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

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.

• 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

Risks

• 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

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

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.

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

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.

• 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.

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

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.