FIXEDINCOMEAnswersQuestion Part A Active management: Duration is mismatched (4.6 versus 5.0) Sectors are over and under weighted versus the index Portfolio turnover is higher than for the index which suggests more active trading than for enhanced indexing Sample Scoring Key: One point for active management and two points each for two supporting reasons Enhanced indexing would closely match primary risk characteristics and then focus on over or under weighting individual securities The mismatch of duration and sector weights is therefore more consistent with active management, though admittedly a manager who is not at this point deviating significantly in sector weights The active return and active risk are consistent with arbitrary numbers quoted in the CFA text for enhanced indexing but could also be consistent with an only modestly successful active manager In other words, they could be consistent with either approach, so they are not useful in answering this question Part B Return over six months: Income yield: (4.5 / 2) / 100.97 = 2.23% Rolldown return: (100.90 – 100.97) / 100.97 = –0.07% Manager expected price change: (–6.9 × –0.0037) + (0.5 × 2.74 × 0.00372) = 0.0255 + 0.0000 = 0.0255 = 2.55% Credit losses: –0.12% × 0.80 = –0.10% Currency gains or losses: –2.55% × 0.30 = –0.77% = 2.23% – 0.07 + 2.55% – 0.10% – 0.77% = 3.84% Sample Scoring Key: One point each for the five components and one point for a correct total Note that the analysis period is specified as six months so the projected rolldown price in six months must be used The fact that effective and modified duration differ indicates embedded options, and effective duration must be used The high positive convexity suggests there are putable bonds in the portfolio Part C Statement The correlation of returns between government bonds and riskier assets tends to increase during periods of market stress With floating-coupon bonds, both the interest and principal are directly protected from inflation Determine whether the statement is correct or incorrect (circle one) Correct Incorrect (1 point) Correct Incorrect (1 point) If incorrect, justify your determination with one reason During severe stress, investors tend flee to the safest securities Their prices may appreciate while all other prices decline, producing negative correlation (2 points) The floating-rate coupon is directly linked to interest rates and rates are likely to rise and fall with inflation Therefore, the coupon link is not direct OR The principal is not adjusted (unlike in inflation indexed bonds) (2 points) See the candidate discussion for more on this question Sample Scoring Key: One point for identifying each statement as incorrect, two points each for justification as to why it is incorrect Candidate discussion: Note that in any given situation floating-rate bonds and inflation-indexed bonds can provide full economic protection for changes in inflation But the mechanism of protection differs and floating rate bonds not provide direct protection of the principal See the SchweserNotes for a longer discussion if needed Part D They increase search costs to find a counterparty to any transaction They make transactions less transparent (i.e., it is harder to find information on past price and volume of transactions, which makes trading more difficult) Dealers are holding smaller inventories and charging wider bid/ask spreads to reflect higher capital costs and increased regulation (and in reaction to less trading volume post 2008) Sample Scoring Key: Two points each for two explanations Question Part A Greater sensitivity to spread change: Credit risk and default risk are much higher for HY As a result, spread changes and resulting price movement can be much larger HY is driven more by credit specific events for the issuer That is captured by spread change and not change in the general level of rates Empirical data shows that spread change may well exceed the change in the general level of interest rates for HY bonds Sample Scoring Key: One point for spread risk and two points for a correct supporting statement The question presumes you know the curriculum and realize that, in this context, risk-free is referring to the credit risk-free (government bonds) used to compute credit spread Part B Lower turnover due to higher trading costs: Bid-ask spreads are wider because bond issues and the market are smaller Regulatory and risk management issues are greater for HY, so dealers tend to hold smaller inventory positions Sample Scoring Key: One point for lower turnover and two points for a correct supporting statement If you simply state higher transaction cost, that is a pretty weak reason and not recommended for two points It also leaves in doubt whether you know the underlying reasons for the higher costs as shown in the answer Part C I-spread is based on swap fixed rates, not government bond yields The SFRs on which I-spread is based can diverge from government bond yields, particularly in periods of crisis The G-spread is meant to be a comparison to a credit risk-free benchmark Although SFRs reflect very high quality, they not reflect fully credit risk-free rates G-spread directly reflects the expected return of a hedged (long the corporate and short the government bonds) portfolio I-spread does not Sample Scoring Key: Two points each for two correct reasons You will notice that four reasons are given and some are very similar So it is wise to make the two you use as distinctly different as possible Part D The short seller benefits the most by shorting the bond with the lowest return The expected returns for half of a year are: Bond 1: 1.75(0.50) – (0.50)(4) – 0.50(0.43)(0.65) = 0.875 – 2.000 – 0.140 = –1.265% Bond 2: 2.40(0.50) – (0.50)(5) – 0.50(0.54)(0.65) = 1.200 – 2.500 – 0.176 = –1.476% Short Bond Sample Scoring Key: One point for selecting Bond and one point if it is clear you are shorting the bond because it has the lowest expected return One point each for the two calculations of expected return for half of a year Part E Bond is putable because its OAS exceeds its Z-spread Putable bonds include an embedded long (put) option The option value and bond price will increase with increasing volatility Sample Scoring Key: One point for selecting Bond Two points if it is clear you compared the OAS and Z-spread to reach the conclusion Bond will best with increasing volatility ... by spread change and not change in the general level of rates Empirical data shows that spread change may well exceed the change in the general level of interest rates for HY bonds Sample Scoring... protection differs and floating rate bonds not provide direct protection of the principal See the SchweserNotes for a longer discussion if needed Part D They increase search costs to find... reaction to less trading volume post 2008) Sample Scoring Key: Two points each for two explanations Question Part A Greater sensitivity to spread change: Credit risk and default risk are much