companies, and pension funds Approaches to liability-based mandates: Liability-based mandates rely on immunization Immunization is an asset/liability management approach that focuses on minimizing the risks associated with a change in market interest rates in a fixed-income portfolio over a known time horizon Immunization approaches include: i ii iii iv Cash flow matching Duration matching Contingent immunization Horizon matching 3.1.1 Cash Flow Matching Cash flow matching aims at precisely matching all future liability payouts by cash flows from bonds or fixed-income derivatives, such as interest rate futures, options, or swaps Exhibit shows the results of a cash flow matching approach for a liability stream and a bond portfolio Future liability payouts are exactly matched by coupon and principal payments from bond portfolio As a result, cash inflows are not required to be reinvested IFT Notes for the Level III Exam www.ift.world Page R21 Introduction to Fixed-Income Portfolio Management IFT Notes Limitations of cash flow matching approach:      It is quite difficult to perfectly match cash flows It is a costly approach as it involves high transaction costs This approach suffers from timing mismatches because some cash inflows tend to precede corresponding cash outflows This mismatch results in reinvestment risk As market conditions change, the lowest cost cash flow matching portfolio may change This approach may fail to meet its objective in case of a default event or a prepayment event 3.1.2 Duration Matching As the name implies, duration matching approach aims at matching the duration of assets and liabilities, such that the liability portfolio and the bond portfolio are affected similarly by a change in interest rates In duration matching following two conditions need to be met: i ii A bond portfolio’s duration must equal the duration of the liability portfolio; The present value of the bond portfolio’s assets must equal the present value of the liabilities at current interest rate levels This implies the following,  If interest rates decrease, an increase in bond prices offsets the decrease in reinvestment income  If interest rates increase, higher reinvestment income offsets the decrease in bond prices It is important to note that immunized portfolio is not fully immunized and some immunization risk almost always exists Following are some important considerations for an immunized portfolio:  Immunization protects only against a parallel shift in the yield curve  A portfolio is an immunized portfolio only at a given point in time and thus portfolio needs to be rebalanced periodically in response to changes in market conditions in order to maintain immunization  Owing to periodic rebalancing requirement, it is important to consider the liquidity of the bond portfolio; rebalancing and the need to liquidate positions can result in high portfolio turnover  Immunized portfolio is not fully immunized because immunization assumes that there is no default risk  Immunization can be used for bonds with embedded options if we use effective duration of bonds in place of duration as an input to the methodology Exhibit gives an overview of key features of duration matching and cash flow matching Duration Matching Cash Flow Matching Yield curve assumptions Parallel yield curve shifts None Mechanism Risk of shortfall in cash flows is minimized by matching duration and present value of liability stream Bond portfolio cash flows match liabilities IFT Notes for the Level III Exam www.ift.world Page R21 Introduction to Fixed-Income Portfolio Management Rebalancing Frequent rebalancing required Not required but often desirable Complexity High Low IFT Notes 3.1.3 Contingent Immunization Contingent immunization is a hybrid approach, which combines immunization with an active management approach when the value of asset portfolio is greater than the present value of the liability portfolio The portfolio manager is allowed to actively manage the asset portfolio, or some portion of the asset portfolio by investing it into any asset category, including equity, fixed-income, and alternative investments, as long as the value of the actively managed portfolio exceeds a specified value (threshold) However, if the actively managed portfolio value falls to the specified threshold, active management ceases and a conventional duration matching or a cash flow matching approach is put in place This strategy requires careful monitoring and adjusting down risk when approaching safety net level 3.1.4 Horizon Matching This approach is a hybrid of cash flow and duration matching approaches Under this approach, shortterm liability portion (i.e four or five years) is covered by a cash flow matching approach, whereas the long-term liability portion of total liability portfolio is covered by a duration matching approach In other words, the cash flows due up to a certain intermediate horizon are matched on a cash flow basis, and the cash flows due after this intermediate horizon are matched on a duration basis Refer to Example from the curriculum Refer to Example from the curriculum 3.2 Total Return Mandates Total return mandates aim at meeting objectives based on a specified absolute return or a relative return For example, they focus on either tracking or outperforming a market-weighted fixed-income benchmark Unlike liability-based mandate, total return mandate does not attempt to match the liabilities Nevertheless, both mandates aim at achieving the highest risk-adjusted returns, given a set of constraints Total return mandates can be classified into the following three approaches based on their target active return and active risk levels Pure indexing Enhanced indexing Active management 3.2.1 Pure Indexing Under pure indexing approach, portfolio fully replicates the bond index by including all of the underlying securities in the same proportions as the index This implies that the targeted active return and active IFT Notes for the Level III Exam www.ift.world Page R21 Introduction to Fixed-Income Portfolio Management IFT Notes risk are both zero Advantages:    This approach results in very little, or zero, tracking error Risk exposure (such as duration, credit (or quality) risk, sector risk, call risk, and prepayment risk) of the bond portfolio is the same as that of the index This approach involves relatively low administrative fees Disadvantages:    It is difficult and expensive to precisely replicate most bond indexes because many bonds included in standard indexes are illiquid Although all or most of the known systematic risk factors can be matched with the benchmark index to the extent possible, but the issuer-specific (or idiosyncratic) risk remains This risk can be mitigated if both the benchmark index and the portfolio are sufficiently diversified Even if the tracking error is zero, the portfolio return will almost always be lower than the corresponding index return because of trading costs and management fees 3.2.2 Enhanced Indexing Enhanced indexing approach attempts to precisely track the benchmark’s primary risk factor exposures (particularly duration) while allowing for mismatches for minor risk factors (e.g sector or quality bets) in order to generate higher returns than the benchmark This approach involves higher turnover compared with pure indexing Advantages:    It is relatively easy and less expensive to implement as compared with pure indexing approach This approach may generate returns higher than pure indexing approach while at the same time exposure to primary risk factor is matched with that of benchmark index Administration/management fees are relatively lower than that of fully active management approach Disadvantages:    This approach has higher administration/management fees relative to pure indexing approach Owing to relatively higher turnover, close monitoring of turnover and the associated transaction costs is required in order to generate positive active returns net of fees and cost This approach has higher tracking error than pure indexing 3.2.3 Active Management Active management involves large risk factor deviations from the benchmark (in particular, duration) in an attempt to outperform the underlying benchmark Advantages:  This approach may result in higher expected return IFT Notes for the Level III Exam www.ift.world Page R21 Introduction to Fixed-Income Portfolio Management  IFT Notes This approach provides more flexibility to managers Disadvantages:    This approach involves higher tracking error and higher risk This approach has higher management fees than pure or enhanced index managers As a result, it is quite difficult to generate positive active returns net of fees and cost This approach results in significant portfolio turnover Refer to the table below that summarizes all the three approaches Pure Indexing Enhanced Indexing Active Management Objective Match benchmark return and risk as closely as possible Modest outperformance (generally 20 bps to 30 bps) of benchmark while active risk is kept low (typically around 50 bps or lower) Higher outperformance (generally around 50 bps or more) of benchmark and higher active risk levels Portfolio weights Ideally the same as benchmark or only slight mismatches Small deviations from underlying benchmark Significant deviations from underlying benchmark Risk factor matching Risk factors are matched exactly Most primary risk factors are closely matched (in particular, duration) Turnover Similar to underlying benchmark Slightly higher than underlying benchmark Large risk factor deviations from benchmark (in particular, duration) Considerably higher turnover than the underlying benchmark Historically, active portfolio performance < index fund performance < benchmark index performance Refer to Example from the curriculum This section addresses LO.c: c describe bond market liquidity, including the differences among market sub-sectors, and discuss the effect of liquidity on fixed-income portfolio management; BOND MARKET LIQUIDITY A liquid security is one that can be bought or sold quickly and with little effect on its price Fixed-income securities are generally less liquid compared with equities owing to various reasons as discussed below    Unlike company’s common stock which has identical features, bonds are very heterogeneous Each individual bond may have its own unique maturity dates, coupon rates, early redemption features, and other specific features Fixed-income markets are typically over-the- counter dealer markets and are less transparent relative to equity markets Fixed income markets have higher search costs as investors have to locate desired bonds and get IFT Notes for the Level III Exam www.ift.world Page R21 Introduction to Fixed-Income Portfolio Management IFT Notes quotes from multiple dealers to obtain the most advantageous pricing Example: Bonds of a highly creditworthy government issuer are more liquid, have greater price transparency, and have lower search costs than bonds of, for example, a corporate issuer with a lower credit quality Bond liquidity is typically highest right after issuance; e.g., on-the-run issues are more liquid than offthe-run issues This is because soon after bonds are issued, dealers have a supply of the bonds in their inventory, but as time passes, many of these bonds are purchased by buy-and- hold investors Liquidity also has an impact on bond yields as investors demand an incremental yield (referred to as liquidity premium) for investing in illiquid bonds, wherein the magnitude of the premium depends on issuer, issue size and date of maturity For example, the off-the-run 10-year US Treasury bond typically trades at several basis points higher yield than the on-the-run bond 4.1 Liquidity among Bond Market Sub-Sectors Bond market liquidity varies across sub-sectors such as issuer type, credit quality, issue size, and maturity    Larger issue size implies higher liquidity: Due to large issuance size, use as benchmark bonds, acceptance as collateral in the repo market, and well-recognized issuers, sovereign government bonds are typically more liquid than corporate and non-sovereign government bonds Similarly, in the corporate bond market, smaller issues are generally less liquid than larger issues Further, Bonds of infrequent issuers are less liquid than the bonds of issuers with many outstanding issues High credit quality implies higher liquidity: sovereign government bonds of countries with high credit quality are typically more liquid than bonds of lower-credit- quality countries and corporate bonds Shorter maturity implies higher liquidity: Bonds with shorter term maturities tend to be more liquid than longer-term bonds because bonds are typically purchased by buy-and- hold investors, so longer-term bonds may be unavailable for trading for a long period 4.2 The Effects of Liquidity on Fixed-Income Portfolio Management Liquidity affects fixed-income portfolio management in multiple ways, including pricing, portfolio construction, and consideration of alternatives to bonds (such as derivatives) 4.2.1 Pricing Pricing in bond markets is less transparent than in equity markets Bonds typically trade infrequently; hence, it is not appropriate to use recent transaction prices to represent current value Similarly, last traded prices are also not representative of current market conditions, as they may be out dated For less frequently traded bonds, it is preferred to use matrix pricing In matrix pricing, we use recent transaction prices of comparable bonds (i.e bonds which have similar features such as credit quality, time to maturity, and coupon rate) to estimate the market discount rate or required rate of return on less frequently traded bonds Benefit of matrix pricing: It is not based on complex financial modeling of bond market characteristics IFT Notes for the Level III Exam www.ift.world Page 10 R21 Introduction to Fixed-Income Portfolio Management 𝐫𝐏 = 𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝐫𝐞𝐭𝐮𝐫𝐧 𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝐞𝐪𝐮𝐢𝐭𝐲 = [𝐫𝐈 × (𝐕𝐄 + 𝐕𝐁 )− (𝐕𝐁 × 𝐫𝐁 )] 𝐕𝐄 = IFT Notes Total return on portfolio− cost of borrowing Portfolio′ sequity Or 𝑽 𝐫𝐏 = 𝒓𝑰 + 𝑽 𝑩 (𝒓𝑰 − 𝒓𝑩 ) 𝑬 Equation A Where, VE = value of the portfolio’s equity VB = borrowed funds rB = borrowing rate (cost of borrowing) rI = return on the invested funds (investment returns) rp = return on the levered portfolio Equation A implies that the degree to which the leverage increases or decreases portfolio returns is proportional to the use of leverage (amount borrowed), VB/VE, and the amount by which investment return differs from the cost of borrowing, (rI – rB)   If the return of invested funds (rI) is higher than the cost of borrowing (rB), then leverage increases the portfolio’s return If the return of invested funds (rI) is lower than the cost of borrowing (rB), then leverage decreases the portfolio’s return 6.2 Methods for Leveraging Fixed-Income Portfolios In fixed-income portfolio, there are varieties of tools available to create leveraged portfolio exposures These include futures contracts, swap agreements, structured financial instruments, repurchase agreements, and securities lending 6.2.1 Futures Contracts We can calculate the futures leverage using the following equation: LeverageFutures = Notional value − Margin Margin Where, Notional value = Current value of the underlying asset × Multiplier, or the quantity of the underlying asset controlled by the contract Futures contracts can be obtained for a modest investment in the form of a margin deposit 6.2.2 Swap Agreements Swap agreements are derivative contracts, which typically exchange – or swap – fixed-rate interest payments for floating-rate interest payments For example, in an interest rate swap, the fixed-rate payer (receiver) has a short (long) position in a fixed-rate bond and long (short) position in a floating-rate IFT Notes for the Level III Exam www.ift.world Page 14 R21 Introduction to Fixed-Income Portfolio Management IFT Notes bond   When interest rates increase, the value of the swap to the fixed-rate payer increases because the present value of the fixed-rate liability decreases and the floating-rate payments received increase When interest rates decline, the value of the swap to the fixed-rate receiver increases because the present value of the fixed-rate asset increases and the floating-rate payments made decrease Interest rate swaps can be viewed as a portfolio of bonds Like futures, swap agreements not require significant capital up front The only capital required to enter into swap agreements is collateral required by the counterparties 6.2.3 Structured Financial Instruments Structured products are synthetic investment instruments specially created to meet specific needs that cannot be met from the standardized financial instruments available in the markets An example of a structured financial instrument with embedded leverage is an inverse floating-rate note, also known as an inverse floater For example, Coupon rate = 15% − (1.5% × Libor3−month ) The above inverse-floater has an embedded leverage as it is linked to LIBOR; as the LIBOR decreases, the coupon rate increases and vice versa An inverse floating-rate note allows a bondholder to benefit from declining interest rates However, owing to embedded leverage, the losses may also magnify in case interest rates rise 6.2.4 Repurchase Agreements A repurchase agreement (repo) is an agreement between two parties whereby one party (the cash borrower) sells the other party (the cash lender) a security at a specified price with a commitment to buy the security back at a fixed time and price Repos are thus effectively collateralized loans From the lender’s perspective, these agreements are referred to as reverse repos The interest rate on a repurchase agreement, called the repo rate, is the difference between the security’s selling price and its repurchase price For example, consider a dealer wishing to finance a $15 million bond position with a repurchase agreement The dealer enters into an overnight repo at a repo rate of 5% The interest amount is computed as follows: Dollat interest = Principal amount × (Term of Repo in days /360) In the above example, dollar interest = $15 million × 5% × (1/360) = = $2,083.33 Thus, the dealer will repurchase the bond the next day for $15,002,083.33 A repo agreement may be cash driven or security driven  A cash-driven transaction is one where the collateral provider (party that owns bond) is seeking to borrow cash In such cases, the securities backing the transaction are typically “general collateral”, meaning that they are part of a class of acceptable securities rather a specific one, e.g Treasury IFT Notes for the Level III Exam www.ift.world Page 15 R21 Introduction to Fixed-Income Portfolio Management  IFT Notes bonds A security-driven transaction is one where the cash lender is seeking to borrow securities (for hedging, arbitrage, or speculation) In such cases, the security is usually specific Repos can be categorized as bilateral repos or tri-party repos based on the way they are settled   Bilateral repos involve two institutions, and settlement is typically conducted as “delivery versus payment,” meaning that the exchanges of cash and collateral occur simultaneously through a central custodian (for example, the Depository Trust Company in the United States) In general, security-driven transactions are conducted as bilateral repos Tri-party repo transactions involve a third party that provides settlement and collateral management services Most cash-motivated repo transactions against general collateral are conducted as tri-party repo transactions In repo agreement, the counterparty that lends capital faces credit risk Protection against a default by the borrower is provided by the underlying collateral bonds Additional credit protection can be provided in the form of “haircut,” which refers to the amount by which the collateral’s value exceeds the repo principal amount For example, haircuts for high-quality government bonds typically range from 1% to 3% Besides providing protection against default risk, the size of the haircut also limits the borrower’s net leverage capacity Generally, the higher the volatility of underlying collateral, the greater the size of the haircut will be 6.2.5 Securities Lending In a securities lending transaction, one party gives legal title to a security or basket of securities to another party for a limited period of time, in exchange for legal ownership of collateral The first party is called the ‘lender’ and the other party is called the ‘borrower’ The primary motive of securities lending transactions is to facilitate short sales (sale of securities the seller does not own) Another motive for securities lending transactions is financing, or collateralized borrowing The underlying collateral in security lending transactions can either be cash or high-credit-quality bonds In general, the value of collateral is greater than the value of the borrowed securities when bonds are used as collateral   When underlying collateral is cash, the security borrower typically pays the security lender a fee equal to a percentage of the value of the securities loaned The security lender earns an additional return by reinvesting the cash collateral However, if securities loan is used for financing purposes, the lending fee is typically negative, indicating that the security lender pays the security borrower a fee in exchange for its use of the cash When underlying collateral is bond, the security lender usually repays the security borrower a portion of the interest earned on the bond collateral Rebate rate represents the following Rebate rate = Collateral earnings rate – Security lending rate  Rebate rate is negative when securities are difficult to borrow;  Negative rebate rate implies that the security borrower pays a fee to the security lender in addition to forgoing the interest earned on the collateral IFT Notes for the Level III Exam www.ift.world Page 16 R21 Introduction to Fixed-Income Portfolio Management IFT Notes Unlike repurchase agreements, security lending transactions are typically open-ended, which means that the securities lender may recall the securities at any time Similarly, the borrower may deliver the borrowed securities back to the lender at any time 6.3 Risks of Leverage A leveraged fixed income portfolio is exposed to various risks as discussed below     Leverage alters the risk-return properties of an investment portfolio; Both gains and losses are magnified in a leveraged portfolio; If the value of the portfolio decreases, the portfolio’s equity relative to borrowing levels is reduced and the portfolio’s leverage increases Increased leverage might lead to forced liquidation at prices which are below fair value; In a financial crisis, counter parties to short-term financing arrangements may withdraw their financing, which in turn undermine the ability of leveraged market participants to maintain their investment exposures This section addresses LO.f: f discuss differences in managing fixed-income portfolios for taxable and tax exempt investors FIXED-INCOME PORTFOLIO TAXATION Taxes can complicate investment decisions in fixed-income portfolio management because taxes vary across investor types, countries, and income sources (interest income or capital gains) Portfolio managers who manage assets for taxable individual investors, as opposed to tax-exempt investors, need to consider a number of issues related to taxes 7.1 Principles of Fixed-Income Taxation Following are six principles of fixed-income taxation 1) The two primary sources of investment income that affect taxes for fixed-income securities are coupon payments (interest income) and capital gains or losses 2) In general, tax is payable only on capital gains and interest income that have actually been received An exception would be zero-coupon bonds, wherein tax is charged on imputed interest throughout a zero-coupon bond’s life 3) Capital gains are frequently taxed at a lower effective tax rate than interest income 4) Capital losses generally cannot be used to reduce sources of income other than capital gains Capital losses reduce capital gains in the tax year in which they occur If capital losses are greater than the capital gains in the year, they can be “carried forward” and applied to gains in future years In some countries, losses may also be “carried back” to reduce capital gains taxes paid in prior years 5) In some countries, short-term capital gains are taxed at usually a higher rate than long-term capital gains Key points for managing taxable fixed-income portfolios include the following:  Selectively offset capital gains and losses for tax purposes IFT Notes for the Level III Exam www.ift.world Page 17 R21 Introduction to Fixed-Income Portfolio Management     IFT Notes If short-term capital gains tax rates are higher than long-term capital gains tax rates, then be judicious when realizing short term gains Realize losses taking into account tax consequences They may be used to offset current or future capital gains for tax purposes Control turnover in the fund In general, the lower the turnover, the longer capital gains tax payments can be deferred Consider the trade-off between capital gains and income for tax purposes 7.2 Investment Vehicles and Taxes The choice of investment vehicle often affects how investments are taxed at the final investor level     In pooled investment vehicles (i.e mutual funds), interest income is generally taxed at the final investor level when it occurs—regardless of whether the fund reinvests interest income or pays it out to investors Taxation of capital gains arising from the individual investments within a fund is often treated differently in different countries For example, in U.S., a pass-through treatment of capital gains is used in mutual funds, whereby, investors need to include the gains on their tax returns because realized net capital gains in the underlying securities of a fund are treated as if distributed to investors in the year that they arise In a separately managed account, an investor typically pays tax on realized gains in the underlying securities at the time they occur Tax loss harvesting (which involves deferring the realization of gains and realizing capital losses early), investors can accumulate gains on a pre-tax basis, which leads to increase in the present value of investments Refer to Example from the curriculum IFT Notes for the Level III Exam www.ift.world Page 18 R21 Introduction to Fixed-Income Portfolio Management IFT Notes Summary LO.a: discuss roles of fixed-income securities in portfolios; Diversification Benefits  Correlation with other asset classes is less than  Fixed income volatility is less than equity volatility Benefits of Regular Cash Flows  Regular and predictable cash flows help investors meet future goals and obligations  Assumes no credit event or market event will occur Inflation Hedging Potential  Inflation linked bonds provide a hedge against inflation  Return includes real return plus return tied to inflation rate  Lower return volatility relative to conventional bonds  Offer returns that differ from other asset classes, leading to superior risk adjusted portfolio returns LO.b: describe how fixed-income mandates may be classified and compare features of the mandates; Two types of mandates: 1) Liability-Based: match or cover expected liability payments with future projected cash flows Immunization: process of structuring and managing a fixed-income portfolio to minimize the variance in the realized rate of return over a known time horizon  Cash flow matching  Duration matching  Contingent immunization  Horizon matching Duration Matching Cash Flow Matching Yield curve Parallel yield curve None assumptions shifts Rebalancing Frequent rebalancing Not required but required often desirable Complexity High Low 2) Total Return Based: Generally structured to either track or outperform a benchmark They can be classified into different approaches based on their target active return and active risk levels Pure Indexing Match benchmark return and risk as closely as possible IFT Notes for the Level III Exam Enhanced Indexing Modest outperformance (generally 20 bps to 30 bps) of benchmark while active risk is kept low (typically around 50 bps or lower) www.ift.world Active Management Higher outperformance (generally around 50 bps or more) of benchmark and higher active risk levels Page 19 R21 Introduction to Fixed-Income Portfolio Management IFT Notes Ideally the same as benchmark or only slight mismatches Small deviations from underlying benchmark Significant deviations from underlying benchmark Risk factors are matched exactly Most primary risk factors are closely matched (in particular, duration) Large risk factor deviations from benchmark (in particular, duration) Similar to underlying benchmark Slightly higher than underlying benchmark Considerably higher turnover than the underlying benchmark LO c describe bond market liquidity, including the differences among market sub-sectors, and discuss the effect of liquidity on fixed-income portfolio management;  Bond market liquidity varies across sub-sectors such as issuer type, credit quality, issue size, and maturity  Higher credit quality  higher liquidity Sovereign government bonds are more liquid than  Larger issue size  higher liquidity corporate bonds and non-sovereign government bonds Recently issued bonds have relatively high  Shorter maturity  higher liquidity liquidity  Pricing in bond markets is less transparent than in equity markets  Infrequent trades  recent transaction price does not necessarily reflect value  Use matrix pricing When constructing portfolios consider trade-off between yield and liquidity  Dealers often carry an inventory of bonds because buy and sell orders not arrive simultaneously  Bid-ask spreads are influenced by illiquidity, riskiness and complexity  Higher bid-ask spread  higher trading costs To overcome liquidity issues use fixed income derivatives and ETFS   LO d describe and interpret a model for fixed-income returns; E(R) ≈ Yield income + Rolldown return + E(Change in price based on investor’s views) - E(Credit losses) + E(Currency gains or losses) Estimation of inputs   Yield income and rolldown return are easy to estimate Investor’s views of changes in yields and yield spreads, expected credit losses, and expected IFT Notes for the Level III Exam www.ift.world Page 20 R21 Introduction to Fixed-Income Portfolio Management IFT Notes currency movements are not easy to estimate Limitations of the model    Only duration and convexity are used to summarize the price–yield relationship Model assumes that all intermediate cash flows of the bond are reinvested at the yield to maturity Model ignores local richness/cheapness effects and potential financing advantages LO e discuss the use of leverage, alternative methods for leveraging, and risks that leverage creates in fixed-income portfolios;  Leverage increases returns if returns on invested funds > cost of borrowing Methods for Leveraging Futures Contracts Swap Agreements Structured Financial Instruments Repurchase Agreements Securities Lending Risks of Leverage  Leverage alters the risk-return properties of an investment portfolio  Gains and losses are magnified  If portfolio value decreases, leverage increases  Increased leverage might lead to forced liquidation at prices which are below fair value  In a financial crisis, counter parties my withdraw their financing LO f discuss differences in managing fixed-income portfolios for taxable and tax exempt investors Key points for managing taxable fixed-income portfolios: a) Consider the trade-off between capital gains and income for tax purposes b) Selectively offset capital gains and losses for tax purposes c) If short-term capital gains tax rates are higher than long-term capital gains tax rates, then be judicious when realizing short term gains d) Realize losses taking into account tax consequences e) Control turnover in the fund Choice of investment vehicle often affects how investments are taxed at the final investor level    Pooled investment vehicles: interest income taxed at final investor level even if reinvested Some countries use pass-through treatment of capital gains Separately managed account: investor typically pays tax on realized gains in the underlying IFT Notes for the Level III Exam www.ift.world Page 21 R21 Introduction to Fixed-Income Portfolio Management IFT Notes securities at the time they occur Tax loss harvesting: defer realization of gains and realize capital losses early  accumulate gains on a pre-tax basis  increase present value of investments Examples from the Curriculum Example Adding Fixed-Income Securities to a Portfolio Mary Baker is anxious about the level of risk in her portfolio based on a recent period of increased equity market volatility Most of her wealth is invested in a diversified global equities portfolio Baker contacts two wealth management firms, Atlantic Investments (AI) and West Coast Capital (WCC), for advice In conversation with each adviser, she expresses her desire to reduce her portfolio’s risk and to have a portfolio that generates a cash flow stream with consistent purchasing power over her 15-year investment horizon The correlation coefficient of Baker’s diversified global equities portfolio with a diversified fixed-coupon bond portfolio is –0.10 and with a diversified inflation-linked bond portfolio is 0.10 The correlation coefficient between a diversified fixed-coupon bond portfolio and a diversified inflation-linked bond portfolio is 0.65 The adviser from AI suggests diversifying half of her investment assets into nominal fixed-coupon bonds The adviser from WCC also suggests diversification but recommends that Baker invest 25% of her investment assets into fixed-coupon bonds and 25% into inflation-linked bonds Evaluate the advice given to Baker by each adviser based on her stated desires regarding portfolio risk reduction and cash flow stream Recommend which advice Baker should follow, making sure to discuss the following concepts in your answer: a Diversification benefits b Cash flow benefits c Inflation hedging benefits Solution: Advice from AI: Diversifying into fixed-coupon bonds would offer substantial diversification benefits in lowering overall portfolio volatility (risk) given the negative correlation of –0.10 The portfolio’s volatility, measured by standard deviation, would be lower than the weighted standard deviations of the diversified global equities portfolio and the diversified fixed-coupon bond portfolio The portfolio will generate regular cash flows because it includes fixed-coupon bonds This advice, however, does not address Baker’s desire to have the cash flows maintain purchasing power over time and thus serve as an inflation hedge Advice from WCC: Diversifying into both fixed-coupon bonds and inflation-linked bonds offers additional diversification benefits beyond that offered by fixed-coupon bonds only The correlation between diversified global equities and inflation-linked bonds is only 0.10 The correlation between nominal fixed-coupon bonds IFT Notes for the Level III Exam www.ift.world Page 22 R21 Introduction to Fixed-Income Portfolio Management IFT Notes and inflation-linked bonds is 0.65, which is also less than 1.0 The portfolio will generate regular cash flows because of the inclusion of fixed-coupon and inflation-linked bonds Adding the inflation-linked bonds helps to at least partially address Baker’s desire for consistent purchasing power over her investment horizon Based on her stated desires and the analysis above, Baker should follow the advice provided by WCC Back to Notes Example Liability-Based Mandates (1) Dave Wilson, a fixed-income analyst, has been asked by his manager to analyze different liability-based mandates for a pension fund client The pension plan currently has a very large surplus of assets over liabilities Evaluate whether an immunization or contingent immunization approach would be most suitable for the pension fund Solution: Because the pension fund currently has a large surplus of assets over liabilities, a contingent immunization approach would be most suitable A pure immunization approach would not be appropriate, because a key assumption under this approach is that the present value of the fund’s assets equals the present value of its liabilities The contingent immunization approach allows the pension fund’s portfolio manager to follow an active management approach as long as the portfolio remains above a specified value If the pension fund’s portfolio decreases to the specified value, a duration matching or even a cash flow matching approach would be put in place to ensure adequate funding of the pension plan’s liabilities Back to Notes Example Liability-Based Mandates (2) If the yield curve experiences a one-time parallel shift of 1%, what is the likely effect on the match between a portfolio’s assets and liabilities for a duration matching approach and a cash flow matching approach? Solution: There should be no effect on the match between assets and liabilities for either a duration matching or cash flow matching portfolio Duration matching insures against any adverse effects of a one-time parallel shift in the yield curve By contrast, non-parallel shifts would cause mismatches between assets and liabilities in a duration matching approach In a cash flow matching approach, asset and liability matching remains in place even if market conditions change Back to Notes Example The Characteristics of Different Total Return Approaches Diane Walker is a consultant for a large corporate pension plan She is looking at three funds (Funds X, Y, and Z) as part of the pension plan’s global fixed-income allocation All three funds use the Bloomberg Barclays Global Aggregate Index as a benchmark Exhibit provides characteristics of each fund and the IFT Notes for the Level III Exam www.ift.world Page 23 R21 Introduction to Fixed-Income Portfolio Management IFT Notes index as of February 2016 Identify the approach (pure indexing, enhanced indexing, or active management) that is most likely used by each fund, and support your choices by referencing the information in Exhibit IFT Notes for the Level III Exam www.ift.world Page 24 R21 Introduction to Fixed-Income Portfolio Management IFT Notes Solution to 1: Fund X most likely uses an enhanced indexing approach Fund X’s modified duration and convexity are very close to those of the benchmark but still differ slightly The average maturity of Fund X is slightly longer than that of the benchmark, whereas Fund X’s average yield is slightly higher than that of the benchmark Fund X also has deviations in quality, maturity exposure, and country exposures from the benchmark, providing further evidence of an enhanced indexing approach Some of these deviations are meaningful; for example, Fund X has a relatively strong underweight in Japan Fund Y most likely uses a pure indexing approach because it provides the closest match to the Bloomberg Barclays Global Aggregate Index The risk and return characteristics are almost identical between Fund Y and the benchmark Furthermore, quality, maturity exposure, and country exposure deviations from the benchmark are very minor Fund Z most likely uses an active management approach because risk and return characteristics, quality, maturity exposure, and country exposure differ markedly from the index The difference can be seen most notably with the mismatch in modified duration (7.37 for Fund Z versus 6.34 for the benchmark) Other differences exist between Fund Z and the index, but a sizable duration mismatch provides the strongest evidence of an active management approach Back to Notes Example Decomposing Expected Returns Ann Smith works for a US investment firm in its London office She manages the firm’s British pound– denominated corporate bond portfolio Her department head in New York has asked Smith to make a presentation on the next year’s total expected return of her portfolio in US dollars and the components of this return Exhibit shows information on the portfolio and Smith’s expectations for the next year Calculate the total expected return of Smith’s bond portfolio, assuming no reinvestment income Solution: IFT Notes for the Level III Exam www.ift.world Page 25 R21 Introduction to Fixed-Income Portfolio Management IFT Notes The portfolio’s yield income is 2.83% The portfolio has an average coupon of£2.75 on a £100 notional principal and currently trades at £97.11 The yield income over a one-year horizon is 2.83% = £2.75/£97.11 In one year’s time, assuming an unchanged yield curve and zero interest rate volatility, the rolldown return is 0.16% = (£97.27 – £97.11)/£97.11 The rolling yield, which is the sum of the yield income and the rolldown return, is 2.99% = 2.83% + 0.16% The expected change in price based on Smith’s views of yields and yield spreads is –0.96% The bond portfolio has a modified duration of 3.70 and a convexity statistic of 0.18 Smith expects an average yield and yield spread change of 0.26% Smith expects to incur a decrease in prices and a reduction in return based on her yield view The expected change in price based on Smith’s views of yields and yield spreads is thus −0.0096 = [3.70 ì 0.0026] + [ẵ ì 0.18 ì (0.0026)2] So the expected reduction in return based on Smith’s yield view is 0.96% Smith expects 0.1% of credit losses in her well-diversified investment-grade bond portfolio Smith expects the British pound, the foreign currency in which her bond position is denominated, to depreciate by an annualized 50 bps (or 0.5%) over the investment horizon against the US dollar, the home country currency The expected currency loss to the portfolio is thus 0.50% After combining the foregoing return components, the total expected return on Smith’s bond position is 1.43% For ease of reference, Exhibit summarizes the calculations Back to Notes Example Components of Expected Return Kevin Tucker manages a global bond portfolio At a recent investment committee meeting, Tucker discussed his portfolio’s domestic (very high credit quality) government bond allocation with another committee member The other committee member argued that if the yield curve is expected to remain unchanged, the only determinants of a domestic government bond’s expected return are its coupon payment and its price Explain why the other committee member is incorrect, including a description of the additional expected return components that need to be included Solution: A bond’s coupon payment and its price allow only its yield income to be computed Yield income is an incomplete measure of a bond’s expected return For domestic government bonds, in addition to yield IFT Notes for the Level III Exam www.ift.world Page 26 R21 Introduction to Fixed-Income Portfolio Management IFT Notes income, the rolldown return needs to be considered The rolldown return results from the fact that bonds are pulled to par as the time to maturity decreases, even if the yield curve is expected to remain unchanged over the investment horizon Currency gains and losses would also need to be considered in a global portfolio Because the portfolio consists of government bonds with very high credit quality, the view on credit spreads and expected credit losses are less relevant for Tucker’s analysis For government and corporate bonds with lower credit quality, however, credit spreads and credit losses would also need to be considered as additional return components Back to Notes Example Managing Taxable and Tax-Exempt Portfolios A bond portfolio manager needs to raise €10,000,000 in cash to cover outflows in the portfolio she manages To satisfy her cash demands, she considers one of two corporate bond positions for potential liquidation: Position A and Position B For tax purposes, capital gains receive pass-through treatment; realized net capital gains in the underlying securities of a fund are treated as if distributed to investors in the year that they arise Assume that the capital gains tax rate is 28% and the income tax rate for interest is 45% Exhibit provides relevant data for the two bond positions The portfolio manager considers Position A to be slightly overvalued and Position B to be slightly undervalued Assume that the two bond positions are identical with regard to all other relevant characteristics How should the portfolio manager optimally liquidate bond positions if she manages a portfolio for: tax-exempt investors? taxable investors? Solution to 1: The taxation of capital gains and capital losses has minimal consequences to tax-exempt investors Consistent with the portfolio manager’s investment views, the portfolio manager would likely liquidate Position A, which she considers slightly overvalued rather than liquidating Position B, which she considers slightly undervalued Solution to 2: IFT Notes for the Level III Exam www.ift.world Page 27 R21 Introduction to Fixed-Income Portfolio Management IFT Notes All else equal, portfolio managers for taxable investors should have an incentive to defer capital gains taxes and realize capital losses early (tax-loss harvesting) so that losses can be used to offset current or future capital gains Despite the slight undervaluation of the position, the portfolio manager might want to liquidate Position B because of its embedded capital loss, which will result in a lower realized net capital gain being distributed to investors This decision is based on the assumption that there are no other capital losses in the portfolio that can be used to offset other capital gains Despite the slight overvaluation of Position A, its liquidation would be less desirable for a taxable investor because of the required capital gains tax Back to Notes IFT Notes for the Level III Exam www.ift.world Page 28 ... are trademarks owned by CFA Institute IFT Notes for the Level III Exam www .ift. world Page R21 Introduction to Fixed- Income Portfolio Management IFT Notes Introduction Fixed- income markets include... bonds, in addition to yield IFT Notes for the Level III Exam www .ift. world Page 26 R21 Introduction to Fixed- Income Portfolio Management IFT Notes income, the rolldown return needs to be considered... Solution to 2: IFT Notes for the Level III Exam www .ift. world Page 27 R21 Introduction to Fixed- Income Portfolio Management IFT Notes All else equal, portfolio managers for taxable investors should