Archive for the 'Investing in bonds' 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 »

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 »

High Yield Bond Returns: Downgrades versus Original Issues

Bonds may either be issued as speculative grade bonds (original issue)or become so following a rating downgrade (fallen angels). In either case, their risk-adjusted returns should be similar. However, in an article published in the Fall 2007Journal of Portfolio Management Fridson and Sterling point out that fallen angels have historically delivered far higher risk-adjusted returns, and discuss several explanations for an apparent market inefficiency.

The authors find the correlation between fallen angels and original-issue speculative grade debt to be lower than that between Treasuries and investment-grade corporate bonds, suggesting dissimilar attributes and below the threshold normally used to classify securities as part of the same asset class.

Possible reasons for the disparity include:

  • Lack of investor awareness, given that the primary high-yield index only recently began breaking out the performance of the two categories
  • Emphasis on security selection and possible overconfidence among managers that they can pick the superior original-issue bonds
  • Investability – fallen angels account for just 30% of available speculative-grade debt and trade infrequently
  • Lottery-like returns for specific original issue bonds
  • Yield appeal due to higher yields typically found with original issue bonds

Posted on 6th October 2008
Under: Active Management, Investing in Distressed Securities, Investing in bonds, Investment Returns, Performance Measurement, Research, Risk 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 »

Continuous Markets

Continuous markets are those in which trades can occur at any time that the market is open. This can happen in one of three ways:

  • An auction market, in which the trades are placed between investors without intermediaries. A trade occurs whenever the highest bid price and the lowest ask price match.
  • A dealer market, in which intermediaries provide liquidity by setting minimum bid and maximum ask prices. In a dealer market, a dealer takes one side of each trade, and an investor takes the other.
  • A hybrid market, in which dealers step in whenever the auction market is not sufficiently liquid.

Posted on 17th August 2008
Under: Investing in Stocks, Investing in bonds, Portfolio Management, Trading Execution | No Comments »

Six Stages of Business Cycle Investing

In Technical Analysis Explained, Martin Pring notes that since there are three major financial markets (stocks, bonds and commodities) and each has two turning points in a given cycle, there are six turning points in each cycle. He calls these turning points the six stages and uses them as a reference point for identifying the current phase of the business cycle and by extension the next likely turning point.

Stage 1: Slowing growth rates or early recession. Interest rates start to fall and bonds rally.

Stage 2: Business cycle trough. Stocks begin to rally.

Stage 3: Late recession and early recovery. Commodities begin to rally.

Stage 4: Early recovery. Interest rates trough and bonds peak.

Stage 5: Cycle peak. Stocks peak.

Stage 6: Slowing growth, commodities peak.

Posted on 25th July 2008
Under: Economic Analysis, Investing in Commodities, Investing in Stocks, Investing in bonds, Technical Analysis | 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 »

Call Markets

Call based securities markets attempt to gather all the bids and asks for a security at a specific time, with the intent being to price a trade that will match the quantity demanded with the quantity supplied.

Many markets use a call system to set the opening price for securities. The opening price then reflects all the buy and sell orders placed since the previous close.

Posted on 17th July 2008
Under: Investing in Stocks, Investing in bonds | No Comments »