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Liability-Driven and Index-Based Strategies INTRODUCTION This reading centers around structured and passive total return fixed-income investment strategies The term ‘passive’ and ‘active’ fixed-income strategies are with reference to the asset manager’s outlook on interest rates and credit market situations Liability-Driven Investing Asset-liabilities management (ALM) strategies take into account rate sensitive assets and liabilities For example, ALM approach helps institutions in reducing interest rate risk by linking loan and deposits rate decisions and filling gaps between asset and liability maturities Asset-driven liabilities (ADL) and Liability-driven investing (LDI) are special cases of ALM In ADL, assets are given and liabilities are structured to match the characteristics of those assets i.e asset side of balance sheet signifies a company’s primary business, and a liability structure is used to reduce the interest rate risk by matching the maturities of its assets and liabilities o For example, a manufacturing company may get operating revenues that are highly dependent on business cycle, which in turn is positively correlated with interest rates Hence, the manufacturer will choose variablerate liabilities to match its operating revenue In LDI, liabilities are given and assets are structured to match the characteristics of those liabilities i.e liability side of balance sheet represents a company’s core business and financial decisions Assets are used to reduce the interest rate risk o o Passive strategies not mean ‘buy & hold’ rather these strategies also require continual monitoring and rebalancing For example, in case of a life-insurance company or a DB pension plan, liabilities are given As the present value of these liabilities are highly sensitive to interest rate changes, estimation of interest rates plays a key role in making investment portfolio decisions Individuals also use LDI approach, particularly when they require sufficient funds at some future date Consider an individual who holds a portfolio of bonds, and plans to purchase an annuity on his retirement 10-years from now In order to fulfil his goal, he will reinvest any cash flows from bonds and/or add a regular amount to his portfolio Size and timing of liabilities are two major considerations for an entity Four liability types categorized by the degree of certainty regarding amount and timing of cash flows are given below: Liability Type I II III IV Cash Outlay Amount Known Known Uncertain Uncertain Timing Known Uncertain Known Uncertain Note: Here, the primary focus is liability, though the same structure can apply to financial assets as well Type I liabilities: These liabilities have known amount(s) and timings e.g an issuer of a fixed rate option-free bond For such type of liabilities, duration measures can be used to estimate their interest rate sensitivities Type II liabilities: These liabilities have known amount but unknown timing of payments e.g callable and putable bonds, term life insurance policy where, timing of the insurer’s death is unknown However, life insurance companies apply the law of large numbers to estimate the payout amounts in any given time period Type III liabilities: Type III liabilities have known payment dates but uncertain payment amounts e.g floating rate notes, inflation-indexed bonds, treasury inflation-protected securities etc Type IV liabilities: Type IV liabilities have unknown amount and timing of obligations Liabilities of property & casualty insurance companies and defined benefit pension plan fall in this category Simple duration measure is appropriate to model type I liabilities, whereas effective duration is required to –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Reading 23 Reading 23 Liability-Driven and Index-Based Strategies estimate interest rate sensitivity for type II, III and IV liabilities The model assumes initial shape of the yield curve, which is then shifted up and down to get new estimates for the PV of liabilities FinQuiz.com Practice: Example 1, Reading 23, Curriculum INTEREST RATE IMMUNIZATION – MANAGING THE INTEREST RATE RISK OF A SINGLE LIABILITY Technique and risks of interest rate immunization: Immunization is a technique used to structure and manage fixed-income portfolio to minimize the effects of volatility of future interest rates on the realized rate of return earned over a specific period At this point, it is assumed that the bond portfolio’s default risk is zero Single liability can be immunized simply by buying a zero-coupon bond whose maturity date and face value matches the liability’s due date and amount (termed as Cash Flow Matching) There is no re-investment or price risk However, in many financial markets desired zero coupon-bonds are unavailable In such situations, immunization can be achieved by purchasing couponpaying bonds and matching the duration of assets to investment horizon (i.e liability’s duration) and the PV of assets to the PV of liabilities (termed as Duration Matching) Immunized portfolio by zero-coupon bonds is considered to be the benchmark to measure the performance of immunized portfolio using coupon-paying bonds Macaulay duration is the weighted average of time until the bond’s cash flows are received where the weights are the percent of PV of cash flows with respect to sum of PV of all cash flows Money duration = bond’s modified duration x bond price For a coupon bond currently trading at par: • • • rise in interest rates will decrease bond price (i.e negative impact) Over the remaining time to maturity of the bond, price will rise to par and reduce the negative impact as time passes On the other hand, coupons will be reinvested at higher rates generating positive impact of higher interest rates These positive (coupon reinvestment effect) and negative (price effect) impacts will cancel each other if investment horizon is equal to Macaulay Duration These effects will be reversed in case of immediate downward shift in the yield curve Conclusion: If investor’s investment horizon = bond’s Macaulay duration, he is effectively immunized from interest rate risk i.e whether rates rise or fall, price and couponreinvestment effects will counterweigh each other Note: A zero-coupon bond’s Macaulay duration is equal to its maturity whereas, coupon-paying bond’s Macaulay duration is less than its maturity INTEREST RATE IMMUNIZATION – MANAGING THE INTEREST RATE RISK OF MULTIPLE LIABILITIES Four approaches to manage multiple liabilities (assuming type-I) are as follows: 4.1 Cash flow matching Duration matching Derivatives overlay Contingent immunization Cash Flow Matching Cash flow matching is a classic strategy to eliminate the interest rate risk of a stream of liabilities simply by constructing a dedicated asset portfolio of high quality zero-coupon or fixed income bonds to match closely the timings and amount of cash outflows Sometimes, accounting defeasance can be the reason for cash flow matching for the company Accounting defeasance (a.k.a in-substance defeasance) is an approach of vanishing the debt liability by setting aside sufficient high-quality assets to pay-off those liabilities i.e the outstanding debt and assets off-set each other and are removed from the company’s balance sheet Cash-in-advance constraint is a concern when implementing this strategy using coupon paying bonds because of availability of funds on or before payment Reading 23 Liability-Driven and Index-Based Strategies dates This would expose the portfolio to cash flow reinvestment risk, particularly, in an upward-sloping yield curve, when yields on high-rated short-term investments are low or negative Practice: Example 3, Reading 23, Curriculum Note: The purpose of this example is to understand the motivation and mechanism of accounting defeasance method, the accounting of such transactions is outside the scope 4.2 Duration Matching Duration matching for multiple liabilities require: i) matching of money duration(BPV/PVBP) of portfolio and liabilities ii) initial investment should be equal to or more than PV of liabilities iii) dispersion/convexity for assets must be equal to or greater than for the liabilities (plus dispersion should be as low as possible) For example, if liability convexity = 300 then asset convexity of 320 is preferred over 380 Duration matching achieves the objective of meeting the liability even if there is a single large parallel shift in interest rates Duration matching may fail if there are multiple parallel shifts, single non-parallel shift or multiple non-parallel shifts in the yield curve Manager must rebalance portfolio (i.e repeat duration matching) after every large parallel shift to keep the portfolio immunized Refer to Curriculum for a very detailed example Practice: Example 4, Reading 23, Curriculum 4.3 Derivatives Overlay Derivatives overlay is an efficient and cost-effective strategy that can be used to rebalance the immunized portfolio (single or multiple liabilities) to keep on its target duration for yield curve shifts or twists or for the passage of time Suppose, a large sudden upward shift in the yield curve, decreases both the duration and market value of an immunized portfolio’s assets and liabilities i.e the BPV of the assets and liabilities goes down Now, if there is a duration gap e.g drop in the value of assets is higher FinQuiz.com than the drop in the value of liabilities, the manager is required to close the money duration gap by increasing the portfolio duration The manager can reduce the duration gap by buying long duration bonds and selling short duration bonds Alternatively, the manager can opt for a more efficient and cost-effective method of using interest rate derivatives in the form of buying or going long, a few interest rate futures contracts Managers often hold a portfolio of short-term bonds for many reasons including such bonds are highly liquid, can be obtained at favorable pricing, managers face liquidity constraints or due to regulatory requirements A derivative overlay strategy is then used to close the duration gap Important: For further illustration and example please refer to Reading 23, 4.3 ‘Derivative Overlay’ from 5th paragraph on page 74 till end Practice: Example 5, Reading 23, Curriculum 4.4 Contingent Immunization Contingent immunization combines immunization strategies with elements of active management If the market value of assets is greater than market value of labilities (surplus is available), the managers can consider contingent immunization as long as surplus is above a certain threshold If the portfolio’s return declines below the designated threshold, the immunization mode is activated Surplus can be invested in any asset category such as equity, fixed-income, alternative investments, commodity options, credit-default swaps etc This strategy allows managers to pursue increased risk strategies that can lead to excess portfolio value and can reduce the cost of retiring the debt obligations The presence of surplus provides opportunities for managers to take a view of interest rates i.e to be over-hedged when yields are expected to fall and under-hedged when yields are expected to rise Refer to CFA Curriculum, Reading 23, 4.4 ‘Contingent Immunization’ paragraph 4th , 5th & 6th page 77 for illustration through example Practice: Example 6, Reading 23, Curriculum Reading 23 Liability-Driven and Index-Based Strategies FinQuiz.com LIABILITY-DRIVEN INVESTING - AN EXAMPLE OF A DEFINED BENEFIT PENSION PLAN Due to the nature of this topic, Team FinQuiz recommends reading it directly from the CFA Institute’s Curriculum Practice: Example 7, Reading 23, Curriculum RISKS IN LIABILITY DRIVEN INVESTING The basic relationship of an immunization strategy of full interest rate hedging (hedge ratio 100%) is expressed below: Asset BPV ൈ ∆ Asset yields + Hedge BPV ൈ ∆Hedge yields ൎ Liability BPV ൈ ∆Liability yields All ∆ in yields are measured in basis points The relation is approximate because of ignoring higherorder terms such as convexity Use of assumptions regarding future events and approximations to measure key parameters involve model risk For example, asset BPV may be mismeasured if the changes in certain variables (e.g nominal interest rates or expected inflation) affect equity and alternative assets not as modeled Measurement error for asset BPV can occur when asset portfolio duration is calculated using weighted average of the individual durations for the component bonds instead of using the cash flow yield to discount the future coupon and principal payments When derivatives overlay are used for immunization purposes, futures BPV calculations are based on CTD qualifying bond divided by its conversion factor Further, advanced measurements involving short-term interest rates and accrued interest, can change the number of contracts needed to hedge the interest rate risk Model risk also arise in LDI strategies For example, in the measurement of liability BPV in DB pension plan, there is difficulty associated with the estimation and assumption of plan’s key inputs such as assumptions about employees’ future salary increase, the discount rates, employees’ life expectancy post-employment, employee turnover etc If the immunization is not perfect i.e the particular fixedincome assets, the hedging derivatives and the liabilities are positioned at varying points along the benchmark yield curve and at varying spreads, non-parallel shifts and twists in the yield curve can affect asset+derivatives differently than liabilities There is a presence of spread risk (the risk that the asset and liability discount rates and their PVs not move equitably) in LDI strategies because spreads on highquality corporate bonds/sectors or on broad index and spreads on government bonds not move in correspondingly Spread risk also exists in the derivatives overlay LDI strategies because the future contracts that are used to hedge the interest rate risk of multiple liabilities are usually based on US treasury notes while liabilities are corporate obligations Spread risk is also a concern in the use of interest rate swap overlays i.e when swaps or swaptions are used to change the duration gap between portfolio assets and liabilities Hedging strategies based on interest rate swaps have less spread risk (because of credit risk being part of both 1)Bond Yield 2) Swap rate – which is based on LIBOR) Usually OTC derivatives contain counterparty credit risk Post 2008-2009 financial crises, the inclusion of collateral requirements and restrictions strengthened the over-thecounter derivatives market and mitigated counterparty credit risk The risk that collateral becomes exhausted is particularly a chief concern in strategies that use derivatives overlay to reduce the duration gap between assets and liabilities Concerns regarding cash management and collateral availability arises with the use of exchange-traded futures contracts because of daily mark-to-market valuation and settlement into a margin account Asset liquidity becomes a key consideration for strategies that involve active investing along with passive fixed-income portfolios and for contingent immunization Practice: Example 8, Reading 23, Curriculum Reading 23 Liability-Driven and Index-Based Strategies FinQuiz.com BOND INDEXES AND THE CHALLENGES OF MATCHING A FIXEDINCOME PORTFOLIO TO AN INDEX Index-based investing generally provides diversification at lower cost and a less risky alternative to active management (protection from negative alpha) The primary focus of indexed investing is selecting the bonds for portfolio in a way that the portfolio returns match the returns of the bond market index Therefore, the major concern is to minimize tracking risk or tracking error Following are some approaches to match an underlying market index Pure indexing or full replication approach involves replicating the index by purchasing all the securities in the index Enhanced indexing strategy involves matching the primary risk factors of the index by purchasing fewer securities than the index with an aim to replicate the index performance more efficiently as compared to pure indexing Active management seeks to produce better returns in which the portfolio can deviate from the primary risk factors associated with the index In contrast to equity markets, where equity market indexes fairly represent the overall equity market performance, in bond markets, the price and yield of the recently issued government bonds more closely gauge the overall bond market sentiment Complexities associated with fixed-income markets Numerous complexities associated with fixed income markets make it is difficult to track or replicate a bond market index These complexities include market size and breadth, wide range of security features, unique issuance and trading patterns, effects of these patterns on index composition, pricing and valuation Size and breadth of bond markets Fixed income markets are significantly bigger and broader than equity markets both in size of market capitalization and in the number of securities outstanding It is practically impossible to replicate a broad fixed-income market index Wide array of fixed-income security characteristics There is a wide range of bonds (public and private) available for investors with varying features such as maturities, ratings, optionality, relative liquidity, performance characteristics, coupon rate, multiple bond issues by single issuer etc Unique issuance and trading patterns of bonds versus other securities Fixed-income securities are largely traded in OTC market through brokers/dealers using a quote-based trading system After 2008-09 financial crises, new regulations restricted dealers’ ability to take risk, and increased cost to hold inventories Lower trading inventories, increased bid-ask spreads and reduced willingness to support block trades, particularly for less liquid off-the-run bonds In many markets it is difficult to track fixed income trading transactions Even if trade data is available (e.g in U.S from TRACE ), several bonds not trade at all and many bonds trade only a few times during a particular year Many non-traded bonds not have observable prices To estimate the current yields and prices of such bonds, matrix pricing or evaluated pricing method is used This estimation analysis is often conducted by external vendors which further increase discrepancies between index and portfolio performance Challenges associated with index-based bond portfolios Managing an index-based bond portfolio is problematic due to bonds’ trading and valuation related intricacies Rebalancing of fixed-income indexes occur more frequently (usually monthly) due to several factors such as new debt issuance, outstanding bonds’ maturities, changes in ratings, optionality etc Therefore, periodic rebalancing of a portfolio incurs higher transaction costs Due to the above-mentioned problems, asset managers pursuing a pure indexing strategy typically match the primary risk factors of the fixed-income index through a diversified portfolio Matching the primary risk factors includes: Effective duration is used to measure the change in the value of a portfolio given a small parallel shift in interest rates The indexed portfolio’s duration should be matched with the benchmark so that portfolio has same interest rate risk exposure as that of benchmark index However, for large parallel shift in interest rates, convexity adjustment must also be considered Key rate duration is used to measure the effect of nonparallel shifts in the yield curve i.e change in slope or twist in the curve In this method, spot rate for particular key maturity is changed (all other spot rates are kept constant) to measure a portfolio’s sensitivity to a change in that maturity This sensitivity is called the rate duration The portfolio and benchmark must have securities with same maturities, key rate durations and the same overall effective duration Reading 23 Liability-Driven and Index-Based Strategies Percent in sector and quality The portfolio must match the percentage weight in the various sectors and qualities of the benchmark index in order to have the same risk exposure Sector and quality spread duration contribution Sector Duration Contribution: The portfolio must match the proportion of the index duration that is contributed by each sector in the index to ensure that a change in sector spreads has the same impact on both the portfolio and the index Spread duration is a measure used to describe how a non-Treasury security’s price will change as a result of widening or narrowing of the spread (spread risk) The portfolio must, therefore, match the proportion of the index duration that is contributed by each quality in the index, (where quality refers to categories of bonds by rating) Sector/coupon/maturity cell weights: Convexity is difficult to measure for callable bonds as they exhibit negative convexity In order to match the convexity of bonds (call exposure) in the index, the sector, coupon, and maturity weights of the callable sectors in the index should be matched instead of matching the convexity because matching convexity involves high transaction costs Issuer Exposure: The portfolio should consist of a sufficient number of securities so that the event risk attributable to any individual issuer is minimized Present Value Distribution (PVD) of Cash flows describes how the total duration of the benchmark index is distributed across its maturity In other words, it describes the fraction of the portfolio’s duration that is attributable to cash flows falling in that time period In order to construct a portfolio to have same exposure to nonparallel yield curve shifts and twists, portfolio must have same present value distribution of cash flows as that of benchmark index FinQuiz.com Following are the steps to calculate PVD of Cash flows: i ii iii iv Calculate the present value of the cash flows from the benchmark index for specific periods i.e every 6- month period is computed Then each present value is divided by the present value of total cash flows from the benchmark to determine the percentage of the index’s total market value attributable to cash flows falling in each period e.g 3% of the index cash flows fall in the first 6-month period), 3.8% in the second period and so on Since the cash flows in each 6-month period can be considered zero-coupon bonds, the time period is the duration of the cash flow For example, the very first 6-month time period has a duration of 0.5 The next time period has duration of 1.0; the next 1.5, and so forth The duration of each period is multiplied by its weight to calculate the contribution of each period’s cash flows to portfolio duration For example, the contribution of the first 6-month period is calculated as 0.03(0.5) = 0.015 The contribution of the second period is 0.038(1.0) = 0.038, and so forth The duration contribution for each of the period is divided by the index duration (i.e., the sum of all the periods’ duration contributions) The resulting distribution is the benchmark’s PVD For example, suppose total index duration is 3.28 then PVD distribution is: Period = 0.015 / 3.28 = 0.46%, Period = 0.038 / 3.28 = 1.16% and so on Note: The goal of matching the primary risk factors is to minimize the tracking error (tracking risk) Tracking risk is the standard deviation of a portfolio’s active return for a given period whereas, active return is the difference between portfolio return and the benchmark return Practice: Example 9, Reading 23, Curriculum ALTERNATIVE METHODS FOR ESTABLISHING PASSIVE BOND MARKET EXPOSURE In a ‘passive investment strategy’, manager tends to just mimic the broader fixed-income market performance without detailed analysis or involvement of active management Full replication is the most direct method to mimic the index performance Managers purchase or sell securities only when there are changes to the index to maintain full replication However, frequent changes in the index and presence of illiquid securities make full replication strategy expensive and to some extent infeasible Index enhancement strategies address many limitations of full replication approach and are used by managers to enhance portfolio returns This typical approach is referred to as stratified sampling or cell approach to indexing In a cell-Matching technique (or stratified sampling), the manager first divides the bonds in the index into cells according to risk factors, such as sector, quality rating, duration, callability etc The manager then measures the total value of the bonds in each of the cells and determines each cell’s weight in the index Finally, the manager selects a sample of bonds from each cell and dollar amount selected from each cell is based on that cell’s weight in the index e.g if A rated corporate bonds Reading 23 Liability-Driven and Index-Based Strategies represent 4% of the entire index, then A rated bonds will be sampled and added until they represent 4% of the manager’s portfolio Enhanced-indexing is also highly significant for ESG investors who consider environmental, social, corporate governance and other related factors in the selection of their fixed income portfolios The five index enhancement strategies are given below: Lower Cost Enhancements: The portfolio’s net return can be increased by maintaining tight controls on trading costs and management fees Issue Selection Enhancements: The manager can identify and select issues that are undervalued relative to a theoretical value or can select issues which according to his/her credit analysis will soon be upgraded to enhance portfolio returns Yield Curve Positioning: Some maturities along the yield curve tend to remain consistently undervalued or overvalued The portfolio’s net return can be increased by overweighting the undervalued areas and underweighting the overvalued areas on the curve Sector and Quality Positioning: It has two forms: a Maintaining a yield tilt towards a specific sector and/or quality e.g maintaining a yield tilt toward short duration corporate issues b Periodic over-or-under weighting of sectors (e.g Treasuries vs Corporates) or qualities For example, when spreads are expected to widen (narrow), portfolio’s net return can be enhanced by overweighting (underweighting) Treasuries Note: Unlike active management strategy, the objective of this strategy is not to outperform the benchmark by a large margin Call Exposure Positioning: For example, when interest rates decrease, callable bonds underperform as compared to non-callable issues Therefore, in case of declining interest rates, portfolio’s net return can be enhanced by underweighting these issues The stratified sampling approach provides the following benefits No need to buy/sell thinly-traded securities Limit the need of frequent rebalancing of portfolio Enhance portfolio return and minimize tracking error by matching portfolio performance as closely as possible using fewer securities Practice: Example 10, Reading 23, Curriculum FinQuiz.com Indirect methods to seek passive bond-market exposures Some alternatives to investing directly in fixed-income securities passively are through: i ii iii Mutual funds Exchanged-traded funds Total return swaps Mutual Funds are pooled investment vehicles whose shares represent proportional share in the ownership of the assets in an underlying portfolio • Shares of open-ended mutual funds are ௦௦௧௦ି௧௦ bought or sold at their NAV ( ), ௦௦ • • • • • • • which is based on fund’s underling securities and is calculated at the end of the trading day Mutual funds are particularly suitable for small investors Mutual funds help diversifying a portfolio without the involvement of large amount of cash needed to replicate a broad index Investors can redeem holdings easily at fund’s NAV with one day time lag though many funds charge early redemption penalties Sale and purchase of individual bonds is expensive whereas, mutual funds offer the benefits of economies of scale because mutual funds’ trading cost decrease as funds’ asset size increase Unlike the underlying bonds, mutual funds have no maturity date because fund managers continuously trade bonds to track the index Mutual fund’s monthly interest payments vary depending on fund holdings Mutual funds charge annual management fee and may charge additional fees in terms of upload or back load Exchange Traded Funds • • • • • ETFs are collection of securities that typically track a particular market index ETFs are more tradeable than mutual funds ETF shareholders buy or sell shares throughout the day in public markets ETFs differ from mutual funds with respect to the process through which funds shares are created and redeemed The creation/redemption process take place between fund and broker/dealers referred to as ‘authorized participants’ (APs) To create ETF share, an AP provides basket of underlying securities to the ETF and in return receives a ‘creation unit’ (a large block of ETF share) AP may hold ETF shares or sell some or all the shares in the secondary market AP redeems shares through the same process in reverse i.e AP returns the specific number of shares in the creation unit to the ETF and receives either basket of shares available in Reading 23 • • Liability-Driven and Index-Based Strategies the ETF portfolio or cash This in-kind redemption (exchange of ETF for basket of shares) helps ETFs shares to trade at price close to market value of their underlying assets APs generally take advantage of any possible arbitrage opportunities (difference between market value of underlying securities and ETF’s NAV) by selling(buying) ETF shares when ETF shares trade at premium(discount) to their NAV Synthetic strategies provide another method to replicate index exposure through over-the-counter (OTC) or exchange-traded derivatives OTC instruments offer customized arrangements between two counterparties whereas, exchanged-traded solutions involve an organized exchange and offer standardized products Total return swap (TRS) TRS is the most common OTC strategy with some combine elements of interest-rate swaps and credit derivatives TRS involves periodic exchange of cash flows between two parties based on some reference obligation such as total return (including income and price change) of equity, commodity or bond index versus Libor + spread Total return payer is compensated for any depreciation/default losses in the index or default losses incurred on the portfolio Basic TRS structure pays receives Index cash flows + Appreciation Total return receiver Total return receiver pays Total return payer Libor + Spread Index depreciation + default losses FinQuiz.com TRS is an efficient risk transfer OTC derivative contract between two parties in which total return payer is typically a dealer One significant benefit of using TRS compared to ETF, mutual fund or direct investment is smaller initial outlay and lower transaction costs (lower swap bid-offer cost) TRS is a customized OTC derivative instrument and can offer exposure to securities that are hard to obtain directly such as high-yield or commercial loan investments Following are some disadvantages of using TRS By entering into a TRS, an investor does not legally own the underlying assets but holds a synthetic long position in the index The investor may face counterparty credit risk and rollover risk (due to the shorter nature of the contract) Counterparty credit risk can be resolved by necessary credit due diligence Rollover risk requires investor’s ability to renew the contract in the future with reasonable pricing and business terms Costs and operational problems of derivative transactions have been increased lately due to fundamental changes to the market, increased regulatory control, stricter rules for dealers, requirement for holding more capital, more frequent mark-to-market collateralization etc Though exchanged-traded derivatives on debt indexes are also available, however, it is challenging for investors to rely on such derivatives compared to over-thecounter instruments on debt indexes because of frequent changes in the availability of such exchangedtraded instruments Practice: Example 10, Reading 23, Curriculum Total return payer receives BENCHMARK SELECTION Benchmark selection is one of the final step in the broader asset allocation process • For fixed-income portfolios, the selection of a benchmark is unique because the investor usually has some form of fixed-income coverage embedded in asset/liability portfolios and therefore, the investment manager must take into account the implicit or explicit duration preferences at the time of selection of fixedincome benchmark • The benchmark selection decision should identify numerous characteristics of bond indexes such as: • The finite maturities of bonds suggest that the duration of the index drift downward with the passage of time even for static bond portfolios For broad-based indices, issuer composition and maturity selection depend on market dynamics Investors who track value-weighted index automatically assign large weights to morelevered borrowers or sectors As creditworthiness and leverage are negatively correlated, this greater allocation to more levered borrowers leads to ‘bums problems’ Reading 23 Liability-Driven and Index-Based Strategies When conducting fixed-income benchmark selection, investors are required to vigorously comprehend and describe their duration preferences and desired riskreturn profile within their fixed-income allocation Targeted duration can be achieved by combining several sub-benchmark categories Smart beta is another alternative for fixed-income investors who want to reduce the cost of their active management while eliminating systematic biases such 10 • • laddered portfolio (bonds maturities evenly distributed along the yield curve) bullet portfolio (bonds maturities concentrated at a particular point on the yield curve) barbell portfolio (bonds maturities concentrated at short and long ends of the yield curve.) If three portfolios (ladder, barbell and bullet) have same duration, percentage change in the value of barbell, bullet and ladder portfolios as a result of a: • • as bums problems Smart beta is a simple rules-based strategy which is well-known among equity managers but now has gained widespread attention among fixedincome managers as well Practice: Example 11, Reading 23, Curriculum LADDERED BOND PORTFOLIO Three maturity-based investment strategies involve constructing a: • FinQuiz.com parallel yield curve shift, will approximately be the same non-parallel shifts or twists, will be very different Benefits of Laddered Portfolio A laddered bond portfolio is popular investment strategy in the wealth management industry Diversification over maturity spectrum Uniform cash flow distribution on maturity spectrum feature of a laddered portfolio provides protection (balanced ‘cash-flow reinvestment’ and ‘market price’ risks) against shifts and twists Maintenance of the overall portfolio duration In a stable, upward sloping yield curve environment; proceeds from maturing bonds are re-invested in long term bonds (offering higher yields) to maintain duration of the portfolio This gives ladder portfolio an edge over bullet and barbell Convexity A laddered portfolio offers high convexity because its cash flows are distributed on the timeline If three portfolios have same duration, the laddered portfolio offers higher convexity than the bullet but lower than the barbell However, compared to barbell, laddered portfolio’s cash flow reinvestment risk is much lower Liquidity Management A laddered portfolio provides liquidity as bonds are constantly maturing and being reinvested If liquidity is needed, selling near-to-maturity bonds naturally offer favorable pricing or such bonds can provide high-quality less risky collateral on a personal loan or on a repo contract Constructing a laddered bond portfolio A laddered bond portfolio can be constructed by using individual bonds or fixed-maturity corporate ETFs These ETFs, often managed passively, have a designated termto-maturity and credit risk profile For example, an ETF replicating the performance of some index such as 50 held-to-maturity investment-grade corporate bonds maturing in 2025 The decision to purchase pertinent ETFs instead of individual bonds offers similar benefits such as diversification over time spectrum, price stability in nearto maturity ETFs, higher convexity etc ETFs are generally more liquid than individual bonds Limitations of laddered portfolios Compared to laddered portfolio, fixed-income mutual fund bonds • • • involve lower cost of acquisition offer greater diversification of default risk can be redeemed more rapidly at favorable pricing Practice: Example 12, Reading 23, Curriculum ... Refer to CFA Curriculum, Reading 23, 4.4 ‘Contingent Immunization’ paragraph 4th , 5th & 6th page 77 for illustration through example Practice: Example 6, Reading 23, Curriculum Reading 23 Liability-Driven... illustration and example please refer to Reading 23, 4 .3 ‘Derivative Overlay’ from 5th paragraph on page 74 till end Practice: Example 5, Reading 23, Curriculum 4.4 Contingent Immunization Contingent... portfolios and for contingent immunization Practice: Example 8, Reading 23, Curriculum Reading 23 Liability-Driven and Index-Based Strategies FinQuiz. com BOND INDEXES AND THE CHALLENGES OF MATCHING
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