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3 views

Chapter 2

Uploaded by

khanh25252
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We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 3

Fixed-Income Portfolio Management


Dr. Le Quy Duong
Email: [email protected]
Phone: 0966973642
Research Interests: efficient stock markets, asset pricing models
Types of fixed-income assets

Government
• Government bond
• Treasury bill

Corporate
• Corporate bond
Roles of fixed-income assets

Risk diversification

Benefits of fixed income

Hedge against inflation risks


Risk diversification
• Thanks to a low correlation to stocks and other investments, adding
fix-income assets to a portfolio would significantly reduces the risk
level
• For example, the correlation coefficient between the Vietnam 1-year
bond yield and the VN-Index from 2012 to 2024 is about 0.04
Benefits of fixed income
• The unique characteristic of fixed income assets is that they generate
regular cash flows. Regular cash flows help investors proactively plan
their budgets to meet future debt obligations.
• The selected bonds will have interest and principal payment terms
corresponding to the maturity and size of the future debt obligations
• Regular cash flows from bonds are based on the assumption that
there will be no credit or market risk.
Hedge against inflation risks
• The interest rate of a floating rate bond is tied to a benchmark rate
• Floating rate bonds offer protection against inflation risk as their
coupon payments adjust with changes in market rates
• The principal repayment at maturity is not adjusted for inflation.
• In a rising interest rate environment, floating rate bonds may provide
higher returns compared to fixed-rate bonds
Advantages of investing in fixed-
income assets

Fixed incomes

Low risk

High liquidity for treasury bills and government bond


Disadvantages of investing in fixed-
income assets

Low return

Low capital gains


Bond Duration
Duration measures the volatility of a bond's price in response to a
change in the bond's yield to maturity
P
CFt: cash flow in period t
r: yield to maturity or required return
Duration in Fixed-Income Portfolio
Management
Dollar duration is a measure of the change in portfolio value for a 100
bps (1%) change in market yields
Dollar duration = Duration × Portfolio value × 0.01
A portfolio’s dollar duration is a weighted average of the dollar
durations of the component securities
Duration in Fixed-Income Portfolio
Management
We have constructed a portfolio consisting of three bonds in equal par
amounts of $1,000,000 each. The initial values and durations are:
Initial Durations:
Bond Price Market value Duration
Bond 1 104.013 1 065 613 5.025
Bond 2 96.089 978 376 1.232
Bond 3 103.063 1 034 693 4.479

What is the Portfolio Dollar Duration?


Duration in Fixed-Income Portfolio
Management
We now move forward one year and include a shift in the yield curve.
Durations after one year:
Bond Price Market value Duration
Bond 1 99.822 1 023 704 4.246
Bond 2 98.728 1 004 770 0.305
Bond 3 99.840 1 002 458 3.596

What is the new Portfolio Dollar Duration?


Calculate the rebalancing ratio to maintain the portfolio dollar duration at
the initial level. The cash required for the rebalancing?
Due to liquidity, the portfolio manager decide to sell a bond. Which bond
should be sold? What proportion of this bond should be sold to maintain
duration?
Duration in Fixed-Income Portfolio
Management
Spread duration is a measure of how the market value of a risky bond
(portfolio) will change with respect to a parallel 100 bps change in its
spread above the comparable benchmark security (portfolio)
Spreads do change and the portfolio manager needs to know the risks
associated with such changes.
Duration in Fixed-Income Portfolio
Management
Spread duration for a bond portfolio based on sectors:

Sector Spread duration


Treasury 0.00
Agencies 3.52
Financial institutions 2.27
Industrials 9.54
Passive Fixed-income strategies

Buy and hold strategy

Pure bond indexing

Enhanced indexing
Pure bond indexing
The goal here is to produce a portfolio that is a perfect match to the
benchmark portfolio. The pure bond indexing approach attempts to
duplicate the index by owning all the bonds in the index in the same
percentage as the index.
Full replication is typically very difficult and expensive to implement in
the case of bond indices. Many issues in a typical bond index
(particularly the non-Treasuries) are quite illiquid and very infrequently
traded.
For this reason, full replication of a bond index is rarely attempted
because of the difficulty, inefficiency, and high cost of implementation
Enhanced indexing
This management style uses a sampling approach in an attempt to
match the primary index risk factors and achieve a higher return than
under full replication.
Primary risk factors are typically major influences on the pricing of
bonds, such changes in the level of interest rates, twists in the yield
curve, and changes in the spread between Treasuries and non-
Treasuries
Tracking risk
Tracking risk is a measure of the variability with which a portfolio’s
return tracks the return of a benchmark index. More specifically,
tracking risk is defined as the standard deviation of the portfolio’s
active return, where the active return for each period is:
Active return = Portfolio’s return − Benchmark index’s return
Tracking risk = Standard deviation of the active returns
Tracking risk
The table below shows the active return for ten periods for a bond
portfolio. Calculate the portfolio’s tracking risk for this time frame
Period Portfolio return (%) Benchmark return
1 5.8 5.6
2 6.8 6.5
3 5.6 6.2
4 4.6 5
5 4 4.1
6 3.3 3.2
7 5.4 5.1
8 5.4 5.7
9 5.1 4.6
10 3.7 3.8
Tracking risk
A tracking risk of x% would indicate that the portfolio return will be
within a band of the benchmark index’s return plus or minus x%
The smaller the tracking risk, the more closely the portfolio’s return
matches, or tracks, the benchmark index’s return.
Evaluate tracking risk using spread
duration
 If the portfolio’s duration is significantly higher than the benchmark’s
duration, then the portfolio has a greater exposure to parallel changes
in interest rates, resulting in an increase in the portfolio’s tracking risk
If the portfolio overweights a risky bond compared with the
benchmark, the tracking risk will be increased
Even though the sector percentages may be matched, a mismatch will
occur if the portfolio’s bonds have a significantly higher duration than
the benchmark
Evaluate tracking risk using spread
duration
Bond portfolio Benchmark
Sector Weight (%) Spread duration Weight (%) Spread duration
Treasury 22.6 0 23.2 0
Agencies 6.8 6.45 6.65 4.43
Financial institutions 6.2 2.84 5.92 3.27
Industrials 20.06 11.04 14.2 10.65
Utilities 5.52 2.2 6.25 2.4
Non-credit 6.61 1.92 6.8 2.02
Mortgage 32.21 1.1 33.15 0.98
Asset Backed 0 0 3.83 3.2

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