Archive for the 'Fixed income investments' Category

Choosing a Fixed Income Manager

When choosing a fixed income manager, some important points to consider include:

  1. Outperformance net of fees is especially difficult for fixed income managers
  2. Style analysis can indicate the ways the portfolio construction differs from that of the benchmark. Is the investor happy with these deviations?
  3. Selection bets can be determined through return decomposition to identify whether the manager is skilled in credit analysis
  4. The investment process should be understood to know the methods used and the drivers of alpha
  5. If multiple managers are used, the alpha generated should not be highly correlated with that of other managers

Posted on 24th November 2008
Under: FInancial Planning, Fixed income investments, Investing in bonds, Portfolio Management | No Comments »

Endogenous Growth Theory

Growth theory seeks to explain the rate of GDP growth in different countries.

Endogenous growth theory assumes that marginal productivity of capital does not necessarily decline as capital is added. Instead, technological advances and improved labor force education can increase productivity and lead to efficiency gains. As such, the economy may never reach a steady state.

Posted on 25th October 2008
Under: Economic Analysis, Fixed income investments | No Comments »

Investing in Emerging Market Debt


  • Low correlation to developed markets is good for diversification
  • Have proven resilient to financial crises and are earning investment grade ratings in many cases
  • Sovereign emerging market debt in particular can:
    • respond to negative events by raising taxes and reducing spending
    • have access to lenders such as IMF and the World Bank
    • have large foreign currency reserves as a cushion


  • High volatility
  • Negative skewness of returns
  • Lack of transparency
  • Lack of legal and regulatory structure
  • Sovereign borrowers tend to over-borrow and there can be little recourse for foreign lenders in the event of default

Posted on 24th October 2008
Under: FInancial Planning, Fixed income investments, International Investing, Investing in bonds, Portfolio Management | No Comments »

Breakeven Spread Analysis

Changes in the spread between domestic and foreign interest rates can diminish the return on a foreign bond investment. Breakeven spread analysis quantifies the amount of spread widening (W) that would eliminate a given yield advantage.

For example, if a foreign bond offers a 300 basis point yield advantage (75 basis points per quarter) adn has a duration of 5:

  • The change in the price of the foreign bond would be 5 X the change in yield or 5W
  • Breakeven = 0.75% X 5W
  • W = 0.13% or 13 basis points

Posted on 24th September 2008
Under: Fixed income investments, International Investing, Investing in bonds, Portfolio Management | No Comments »

The Effect of Domestic Interest Rates on the Value of Foreign Bonds

Duration measures the change in value for a bond given a 100 basis point change in interest rates. However, since international rates are not perfecltly correlated with domestic rates, the duration of a foreign bond does not have the same impact on value and portfolio duration for a change in domestic interest rates.

Instead, the relationship between domestic and foreign rates can be estimated empirically to determine a country beta.

The percentage change in a foreign bond due to a change in domestic interest rates would be estimated as the product of country beta and duration. The portfolio’s weighted average duration would also be affected by the weight of the foreign bond multiplied by the product of country beta and duration.

Posted on 24th August 2008
Under: Fixed income investments, Investing in bonds, Investment Returns, Portfolio Management | No Comments »

Sources of Excess Return in International Bond Portfolios

International bond managers can seek excess return from a variety of sources:

  1. Bond market selection – choosing the best country in which to invest
  2. Currency selection – deciding whether to hedge or retain currency risk
  3. Duration/yield curve management – getting the most favorable returns within the selected market
  4. Sector selection – choosing among government, corporate, local currency or dollar-denominated bonds
  5. Issuer credit analysis – being able to identify improvement or deterioration in advance of changes in rating
  6. Benchmark mismatches – investing in markets that are not included in the benchmark index

Posted on 24th July 2008
Under: Active Management, Asset Allocation, FInancial Planning, Fixed income investments, Investing in bonds, Investment Returns, Portfolio Management | No Comments »

Immunization Strategies for Fixed Income Portfolios

Changes in interest rates affect both the reinvestment rate earned on portfolio income (directly) and the value of the portfolio (inversely.) An immunization strategy is designed to lock in total return over a specified time horizon by creating a portfolio in which the two total return factors exactly offset each other.

To immunize a portfolio over a single period, the portfolio must have duration equal to the investment horizon and an initial present value of cash flows equal to the present value of the future liability.

Since yield changes over time will result in duration changes other than those caused solely by the passage of time, it is necessary to periodically rebalance an immunized portfolio. This must be done only if the benefits outweigh the costs. Some transaction costs must be borne in order to avoid duration mismatch, but some duration mismatch is needed to avoid transaction costs.

Typically the rebalancing will restore the dollar duration equivalency to the time horizon. Dollar duration is the product of Duration X Portfolio Value X 0.01.

To rebalance the dollar duration requires three steps:

  1. Calculate present dollar duration based on the prevailing yield curve and time to maturity
  2. Calculate the rebalancing ratio by dividing the original dollar duration by the new dollar duration. This can be expressed as the percentage change for each position by subtracting one and converting the result into percentage terms.
  3. The new market value of the portfolio multiplied by the percentage change is the amount of cash that will be needed for rebalancing.

Posted on 23rd July 2008
Under: Active Management, Fixed income investments, Investing in bonds, Investment Returns, Portfolio Management | No Comments »

Using Derivatives to Hedge Different Types of Credit Risk

There are three primary types of credit risk:

  • Default risk is the chance the issuer will fail to meet its obligations
  • Credit spread risk is the chance the spread between the risky bond and risk-free securities will vary after purchase
  • Downgrade risk is the chance a rating agency will lower its rating on the issuer

These risks can be hedged using option contracts.

A binary credit option pays off only if a specified negative event occurs. These can be used to hedge default risk or downgrade risk.

Credit spread options pay off based on the spread over a benchmark rate. They can be used to hedge credit spread risk.

Posted on 24th June 2008
Under: Derivatives, Fixed income investments, Futures, Investing in bonds, Portfolio Management | No Comments »

Portfolio Leverage and Repo Rates in Fixed Income Portfolios

Using leverage magnifies the return in a portfolio. If a portfolio can earn 7% and can borrow funds at 5%, the additional 2% accrues to the fund investors. Instead of earning 7,000 on a 100,000 investment, the manager borrows an additional 100,000 and can earn 14,000, but must pay 5,000 in interest. The 9,000 remaining equates to a 9% return for the investors.

If the fund fails to earn the cost of borrowing, the leverage will work in the opposite direction as a drag on returns.

Given the liquidity of certain types of bonds, many managers seeking leverage make use of repurchase agreements (repos). These are agreements to sell a set of securities and to buy them back at a later agreed-upon date and price. The price difference is called the repo interest.

Repos offer the borrower lower rates (due to the liquid collateral) and the lender higher returns than Treasury bonds. Several factors contribute to the final repo rate that will be charged:

  • Quality of collateral – higher quality bonds result in a lower repo rate
  • Term of the repo – a longer term equates to a higher repo rate
  • Delivery requirement – if the lender takes physical delivery of the collateral there is no default risk and the repo rate will be lower. Escrow accounts will reduce the rate to a lesser extent relative to no delivery.
  • Availability of the collateral – if the bonds being offered as collateral are difficult to buy, the lender may accept a lower rate for the repo
  • Prevailing interest rates – repos are generally tied to short-term interest rates
  • Seasonal factors – certain market participants may have seasonal factors that affect their supply and demand for capital

Posted on 23rd June 2008
Under: Active Management, Fixed income investments, Investing in bonds, Investment Returns, Portfolio Management | No Comments »

Immunizing a Fixed Income Portfolio Using Futures

The difference between the cash price of a bond and the futures price is called its basis. Basis risk is the chance that basis will change between unpredictably between the time the hedge is initiated and the time the hedge is lifted.

If the bond underlying the futures contract differs from the portfolio bond (a situation known as a cross hedge) the basis risk can be substantial. In essence the hedge substitutes basis risk for price risk.

The hedge ratio equals the factor exposure on the portfolio divided by the factor exposure on the hedging instrument.

If the factor is limited to interest rate exposure and one assumes a fixed yield spread between the bond being hedged and the cheapest-to-deliver (CTD) bond on the futures contract, the hedge ratio equals the product of the duration and price of the hedged bond, divided by the product of the duration and price of the CTD bond.

Posted on 24th May 2008
Under: Asset Allocation, Fixed income investments, Investing in bonds, Investment Returns, Portfolio Management | No Comments »