Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Sixth Edition
by

Frank K. Reilly & Keith C. Brown

Chapter 17
Version 1.2
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Chapter 17 - Bond
Portfolio Management Strategies
Questions to be answered:
What are the four major bond portfolio
management strategies?
What are the two specific passive
portfolio management strategies
available?

Copyright 2000 by Harcourt, Inc. All rights reserved

Chapter 17 - Bond
Portfolio Management Strategies
What are the five alternative strategies
available within the active management
category?
What is meant by matched-funding
techniques, and what are the four specific
strategies available in this category?

Copyright 2000 by Harcourt, Inc. All rights reserved

Chapter 17 - Bond
Portfolio Management Strategies
What are the major contingent
procedure strategies that are also
referred to as structured active
management strategies?
What are the implications of capital
market theory for those involved in bond
portfolio management?

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Chapter 17 - Bond
Portfolio Management Strategies
What is the evidence on the efficient
market hypothesis as it relates to bond
markets?
What are the implications of efficient
market studies for those involved in bond
portfolio management?

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Alternative Bond Portfolio Strategies

1. Passive portfolio strategies
2. Active management strategies
3. Matched-funding techniques
4. Contingent procedure (structured active
management)

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Passive equity portfolios attempt to track the returns of

an established benchmark, such as the S&P 500,
or some other benchmark that meets the investors
needs.
Active portfolios attempt to add value relative
to their benchmark by market timing and/or by seeking
to buy undervalued stocks.
Index mutual funds and exchange-traded funds are
popular ways for small investors to make passive
investments.

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Passive Portfolio Strategies

Buy and hold
Can be modified by trading into more
desirable positions

Indexing
Match performance of a selected bond index
Performance analysis involves examining
tracking error
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Three basic techniques exist for constructing

a passive portfolio: (1) full replication of an
index, in which all securities in the index are
purchased proportionally to their weight in the
index; (2) sampling, in which a portfolio
manager purchases only a sample of the
stocks in the benchmark index; and (3)
quadratic optimization or programming
techniques, which utilize computer programs
that analyze historical security information in
order to develop a portfolio that minimizes
tracking error.
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How do trading costs and market efficiencies affect

the active manager? How may an active manager
try to overcome these obstacles to success?
The job of an active portfolio manager is not easy. In
order to succeed, the manager should maintain his/her
investment philosophy, dont panic. Since the
transaction costs of an actively managed portfolio
typically account for 1 to 2 percent of the portfolio
assets, the portfolio must earn 1-2 percent above the
passive benchmark just to keep even. Therefore, it is
recommended that a portfolio manager attempt to
minimize the amount of portfolio trading activity. A high
portfolio turnover rate will result in diminishing portfolio
profits due to growing commission costs

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How can mangers add value to their portfolio

Managers attempt to add value to their portfolio by
: (1) timing their investments in the various markets in light of
market forecasts and estimated risk premiums;
(2) shifting funds between various equity sectors, industries, or
investment styles in order to catch the next hot concept; and
(3) stock picking of individual issues (buy low, sell high).

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EUpk = ERp (p2/RTk

Expected Utility
RT= Risk tolerance factor
We use EU in order to reach the optimal
allocation of assets with accepting risk levels

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Active Management Strategies

Interest-rate anticipation
Risky strategy relying on uncertain forecasts
Ladder strategy staggers maturities
Barbell strategy splits funds between short
duration and long duration securities

Valuation analysis - intrinsic value

Credit analysis
Determine default risk
Special case of high-yield bonds
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P/E Ratio =
(Current Price Per Share)
(Earnings Per Share
where the earnings per share (EPS) measure can be based on either current or future
(i.e., forecasted) firm performance. In broad terms, value and growth managers will
focus on different aspects of this equation when deciding whether a stock should be
added to an existing portfolio. Specifically, a growth-oriented investor will
focus on the EPS component (i.e., the denominator) of the P/E ratio and its
economic determinants;
look for companies that he or she expects to exhibit rapid EPS growth in the future;
and often implicitly assume that the P/E ratio will remain constant over the near
term, meaning that the stock price will rise as forecasted earnings growth is realized.
On the other hand, a value-oriented investor will
focus on the price component (i.e., the numerator) of the P/E ratio; he or she must
be convinced that the price of the stock is cheap by some means of comparison;
not care a great deal about current earnings or the fundamental drivers of earnings
growth; and
often implicitly assume that the P/E ratio is below its natural level and that the
market will soon correct this situation by increasing the stock price with little or no
change in earnings.

There are a number of active management strategies discussed in the

chapter including sector rotation, the use of factor models,
quantitative screens, and linear programming methods.
Following a sector rotation strategy, the manager over-weights certain
economic sectors, industries or other stock attributes in anticipation of
an upcoming economic period or the recognition that the shares are
undervalued.
Using a factor model, portfolio managers examine the sensitivity of
stocks to various economic variables. The managers then tilt the
portfolios by trading those shares most sensitive to the analysts
economic forecast.
Through the use of computer databases and quantitative screens,
portfolio managers are able to identify groups of stocks based upon a
set of characteristics.
Using linear programming techniques, portfolio managers are able to
develop portfolios that maximize objectives while satisfying linear
constraints.

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Active Management Strategies

Yield spread analysis
Bond swaps

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Analysis of High-Yield Bonds

Firms competitive position
Cost and pricing

Firms borrowing capacity and cash flow

Related to cash requirements for interest payments,
research, and growth, during periods of economic decline

Liquidity value of the firms assets

Competence of total management team
Firms financial leverage

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Active Management Strategies

Yield-spread analysis
By sectors - bond grade or industries

Bond swaps
Selling one bond (S) and buying another
(P) simultaneously
Swaps to increase current yield or YTM,
take advantage of shifts in interest rates or
realignment of yield spreads, improve
quality of portfolio, or for tax purposes
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Bond Swaps

Pure yield pickup swap

Substitution swap
Tax swap
Swap strategies and market-efficiency
Bond swaps by their nature suggest
market inefficiency

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A Global Fixed-Income
Investment Strategy

Factors to consider

1. The local economy in each country

including the effects of domestic and
international demand
2. The impact of total demand and domestic
monetary policy on inflation and interest
rates
3. The effect of the economy, inflation, and
interest rates on the exchange rates among
countries
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Matched-Funding Techniques
Classical (pure) immunization
Interest rate risk
Price risk
Reinvestment risk
Investment horizon
Maturity strategy
Duration strategy
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Difficulties in Maintaining
Immunization Strategy
Rebalancing required as duration
declines more slowly than term to
maturity
Modified duration changes with a
change in market interest rates
Yield curves shift
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Matched-Funding Techniques
Dedicated portfolio, exact cash match
Useful for sinking funds and maturing principal payments

Dedicated portfolio, optimal cash match, and

reinvestment
Does not require exact cash flow match to the liability
stream

Horizon matching
Combines these two techniques by dividing the liability
stream into segments

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Contingent Procedures
A form of structured active management
Constrains the manager if unsuccessful

Contingent immunization
duration of portfolio must be maintained at the
horizon value
cushion spread is potential return below current
market
safety margin
trigger point
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Applications of Capital Market Theory and

the EMH on Bond Portfolio Management

High returns in recent years

Provide substantial diversification benefits
Lower end of capital market line
Default risk and interest rate risk
Bond betas correlation to stock betas
Announcements of upgrading related to
returns
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End of Chapter 17
Bond Portfolio Management
Strategies

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Future topics
Chapter 18
Applying the valuation model to the market
estimating the earnings multiplier for a stockmarket series
Estimating expected earnings per share
Calculating the expected rate of return on
common stocks
Analysis of world markets
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Copyright 2000 by Harcourt, Inc. All rights reserved