CFA Level 3 - Fixed Income Portfolio Management

Managing funds against a bond market index benchmark
- Pure bond indexing
- Enhanced indexing by matching primary risk factors
- Enhanced indexing by small risk factors mismatches
- Enhanced indexing by larger risk factors mismatches
- Active management by larger risk factor mismatches
- Full blown active management

Managing funds against liabilities
- Immunization: locking in a guaranteed return over a particular horizon
1) single period immunization (classical immunization). It requires offsetting price risk and reinvestment risk. It can be done by duration matching (matching the duration of portfolio to liabilities)

for upward sloping yield curve, the immunization target rate of return < ytm because of lower reinvestment return. (price risk -> high yield lowers bond prices, price change is more than the increase in reinvestment of coupons )

type of risks:
interest rate risk, contingent claim risk (mortgage back securities when underlying mortgage prepay principal), cap risk (asset return are capped)

2) Multiple liabilities Immunization: composite return of portfolio equal composite return of liabilities

- Cash flow matching
match liability flow with assets flows of the portfolio. Immunization require less money to fund liabilities

Duration hedging
Basis risk : the difference between cash price and futures price is called basis, risk that basis will change is called basis risk
Unhedged position - has price risk, which is a risk that cash market price will move adversely
A hedged position substitute basis risk for price risk

hedged ratio = Factor exposure of bond to be hedged/factor exposure of hedging instrument
= (D_T-D_I)P_I/D_CTDP_CTD * conversion factor of CTD bond

Derivative Strategies
-interest rate future
-interest rate swap: dollar duration of swap = dollar duration of fixed rate bond -  dollar duration of floating rate bond
-interest rate options
-credit risk instruments

International bond investing
 Δ in value of foreign bond = duration * Δin foreign yield given change in domestic yield
 Δ in value of foreign bond = duration * Δin yield * country beta

Duration definition
Macaulay duration: weighted average time to receive of CFs, using PV of each CF as the weight on time until it is received
Modified duration: % Δ bond price  for 1% Δ in the its ytm, assuming CFs don't change
Effective duration:  % Δ bond price  for 1% Δ in the its ytm, assuming CFs might change
spread duration:  % Δ bond price  for 1% Δ in its spread over treasury of same maturity
key rate duration: % Δ bond price  for 1% Δ in the ytm of treasury of a given maturity

Duration of Foreign bonds
adjusted duration = county duration * country beta
ΔPrice = adjusted duration * Δyield
Contribution = % weight * adjusted duration

Important points
As interest rate changes, portfolio duration will change (look at the price yield curve), portfolio must be re-balanced to adjust duration to desired level.

Portfolio can be managed to generate additional returns, the incremental difference between min return and higher possible immunized rate, is known as cushion spread. When there is cushion spread, manager can actively manage part of the portfolio. Contingent immunization is to integrate immunization strategies within active mgt strategies.

When manager expects credit spread will widen due to economic worsening, curve adjustment trades take place. The strategy is to shift the portfolio exposure to shorten the spread duration by buying shorter maturity bonds, and sell longer maturity bonds, and lower the contribution to spread duration

To immunize portfolio target yield against change in market yield, the bond portfolio must be (1) duration = investment horizon (2) Initial PV of all CFs = PV of future liability

Given a upward sloping yield curve, bond's ytm increase as maturity of the bond portfolio increase. A long duration portfolio will fall more in price than the short duration portfolio.

Hedging of foreign bonds
Example: domestic currency USD, holds Euro denominated bonds, Euro rate 2.50% US rate 0.25%

According to IRP, USD appreciates by 0.25%-2.50% = -2.2.5% (Euro depreciates)

expected depreciation of euro is 1.75%.

There is no need to hedge in this case.