Advanced Portfolio Management
ADMS 4501 – Winter 2012 – Lois King
Lecture 10 – Chapter 16 – Bond P/M Strategies – Mar 15
Bond Portfolio Performance
- Fixed-income portfolios generally produce both less return and less volatility than
found in other asset classes.
- The low historical correlation between fixed-income and equity securities – has
made bond portfolios an excellent tool for diversifying risk.
Bond Portfolio Style
- Investment style of a bond portfolio can be summarized by two important
o Credit quality.
o Interest rate sensitivity.
- Average credit quality of the portfolio can be classified as high, medium, and low
- Interest rate sensitivity of the bond portfolio can be separated as short-term,
intermediate-term, and long-term.
Bond Portfolio Strategy
- Bond portfolio strategy
o Passive portfolio strategies.
Buy and hold.
o Active management strategies.
Interest rate anticipation.
Yield spread analysis.
Other (e.g. liquidity, currency, anomaly capture).
o Core-plus management strategy.
Active/passive ‘plus’ sectors.
o Matched-funding techniques.
Dedicated: exact cash match.
Dedicated: optimal cash match.
o Contingent procedure (structured active management).
Structured management. Passive Management Strategies
- Buy and hold
o A manager selects a portfolio of bonds based on the objectives and
constraints of the client with the intent of holding these bonds to maturity.
o Can be modified by trading into some desirable positions (‘modified buy
and hold’ strategy) if opportunities arise.
o The objective is to construct a portfolio of bonds that will track the
performance of a bond index (using full replication or sampling).
o Performance analysis involves examining tracking error for differences
between portfolio performance and index performance.
Active Management Strategies
- Active management strategies attempt to beat the market (create superior risk-
adjustment returns or ‘alpha’).
- This manager has a view as to which factors or market conditions will be the
source of the ‘alpha’:
o Interest rate anticipation.
o Valuating analysis.
o Credit analysis.
o Yield spread analysis.
o Global fixed-income analysis.
- Review: bond duration
o Duration is the weighted average term to maturity of bonds cash flows and
therefore, is a valuable tool in assessing bond price sensitivity to interest
o It is the most common technique for quantifying this sensitivity and is
generally used to approximate changes in the price of the bond for every
100 basis point change in yields (modified duration)
o As a general rule, the greater the value of duration, the more price
volatility results from interest rate movements.
Let’s take a look at the formula that Frederik Macaulay devised to
calculate bond duration.
o How you can use the concept of duration
A general rule is that a bond with a longer duration is far more
volatile than a bond with a shorter duration.
Zero coupon bonds have the same duration and maturity and
therefore have the highest risk to interest rate changes.
Zero coupon bonds aside, will the duration of a bond always be
shorter than its term to maturity.
Lower coupon bonds will have higher durations than larger coupon
bonds and therefore,
Larger coupon bonds will be less when interest rates are changed.
- Interest-rate anticipation o Risky strategy relying on uncertain forecasts.
o Ladder strategy staggers maturities.
o Usually attained by altering the portfolio’s duration structure:
Decrease portfolio duration when increase in rates is anticipated
(risk if you are wrong: opportunity cost).
Increase portfolio duration when decline in rates is anticipated (very
risky is rates continue to increase because bond prices decline).
- Valuation analysis
o Portfolio manager attempts to select bonds based on their intrinsic value.
o Manager analyses and estimates the yield cost of certain features, such