Introduction to Fixed Income Portfolio Management INTRODUCTION Fixed income is the largest asset class in financial markets and is an important asset class in most of investors’ portfolios Fixed income markets incorporate: i ROLES OF FIXED INCOME SECURITIES IN PORTFOLIOS In investment portfolios, fixed income securities provide: Diversification benefits Regular cash flows Inflation hedging Diversification Benefits Diversification Benefits Fixed income when combined with other asset classes provide diversification benefits For a period of 2003 to 2015, the correlation matrix showed: • • • • • commercial papers, notes, bonds) Non-publicly traded securities (such as loans and privately placed securities) Publicly traded securities (such as 2.1 ii Various U.S investment grade (IG) bonds were highly correlated with each other The correlation between U.S IG bonds sector and international IG bonds (including U.S IG bonds) was 0.54, and offered diversification benefits The U.S IG bond sub-sector exhibited low and (in some cases -ve) correlations with U.S high-yield bonds, emerging market bonds and equities Similarly, international IG bonds showed low correlation with U.S high-yield bonds and equities but were moderately correlated with emerging market bonds High-yield bonds, emerging market bonds and equities indicated +ve correlation (less than 0.5) with each other In a portfolio, correlation among assets is significant for diversification benefits Another important factor is the volatility of the asset classes Bonds are considered to be less volatile compared to equities or other asset classes, therefore, including fixed income asset class in a portfolio that has other major asset classes, may significantly lower portfolio risk However, it is important to notice that the correlations among asset classes or volatility of asset class returns may change overtime or due to changes in capital market dynamics or can differ from average correlation in any particular period During times of market stress, • correlation between government bonds and riskier assets (such as equities or high-yield bonds) may decrease because of preference of safer assets and the correlation among riskier assets may increase • standard deviation of returns for high-yield bonds can rise significantly and investor may view these bonds as similar to equities 2.2 Benefits of regular Cash Flows Fixed-income investments often provide regular cashflow streams that can help investors to estimate their future obligations (such as college tuition fees, mortgage payments etc.) with some certainty To fund the projected future liabilities, a ‘dedicated portfolio’ is created with some fixed income securities that match the timing and amount of the projected liabilities • • Investors can build ‘ladder’ bond portfolio by staggering the maturity dates of the bonds throughout the investment horizon This approach balances price risk and reinvestment risk Investor can also use customized ‘buy-and-hold’ portfolios to meet their future obligations For example, an investor with 10-year investment horizon can buy 10-year coupon paying bond The above discussion assumes that there is no credit event or changes in interest rates In reality, the investor may have to adjust his portfolio if any credit or market event occurs and the actual cash flows of fixed income investments may differ from the scheduled cash flows 2.3 Inflation Hedging Potential Inflation-linked bonds provide inflation-hedging benefits as their coupons and/or principal are adjusted for inflation There are many various structures of inflationlinked bonds such as: –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 21 Reading 21 • • Introduction to Fixed Income Portfolio Management Zero-coupon bonds, where principal is adjusted for inflation Capital-indexed bonds, where principal is indexed to inflation and a fixed coupon rate is applied to that principal The return on inflation-linked bonds has two components: i ii Real return Additional return (directly linked to inflation rate) The return volatility of inflation-linked bonds depends on volatility of real-interest rates, whereas, the return volatility of conventional bonds or equities depends on nominal interest rate, therefore, the return volatility of inflation-inked bonds is relatively lower than conventional bonds and equities Inflation-linked bonds are suitable for investors with longinvestment horizon (e.g DB plans, life insurance companies etc.) Various Bonds and Inflation Protection FixedFloatingcoupon coupon bonds bonds Coupon Inflation Inflation protected Principal unprotected Inflation unprotected Liability-based mandates, also known as, structured mandates, asset/liability management (ALM), or liability-driven investments (LDI)-are structured to cover liability (or stream of liability payments) with future projected cash inflows Total return mandates-are managed to track or outperform certain fixed-income benchmark Though attaining highest risk-adjusted return is a common feature of both mandates, however, these mandates have fundamentally different objectives Some fixed-income mandates require environmental, social and governance (ESG) considerations in the investment process Inflation protected Introducing inflation linked bonds in a diversified portfolio of bonds and equities can result in superior risk-adjusted real portfolio returns Practice: Example 1, Reading 21, Curriculum All these approaches are immunization approaches Immunization is based on the objective of constructing a portfolio that over a fixed horizon will earn a predetermined return to meet a liability regardless of interest rate changes 3.1.1) Cash Flow Matching • • • • Liability-Based Mandates Liability-based mandates are used by individuals with cash flow or lifestyle needs and institutions such as banks, insurance companies and pension funds etc The two main approaches to liability-based mandates are: Cash flow matching Duration matching Hybrid forms of cash flow and duration matching approaches include: Contingent immunization Horizon matching Inflationlinked bonds FIXED-INCOME MANDATES Two broad classifications of fixed income mandates are: 3.1 FinQuiz.com • • Simplest immunization approach to match precisely all future liability streams by cash flows from fixed income investments such as bonds, interest rate futures, options or swaps etc Unlike duration matching, this approach has no underlying assumptions When executed well, cash flow matching assures returns for a specific time horizon as future liability payouts are mirrored by coupon and principal payments from the bonds In reality, perfect cash flow matching is difficult to achieve mainly because of two reasons: o exact match of timings and amount of cash flows is challenging o involvement of relatively high transaction costs Timing mismatches may result in some reinvestment risk Theoretically, cash flow matching portfolio does not need to be rebalanced, however, practically, such portfolios may require rebalancing Some reasons might include: o bonds with embedded options o a corporate bond issuer may default o changes in market conditions may change the characters of securities Reading 21 Introduction to Fixed Income Portfolio Management 3.2.1) Duration Matching Duration matching is an immunization approach that is based on matching the duration of assets and liabilities in such a way that when interest rates rise or fall, changes in bond portfolio’s market value closely match changes in the liability portfolio, Conditions: Duration matching approach demands two conditions that need to be satisfied: Key Features of Liability Matching and Duration Matching Complexity How to offset liability stream? (Basic Principle) Mechanism i ii Bond portfolio duration must be equal to the liability portfolio duration PV of bond portfolio’s assets must be equal to the PV of bond portfolio liabilities at current interest rate levels The duration matching approach requires that price risk exactly offset reinvestment risk i.e changes in reinvestment income and changes in bond prices immunize against the effects of interest rate changes • If interest rates increase, gain in reinvestment income is offset by loss in the portfolio value • If interest rates decrease, gain in portfolio value is offset by loss in the reinvestment income Limitation: Practically, immunization remains imperfect when shape of the yield curve changes, such as, steepening, flattening or changes in curvature Therefore, a crucial limitation of immunization is that it protects against only a parallel change in yield curve Yield curve Assumptions Rebalancing • • • • Cash Flow Matching Low Coupon & principal repayment of bonds Matching cash flows of assets & liabilities None Not required but often desirable 3.1.3) Contingent Immunization • • Contingent immunization is commonly used hybrid approach that combines immunization with active management approach when there is a surplus available i.e when portfolio value > PV of liabilities The portfolio (or some portion of portfolio) can be managed actively into asset categories such as fixed income, equity, alternative investments, as long as the value of the actively managed portfolio exceeds some threshold value, whereas, immunization serves as a fallback strategy 3.3.2) Horizon Matching • Some other important considerations for an immunized portfolio are: Change in market conditions require rebalancing to retain the immunization Mismatch between cash flow timings of assets and liabilities may require bond liquidation – a liquidity concern Rebalancing and liquidity needs may result in high portfolio turnover Immunization assumes that bond issuer does not default Use of effective duration accommodates investment in bonds with embedded options Duration Matching High Coupon, principal repayment & sale proceeds of bonds Matching duration and PV of assets & liabilities Parallel yield curve shifts Frequent Variation of duration and cash flow matching approaches are contingent immunization and horizon matching If a portfolio of zero-coupon bonds is designed to match liability cash flows, there is no price risk, reinvestment risk and hence, no immunization risk, although some credit risk remains • FinQuiz.com • Under horizon matching, a hybrid approach, liabilities are sorted into short and long-term liabilities The short-term liabilities (usually up to five years) are linked using cash flow matching approach, whereas, long-term liabilities are linked using duration matching approach This approach provides flexibility over the longerterm, less certain obligations as well as alleviate liquidity concerns for shorter-term, more certain cash outflows Practice: Example & 3, Reading 21, Curriculum 3.2 • • • Total Return Mandates Total return mandates are generally structured to either track or outperform a benchmark The objectives of total return mandates can be based on a specified absolute return or relative return Key considerations of total return mandates are Reading 21 Introduction to Fixed Income Portfolio Management total return, total risk, active return and active risk Active return = portfolio return minus benchmark return Active Risk (tracking error or tracking risk) = Annualized S.D of active return Total return mandates can be categorized into different approaches (from pure indexing to fully active management) based on target active return and active risk levels • 3.2.1) Pure Indexing • • • • • • • In this approach, portfolio will have exactly the same risk exposures as the benchmark Full replication is done by owning all the bonds in the index in the same percentage as the index This approach fairly closely tracks the index; thus, the targeted active return and active risk (tracking error) is zero Pure indexing generates return less than that of benchmark because of trading cost and management fees, e.g if benchmark earns 10%, the strategy earns 9.5% Full replication is inefficient, costly & difficult to implement due to presence of illiquid & infrequently traded issues in the bond index i.e high transaction costs To reduce costs and make portfolio more feasible to implement, portfolio managers are generally allowed to have some flexibility around index holding Flexibility includes matching systematic risk factors of the benchmark index such as, duration, credit risk, call risk, prepayment risk, to the extent possible However, the portfolio still remains exposed to idiosyncratic risk, which can be mitigated by appropriate diversification Pure indexing exhibits lower turnover as compared to other approaches 3.2.2) Enhanced Indexing • • • The objective of this approach is to outperform the index while still maintaining a close link to the benchmark i.e allowing small deviations from the benchmark index but closely tracking the benchmark’s primary risk factor exposures The intent of small risk factor mismatches (e.g sector/quality bets) is to generate higher return than the benchmark Compared to pure indexing, this approach less FinQuiz.com closely tracks the index and incurs marginally higher turnover and higher management fees 3.2.3) Active Management • In this approach, manager actively pursues opportunities in the market to increase return i.e by opting for large risk factor mismatches on duration, sector weights and other factors • The objective of active management is to outperform the underlying benchmark and to earn return that is enough to overcome the higher transaction costs and risk involved However, historically most active managers have underperformed their benchmarks after fees and transaction costs • Active management often incurs significant portfolio turnover and higher management fees Total Return Approach: Key Features Objective Portfolio weights Risk factor matching Turnover Comparison of Total Return Approaches Pure Enhanced Active Indexing Indexing Management Match Modest Higher benchmark outperforman outperforman return and ce (20-30 bps) ce ( 50 bps) risk of benchmark of benchmark while keeping and higher active risk low active risk levels Same as Small Significant benchmark deviations deviations from from benchmark benchmark Same as Match primary Large risk benchmark risk factors factor deviations from benchmark Similar to Slightly higher Considerably benchmark than higher than benchmark benchmark Practice: Example 4, Reading 21, Curriculum BOND MARKET LIQUIDITY Liquid security is one that is traded quickly with little or no effect on the security’s price Different fixed income securities vary greatly in their liquidity For example, recently issued, on-the-run government bonds are considered to be highly liquid and trade frequently at narrow bid-ask spread whereas, some corporate and non-sovereign government bonds may Reading 21 Introduction to Fixed Income Portfolio Management be very illiquid and trade infrequently in small quantities at wider bid-ask spread 4.2 FinQuiz.com The Effects of Liquidity on Fixed-Income Portfolio Management Compared to equity market, bond markets are less transparent, less liquid and incur higher search costs A single company may issue many different types of bonds with varying features and maturity dates but only one type of common stock 4.2.1) Pricing Pricing in bond markets is less transparent than equity markets though recent electronic systems are facilitating to improve price transparency both in the U.S and nonU.S corporate bond and municipal bond markets Bond typically trade over the counter and, therefore, require search (getting quotes from different dealers) to trade effectively Additionally, for bonds that trade in markets, price transparency is an issue Finally, liquidity is another problem for bond investors and all three (i.e search costs, price transparency and liquidity) issues are more pronounced for credit bonds compared to government issues Generally, bonds are traded using recent price and value information The determinants of corporate bond value such as, interest rates, credit spreads, liquidity premiums change frequently 4.1 Liquidity among Bond Market Sub-Sectors Liquidity varies among different bond market subsectors Bond market can be categorized on the basis of various key structures such as, issuer type, issuer size, credit quality, maturity etc Numerous types of bonds included in the global bond market are: • • • • • Sovereign government bonds Non-sovereign government bonds Government-related bonds Corporate bonds Securitized bonds For simplicity, we will focus primarily on sovereign government and corporate bonds only Sovereign government bonds are more liquid than nonsovereign government bonds or corporate bonds because of the following features • • • Large issuance size Well organized issuers Treated as benchmark bonds or collateral in the repo market Note: Sovereign bonds issued by countries of high credit quality are more liquid than those issued by lower credit quality Some common features of corporate bonds include the following: • • • • • issued by various companies represent a wide range of credit quality issued by infrequent issuers are often less liquid than the bonds issued by companies with many different issues small sized issues are less liquid than larger issues bonds with longer maturity are less liquid than nearer-term bonds Recent transaction data of less frequently traded bonds may not incorporate properly the current market conditions Therefore, the infrequently traded bonds often use ‘matrix pricing’ approach Under this approach, information regarding recent trades of comparable bonds is used to estimate market discount rate or required rate of return of infrequently traded bonds The features that make a bond comparable are credit quality, time-to-maturity and coupon rate Matrix pricing approach does not require sophisticated financial modeling of bond market characteristics such as term structure and credit spreads, however, the presence of some features (like call options) make using this approach somewhat difficult 4.2.2.) Portfolio Construction Investors’ liquidity considerations are important in portfolio construction because there is a trade-off between liquidity and yield • • • • Buy-and-hold investors may prefer less liquid bonds and higher yields Active investors and traders who intent to sell bonds before maturity may prefer higher liquidity and lower yields Investors that have liquidity concerns may avoid longer-term bonds, small issues and private placements of corporate bonds In dealer market, dealers widen the bid-ask spread for riskier and illiquid bonds and bonds with nonstandard or complex features (e.g embedded options) 4.2.3) Alternatives to Direct Investment in Bonds Fixed income derivatives are often more liquid than their underlying bonds Investors can use two types of fixed-income derivatives: i Derivatives traded on exchange (e.g futures, options on futures) ii Derivative traded over-the-counter (e.g interest rate swaps, credit-default swaps) • An investor who wants to gain exposure to an Reading 21 • • Introduction to Fixed Income Portfolio Management underlying bond, bond futures are the most liquid alternative Interest-rate swaps are the most widely used over-the-counter derivative, based on notional amount outstanding Other swaps used by fixed-income managers are inflation swaps, total return swaps and credit swaps FinQuiz.com securities because of their in-kind deposit and redemption features Exchange-traded funds (ETFs) and pooled investment vehicles are also used as alternative to individual bonds ETF shares are traded easily and exhibit higher liquidity than the underlying A MODEL FOR FIXED-INCOME RETURNS In order to evaluate fixed-income strategies, it is important to estimate expected returns and comprehend its components 5.1 Decomposing Expected Return Assuming investor expects change in yield curve, expected return component is calculated as: E( ∆ ݅݊ ݎݐݏ݁ݒ݊݅ ݊ ݀݁ݏܾܽ ݁ܿ݅ݎᇱ ݏ݀ܽ݁ݎݏ ݈݀݁݅ݕ & ݏ݈݀݁݅ݕ ݂ ݏݓ݁݅ݒ ݏ ଵ ) = [-MD× ∆ܻ݈݅݁݀]+ × × ݕݐ݅ݔ݁ݒ݊ܥሺ∆ܻ݈݅݁݀ሻଶ ଶ Five components of expected return E(R) are: E(R) ≈ Yield income + Rolldown return + E(∆ in price based on investor’s views on yields and yield spread) − E(Credit losses) + E(currency gains & losses) where, E = expected, MD = bond’s modified duration, ∆ܻ݈݅݁݀ = expected change in yield • • • Note: For simplicity, model does not reflect taxes and assumes annual period Yield income represents coupon payment and interest on re-investment income In the absence of reinvestment income, yield income = bond’s annual current yield i.e Yield income (or Current yield) = ௨ ௨ ௬௧ ௨௧ ௗ Rolldown return results from change in bond value as time passes assuming market discount rate remains same i.e no interest rate volatility This component clarifies ‘pull to par effect’ on the price of the bond trading at premium or discount to par value Investors in bonds trading at premium (discount) to their par value will experience capital losses (gains) as time passes Expected Credit Losses show the expected % of par gone due to default Expected credit losses = bond’s probability of default × expected loss severity Expected loss severity is also known as loss given default Expected fluctuations (gain/loss) in the currency exchange rate over the investment period This measure can be based on survey information, locked in exchange rate values over the investment horizon or simply be a reflection of investor’s own views 5.2 Rolldown Return = Effective duration and effective convexity are most appropriate for bonds with embedded options For bonds with floating rate notes, value of modified duration is close to zero If investor believes that yield curves and yield spreads remain unchanged, value of expected price change becomes Estimation of the Inputs ൫ௗ ಶ ିௗ ಳ ൯ ௗ ಳ Note: Sum of yield income and rolldown return may be called bond’s rolling yield Expected Price Change is based on investor’s expectation of changes in yields and yield spreads • Yield income is the easiest component to estimate among the expected fixed-income return components discussed earlier • Rolldown return is also straight forward though it depends on the curve-fitting technique • The other three components are quite uncertain as they depend on qualitative (subjective) criteria, on Reading 21 Introduction to Fixed Income Portfolio Management survey information or on a quantitative model o Limitations of the Expected Return Decomposition 5.3 • • • Fixed-income return decomposition is an approximation Model assumes that all intermediate bond cash inflows are reinvested at the YTM Model ignores other factors, such as o ‘local richness/cheapness effects’ deviations of individual maturity segments from the yield curve obtained through curve estimation technique ‘potential financing advantages’ to certain maturity segments in the repo market Practice: Example & 6, Reading 21, Curriculum LEVERAGE Leverage increases investment exposure and portfolio return potential, however, this higher return potential may come at the cost of higher risk 6.1 FinQuiz.com Using Leverage 6.2 Methods for Leveraging Fixed-Income Portfolios A variety of tools are used to construct a leveraged portfolio Financial derivatives or borrowing through collateralized money markets are explicit forms of leverage whereas structured financial instruments are implicit forms of leverage Leverage increases portfolio returns particularly in a lower interest rate situation as the invested funds exceed the equity of the portfolio by the borrowed amount ௧ ோ௧௨ Leverage Portfolio Return ݎ ൌ ௧ ா௨௧௬ ܶ ݏݐ݁ݏݏܣ ݈݂݅ݐݎܲ ݊ ݊ݎݑݐܴ݁ ݈ܽݐെ ܿ݃݊݅ݓݎݎܾ ݂ ݐݏ ൌ ܲݕݐ݅ݑݍܧ ݈݂݅ݐݎ ሾݎூ ൈ ሺܸா ܸ ሻ െ ሺܸ ൈ ݎ ሻሿ ൌ ܸா VE = value of portfolio equity VB = borrowed funds rB = borrowing rate rI = return on invested funds rP = return on the levered portfolio 6.2.1) Future Contracts Futures contracts are important source of leverage because investor only require a small fraction of the notional value of the contract known as margin (or equity capital) to gain exposure to a large amount of the underlying asset Notional value of the future contract is equal to the current value of the underlying x multiplier LeverageFutures = ே௧ ௨ିெ ெ (where margin is invested equity) 6.2.2) Swap Agreements To recognize the significance of leverage on returns, the above equation can be decomposed into two portions: ܸ ݎ ൌ ݎூ ሺݎூ െ ݎ ሻ ܸா 1st portion ݎூ represents return on invested funds 2nd portion ಳ ሺݎூ െ ݎ ሻ explains the effect of leverage i.e ಶ The degree to which leverage ↑ ↓ ݎportfolio return is proportional to the amount borrowed ಳ and the ಶ difference of investment return and cost of borrowing ݎூ െ ݎ If ݎூ ݎ leverage increases the portfolio return If ݎூ ൏ ݎ leverage decreases the portfolio return Practically, interest rate swaps are equivalent to longshort bond portfolio In an interest rate swap, the fixedrate payer effectively short a fixed-rate bond and long a floating rate bond and the value of the swap for the fixed rate payer increases when interest rates increase The fixed-rate receiver effectively long a fixed rate bond and short a floating-rate bond and the value of the swap for the fixed-rate receiver increases when interest rates decline Interest rate swaps require no initial investment However, counterparties may require some collateral Increasingly, central clearinghouses are getting involved in these swap agreements thus increasing standardization and lower counterparty credit risk Reading 21 Introduction to Fixed Income Portfolio Management 6.2.3) Structured Financial Instruments Structured financial instruments are constructed to redistribute risk Many structured products have embedded leverage Inverse floater is a type of structured financial instrument whose coupon rate has an inverse relationship to the market interest rate such as Libor For example, the coupon rate for an inverse floater may be The lenders bear credit risk in repos Underlying collateral bonds protect lenders from default ‘Haircut’, the amount by which collateral value exceeds the repo principal amount, provides additional protection Thus, lender holds collateral worth more than the funds lent The haircut amount is higher for riskier and less liquid securities On the basis of settlement, repos can be categorized as bilateral repos or tri-party repos • Coupon rate = 15% - (1.5 x Libor3-month) If the benchmark rate is high and an investor believes that the interest rates will decrease in future, he would want to take a long position in an inverse floater A decline in market rates will increase the coupon Moreover, the presence of leverage can augment the price volatility of a fixed-income portfolio FinQuiz.com • Bilateral repos are conducted directly between two parties by “delivery versus cash payment” where cash and collateral are exchanged simultaneously through a central custodian e.g Depository Trust company in the U.S Tri-party repos usually involve a third party (such as bank) that holds the collateral for the two parties and provide settlement and other collateral management services 6.2.4) Repurchase Agreements Repurchase agreements (repos) are an important source of short-term financing for fixed-income dealers and financial institutions Repos are kind of collateralized loans In a repurchased agreement, security owner (borrower) sell a security for cash and agrees to repurchase it from the lender at a specific future date and an agreed on price From the lender’s position, these agreements are called ‘reverse repos’ The repo rate is the interest rate, which is calculated by taking the difference between selling price and the repurchase price For example, a security dealer who requires $20 million might enter into an overnight $20 million repo at 5.5% repo rate Dollar interest can be calculated as: ் ௗ௬௦ Dollar interest = Principal x Repo rate x ( Dollar interest = 20,000,000 x 0.055 x ଵ ଷ ଷ ) = 3,055 Overnight repos are common, though the repos can be rolled over to create longer-term loans Repo agreements may be cash driven or security driven • In cash driven transaction, the actual securities sold are typically, not specified i.e the borrower can deliver any types of securities commonly accepted by investors and dealers such as Treasury bonds This is called general collateral In security driven transaction, the lender often demands a particular security The lender’s purpose for taking a particular security may be hedging, arbitrage or speculation 6.2.5) Security Lending Security lending, another type of collateralized lending, is similar to repo market but have different motives The two motives of security lending are: • • Thus, the dealer will sell the bonds for $20,000,000 today and will repurchase the bonds for $20,003,055 the next day • Note: Security driven transactions are usually settled using bilateral repos Cash driven transactions are often conducted using tri-party repo settlement to facilitate short selling for collateralized borrowing or financing In a short selling, short seller borrows the security from someone else and then sells the security and receives immediate payment The short seller later returns the security In financing-motivated loan, a bond owner lends securities to investor and receives cash The collateral in security lending may be cash or highrated bonds Security lenders generally receive original principal plus additional value of the borrowed securities This extra amount in percentage term is the same as the haircut in the repo market The lender receives higher compensation for risky bonds In security lending transaction with cash collateral, the borrower pays the lender some fees equal to the % of the value of the securities loaned The lender invests that fees (cash collateral) and earns some additional return This fee is small for securities that are readily available Instead of receiving the lending fee, in the case where security lender needs financing, lending fee will be paid by the security lender Reading 21 Introduction to Fixed Income Portfolio Management Security lender, who takes custody of bonds used as collateral, receives any income earned on the collateral, however, he usually refunds some portion of the collateral earnings to the security borrower This rate is called rebate rate and is calculated as: Rebate rate = Collateral earning rate – Security lending rate A significant difference between security lending and repurchase agreement is that security lending transactions are open-ended i.e no specified maturity date, which may create additional risk The lender may recall or the borrower may deliver the securities back at any time, forcing the counterparty to settle the transaction straightaway Principles of Fixed-Income Taxation Though tax codes differ across countries, however, some common tax principles of fixed-income investments are: • • • • • Risks of Leverage Leverage may significantly increase the magnitude of losses even for moderate valuation declines This momentous decline in portfolio value can lead to forced liquidation of portfolio assets even when market conditions are adverse for selling Such forced sale of assets at heavily discounted prices, typically when seller faces bankruptcy, is referred to as ‘Fire sale’ During financial crises, significant decline in asset prices cause fire sales and forced liquidation which in turn aggravate financial fragility In extreme cases credit crunch occurs in which counterparties to short-term financing such as repo agreements, securities lending and credit lines withdraw their financing FIXED INCOME PORTFOLIO TAXATION Both taxable and tax-exempts investors seek highest possible risk-adjusted returns net of fees and transaction, however, taxable investors also consider the effects of taxes on the investment decisions 7.1 6.3 FinQuiz.com Two primary sources of bond return that are taxed at different rates are interest income and capital gains/losses Generally, realized capital gain and interest are taxed Zero-coupon bonds investors are required to pay tax on imputed interest income (i.e amortization of discount in some countries) Typically, capital gains are taxed at lower rate than interest income Capital losses can be used to reduce capital gains only (and not other sources of income) in the tax year in which they occur If capital losses are more than capital gains, they can be carried forward to future years In some jurisdictions, losses can be carried back to reduce capital gain taxes paid in previous years However, capital losses can be carried forward or back to some limited number of years In some countries short-term capital gains are taxed at higher rate than long-term capital gains An investor or portfolio manager have some control over the timing of realized capital gains/losses but no control over the timing of coupon income received This control enables portfolio managers to realize losses as early as possible, the losses are then credited against realized gains occurred in the portfolio This strategy is known as ‘tax-loss harvesting’ Some tactics to manage fixed-income portfolios for tax purposes include the following: • • • • • 7.2 Prudently cancel out capital gains and losses Carefully realize short-term gains if short-term capital gain tax rate > long-term capital gain tax rate Realized losses can be used to offset current or future capital gains Extend holding periods to defer taxes Take into account the trade-off between capital gains and income Investment Vehicles and Taxes Different investment vehicles are taxed differently based on type of assets involved and jurisdiction Generally, in pooled investments (e.g mutual fund) interest income is taxed at the fund level (i.e tax on interest income is paid regardless of the fact that interest income is distributed to the investor or not) Capital gains are sometimes taxed at the fund level and sometimes, investors pay capital gain tax only when they divest their investments in the fund Practice: Example 7, Reading 21, Curriculum ... Example & 3, Reading 21, Curriculum 3. 2 • • • Total Return Mandates Total return mandates are generally structured to either track or outperform a benchmark The objectives of total return mandates... characters of securities Reading 21 Introduction to Fixed Income Portfolio Management 3. 2.1) Duration Matching Duration matching is an immunization approach that is based on matching the duration of assets... & 6, Reading 21, Curriculum LEVERAGE Leverage increases investment exposure and portfolio return potential, however, this higher return potential may come at the cost of higher risk 6.1 FinQuiz. com