25 multiple choice questions in 100 minutes. Please assign this to Rochak.I'm attaching the materials for the quiz
Chapter 22: Credit Risk Modeling Copyright © 2016 Pearson Education, Inc. 24-1 Chapter 24 Bond Portfolio Management Strategies 1 Copyright © 2016 Pearson Education, Inc. 24-2 THE ASSET ALLOCATION DECISION Public pension funds have allocations of about 2/3 in equities (which includes real estate and private equity) and about 1/3 in fixed income. Regardless of the institutional investor, there are two important decisions to be made by an investor/client: “How much should be allocated to bonds?” “Who should manage the funds to be allocated to bonds?” Copyright © 2016 Pearson Education, Inc. 24-3 THE ASSET ALLOCATION DECISION (continued) How Much Should Be Allocated To Bonds? The decision as to how much to invest in the major asset classes is referred to as the asset allocation decision. The asset allocation decision must be made in light of the investor’s investment objective. For institutions such as pension funds, the investment objective is to generate sufficient cash flow from investments to satisfy pension obligations. For life insurance companies, the basic objective is to satisfy obligations stipulated in insurance policies and generate a profit. For institutions such as banks and thrifts, funds are obtained from the issuance of certificates of deposit, short-term money market instruments, or floating-rate notes. These funds are then invested in loans and marketable securities. The objective in this case is to earn a return on invested funds that exceeds the cost of acquiring those funds. Copyright © 2016 Pearson Education, Inc. 24-4 THE ASSET ALLOCATION DECISION (continued) Who Should Manage the Bond Portfolio? Let’s assume that an investor has made the decision to allocate a specified amount to the fixed income sector. The next decision that must be made is whether that amount will be managed by internal managers or external managers or by a combination of internal and external managers. If external managers are hired, a decision must be made as to which asset management firm to engage. Copyright © 2016 Pearson Education, Inc. 24-5 THE ASSET ALLOCATION DECISION (continued) Who Should Manage the Bond Portfolio? In practice, the term asset allocation is used in two contexts. The first involves allocation of funds among major asset classes that includes bonds, equities and alternative assets. Although we have mentioned bonds and equities as the major asset classes, there is now accepted a group of assets referred to as alternative assets. The second way is how the funds should be allocated amongst the different sectors within that asset class after a decision has been made to invest in a specified asset class. In the case of equities, equities are classified by market capitalization and by other attributes such as growth stocks value. Copyright © 2016 Pearson Education, Inc. 24-6 THE ASSET ALLOCATION DECISION (continued) Who Should Manage the Bond Portfolio? The asset allocation among the different sectors of the bond is made at two levels. The first is where a client must make a decision as to allocate among each sector and then if an external money manager is to be hired, deciding on the asset management and amount to be allocated to each. Copyright © 2016 Pearson Education, Inc. 24-7 PORTFOLIO MANAGEMENT TEAM We refer to the person making the investment decisions as the “manager” or “portfolio manager.” The composition and therefore risk exposure of a portfolio is the result of recommendations and research provided by the portfolio management team. At the top of the investment organization chart of the investment group is the chief investment officer (CIO) who is responsible for all of the portfolios. A chief compliance officer (CCO) monitors portfolios to make sure that the holdings comply with the fund’s investment guidelines and that there are no activities conducted by the managers of the fund that are in violation of federal and state securities laws or investment policies. Copyright © 2016 Pearson Education, Inc. 24-8 PORTFOLIO MANAGEMENT TEAM (continued) An asset management firm employs analysts and traders. The analysts are responsible for the different sectors and industries. The traders are responsible for executing trades approved by a portfolio manager. The analysts and traders can support all of the portfolios managed by the firm or just designated portfolios. A large firm may also employ an economist or an economic staff that would support all portfolios managed by the firm. At the individual portfolio level there is either a lead or senior portfolio manager or co-managers. It is the lead manager or co-managers who will make the decision regarding the portfolio’s interest rate exposure and the allocation of the fund’s assets among the countries, sectors and industries. Copyright © 2016 Pearson Education, Inc. 24-9 SPECTRUM OF BOND PORTFOLIO STRATEGIES The bond portfolio strategy selected by an investor or client depends on the investment objectives and policy guidelines. In general, bond portfolio strategies can be categorized into the following three groups: bond benchmark-based strategies, absolute return strategies, and liability-driven strategies. Copyright © 2016 Pearson Education, Inc. 24-10 SPECTRUM OF BOND PORTFOLIO STRATEGIES (continued) Bond Benchmark-Based Strategies There is a wide range of bond portfolio management strategies for an investor or client who has selected a bond index as a benchmark. Traditional bond benchmark-based strategies can be classified as: pure bond index matching; enhanced indexing: matching primary risk factors; enhanced indexing: minor risk-factor mismatches; active management: larger risk-factor mismatches; and active management: full-blown active. These strategies range from low risk strategies at the top to high risk-tolerance strategies at the bottom of the list. It is not only important to understand what the risk factors are, but also how to quantify them. Copyright © 2016 Pearson Education, Inc. 24-11 SPECTRUM OF BOND PORTFOLIO STRATEGIES (continued) Bond Benchmark-Based Strategies The last two strategies are active bond portfolio management strategies. They differ to the extent with which they allow mismatches relative to the benchmark. It is important to note that even if a manager pursues an active strategy, the manager may still elect to have a duration equal to that of the benchmark (i.e., pursue a duration-matching strategy). Copyright © 2016 Pearson Education, Inc. 24-12 SPECTRUM OF BOND PORTFOLIO STRATEGIES Portfolio managers often pursue what is referred to as a core/satellite strategy. Basically, this strategy involves building a blended portfolio using an indexed and active strategy. The core component is a low-risk portfolio constructed using one of the indexing strategies. The satellite component is constructed using an active strategy with a benchmark that is specialized rather than a broad liquid bond market index. Copyright © 2016 Pearson Education, Inc. 24-13 SPECTRUM OF BOND PORTFOLIO STRATEGIES (continued) Absolute Return Strategies In an absolute return strategy, the portfolio manager seeks to earn a positive return over some time frame irrespective of market conditions. Few restrictions are placed on the exposure to the primary risk factors. Absolute return strategies are typically pursued by hedge fund managers using leverage. Other absolute return managers set as their target as earning a return from 150 to 400 basis points per annum over the return on cash and hence such strategies are referred to as cash-based absolute return strategies. Copyright © 2016 Pearson Education, Inc. 24-14 SPECTRUM OF BOND PORTFOLIO STRATEGIES (continued) Liability-Driven Strategies Liability-driven investing (LDI) is concerned with controlling investment risk where the benchmark for assessing performance is not in terms of an asset benchmark or a peer group but by reference to a client’s liabilities. These strategies involve managing both assets and liabilities to achieve some return objective or a series of liabilities that a client faces. Life insurance companies use LDI strategies known as immunization and cash flow matching for several products that they issue: annuities, guaranteed investment contracts, and structured contracts that guarantee a minimum rate. Copyright © 2016 Pearson Education, Inc. 24-15 Bond Benchmarks Typically, bond portfolio managers are given a mandate that involves their performance evaluation relative to a benchmark. The construction of a benchmark requires that a set of rules be specified for the purpose of determining which specific issues from the bond universe should be included and excluded. Since the turn of the century, there have been challenges to the suitability of bond market indexes to serve as a bond benchmark. This has led to the creation of customized and alternative bond indexes Copyright © 2016 Pearson Education, Inc. 24-16 Bond Benchmarks (continued) U.S. bond market indexes are classified based on one or more of the following characteristics with respect to the bonds that are included in the index. sectors covered (government bonds, corporates, securitized products), credit rating (investment grade and high yield), and maturity (short term, intermediate term, and long term). Understanding the eligibility requirements for inclusion in a bond index is important. Active bond portfolio strategies often attempt to outperform an index by buying non-eligible or non-index securities. Copyright © 2016 Pearson Education, Inc. 24-17 Bond Benchmarks (continued) Once all of the bond issues are identified, the construction of the portfolio turns to how to weight each issue. U.S. The typical bond market index is based on market-capitalization weights. The market cap of a bond issue is its market value. Suppose there are N bond issues whose market cap is denoted by M1, M2, . . . MN. The market cap of the bond index is then Mindex = Mi + M2 + . . . + MN. Denoting the weight for each bond issue in the index by wi, then the weight for each bond issue in the index is wi = Mi / Mindex. Copyright © 2016 Pearson Education, Inc. 24-18 Bond Benchmarks (continued) A common market-cap bond market index used by institutional investors is Barclays Capital U.S. Aggregate Bond Index, which is a broad-based U.S. bond market index. There are more than 6,000 issues in this index, which includes only investment-grade securities. The index is computed daily. The pricing of the securities in each index is either trader priced or model priced. Each broad-based bond index is broken into sectors. The sector breakdown for the Barclays Capital U.S. Aggregate Bond Index is Treasury, Agency, Corporate, Mortgage pass-through and Commercial. Copyright © 2016 Pearson Education, Inc. 24-19 Bond Benchmarks (continued) There are problems associated with a market-cap-weighted bond index. First, there is a duration problem that refers to the conflict that exists between bond issuers and bond investors with respect to the duration of bonds issued and the resulting duration for the bond market index. Second, there is a changing risk exposure problem associated with using a bond market index as a benchmark where the investment characteristics of the index change over time. Third, there is a “bum’s” problem where highly leveraged corporate bond issuers and troubled sovereign issuers (that issue greater amounts of debt) have increasing weight in a market-cap index. Finally, there is the concern with the illiquidity of the bond issues in the index. Copyright © 2016 Pearson Education, Inc. 24-20 Bond Benchmarks (continued) Customized