Four-in-One Bond Fund

1. What is the problem according to the Director of Global Equities and Fixed Income? Who will solve this issue and what is the solution proposed? Many investors seem more interested in stocks than bonds and dont seem to pay enough attention to the bond market. Then, if a certain type of fixed income portfolio does well, investors are concerned after-the-fact that they were not exposed to that bond fund. The Director proposes having a bond fund that is set up to have exposure to different types of fixed income securities. 2. What is the difference between IEF, TIP, BND, LQD? What is AGG and its importance? The IEF is an ETF consisting of 7-10 year Treasury bonds. The TIP is an ETF that has inflation protected Treasury securities. The BND is an ETF called the Vanguard Total Bond Market, and LQD is an ETF of investment grade corporate bonds. The ETF with ticker symbol AGG is the Barclays Aggregate Bond Fund and is often considered an acceptable benchmark for bond funds. 3. Explain the concept of duration and how it compares to maturity? What is the relationship between duration and interest sensitivity for a bond? Duration is similar to maturity but takes into account that on coupon bonds, the investor is really getting paid back a bit sooner than the maturity date. So, if a bond pays 10% interest and has a 10 year maturity on a face value of 1,000, the investor is receiving $100 each year in interest and then in the final year the $100 plus the $1,000. The maturity is 10 but the duration is less since investors receive some payment each year. Duration is the correct measure of a bonds interest rate sensitivity. (Maturity is a proxy for duration but the exact correct measure is duration.) 4. What is the U.S. Treasury yield curve? What are the various slopes of yield curves? Yield curve plots term to maturity on x-axis and interest rate on y axis. The yield curve may be upward sloping, relatively flat, or downward sloping (inverted). 5. Explain the difference between investment grade and high yield bonds. How will their yields compare to Treasuries? Investment Grade bonds are corporate bonds with high ratings (say AAA, AA, A, BBB). The higher is the rating, the less of a risk premium paid over Treasuries. Investment grade, also called high yield are low rated bonds and the premium paid over Treasuries is higher.

6. The Director notes a concern regarding clients needs and how to design a portfolio that better matches differing needs. Explain. Clients would be best served by offering a portfolio that is diversified across different types of bond funds. For example, start with 1million dollars and set up a bond fund that is invested 30% in IEF, 10% in TIP, 30% BND, and 30% LQD. Then this portfolio would be diversified across intermediate Treasuries (IEF), Inflation Protected Treasuries (TIP), investment grade bond market of Treasuries, mortgage backed securities and corporate securities (BND), and Investment Grade Corporate (LQD). The average credit rating would be high. Based on 1 million, you would want to open a spreadsheet and find things such as: ticker, name of ETF, percent allocation, dollar allocation, average credit quality, average coupon, average duration, and then trailing total return (price, not NAV) on a 3 month basis, 1 year basis, 3 year basis, and possibly even a 5 year basis. Below this keep track of the iShares Barclays Aggregate, AGG, which is considered the benchmark for bonds. Next, alter the portfolio to see if you could get the average duration lower or higher to meet certain client needs. That is if an institutional client has shorter term liabilities, then that client may prefer a portfolio of fixed income assets with shorter duration. This can be achieved by replacing IEF with SHY, iShares Barclay 1-3 Treasury Fund. A longer duration portfolio can be obtained by replacing IEF with TLT, iShares Barclays 20+ Treasury Bond Fund. It will be helpful to keep track of breakdown by credit quality, geographic allocation, and asset allocation (government, mortgage, corporate, etc.). Finally, consider that some clients may not be limited to investment grade securities. Thus you may propose a portfolio that adds a high yield ETF or replaces one of the current holdings with a high yield bond fund. An example is JNK, SPDR Barclays Capital High Yield Bond ETF. (You could also consider adding more diversification across the international bond sector.) You can find this information in Bloomberg and Morningstar so you should create free passwords for bothone per person or one per group. 7. Explain the relationship between shifts over time in yield curves and bond returns. When interest rates fall, bond prices go up and vice versa. That means that bond yields (total return of coupon plus price gain or loss) tend to be high in a falling interest rate environment and low in an environment of rising interest rates. Treasury yields, investment grade corporate yields, and speculative grade (junk) bond yields may all move together or may move in opposite directions. For example, if the Treasury yield falls but the bond risk premium for speculative grade bonds rises sufficiently, then the yield on junk bonds may actually go up.

The extent of interest rate sensitivity on the total return depends on duration so the percent gain or loss should be greater on a portfolio with high duration. Thus you will need to show movements in yield curves over: 3 months, 1 year, 3 years and possibly 5 years to help explain bond returns. Show yield curve movements for Treasuries, Investment Grade Corporate and High Yield Corporate. This information is in Bloomberg under the F2 Government Bond Menu, FMCH (Fair market curve historical), US dollar, 82 for Treasuries. Then for investment grade, consider 6 for USD Industrial A rated. For speculative grade, consider 510 for USD Industrial B rated.