1
Q
What are the major responsibilities of a fixed income portfolio manager?
A
- creating investment mandate, goals, guidelines/restrictions
- developing an executing FI strategy
- providing timely information to the head of FI markets
- supervising staff and traders
- providing information marketing and client service dept
- focus on economic analysis, monetary policy, and overall creation of FI strategy
2
Q
A trader has a narrower range of responsibilities then a fixed income manager. A trader’s major responsibilities include:
A
- effective/best execution
- remain informed about strategy
- keep PM updated on bond market conditions and trends
- maintain relationships with FI sales and trading staff
- trader often serves as a PM’s “ear to the market”
3
Q
What is a repo transaction?
A
- a sale/repurchase agreement wherein a broker/dealer sells a FI security to a third a party on a specific day, at a specific price and simultaneously agrees to buy it back at a set price on a future day
- traders and market makers at brokers/dealers normally leverage their FI portfolios by using repo transactions
- usually spans one day but can be as long as a week
4
Q
What are the primary and secondary occupational goals of a fixed income trader at a broker/dealer (sell side)?
A
primary: absolute performance (earn highest capital gains from trading operations)
secondary: increase market share of trading activity with institutional investor target market
5
Q
What are the primary and secondary occupational goals of an institutional FI PM (buy side)?
A
- primary: relative performance (rank as high as possible in appropriate peer performance analysis)
- secondary: contribute to growth of firm’s AUM by supporting sales/marketing efforts and client service activities
6
Q
What are the tertiary occupational goals/performance factors for the buy side and the sell side?
A
Sell side: assist with the growth and profitability of the firm’s fixed income underwriting operations by providing counsel regarding market conditions and new issue pricing
Buy side: contribute to the firm’s growth through the support of new product design and launches
7
Q
With a normal (rising) yield curve, _____ maturities will have _______ yields and be _____ attractive.
A
- long
- higher
- more
8
Q
Describe passive bond management
A
- minimizes the effects of interest rate risk on a bond portfolio
- no attempt is made to predict the direction or magnitude of interest rates
9
Q
Describe active bond management
A
-attempts to profit from interest rate risk by predicting the direction or magnitude of rate changes
10
Q
Describe Interest rate risk
A
- the variation in bond values due to changes in market yields
- contains price risk and reinvestment risk
11
Q
What factors about a bond increase sensitivity to changes in interest rates?
A
- long maturity
- low coupon
12
Q
What are the three applications of duration?
A
- primary use is to capture effective average maturity
- measures the sensitivity of a bond’s price to changes in interest rates
- aids in immunizing against interest rate sensitivity
13
Q
A bond portfolio’s modified duration has what 5 general properties?
A
- it is the dollar weighted sum of individual bond modified durations
- the proportional change in a bond’s price following a yield change is the product of modified duration and the change in a bond’s yield to maturity (change in price= (-ModDur) * change in yield)
- For the same maturity , the higher a bond’s coupon, the lower its ModDur
- For the same maturity, the higher a bond’s YTM, the lower its ModDur
- For the same coupon, the longer a bond’s term to maturity, the greater its ModDur (except maybe it is trading at a discount)(because early payments become more relevant in the calculation)
14
Q
What is a ModDur formula?
A
=MacDur/(1+(y/k))
15
Q
What are the two portfolio structures that achieve the goal of receiving a yield to maturity that is equal to a bond’s original coupon rate or YTM at the time of purchase?
A
- Barbell portfolio
2. Laddered portfolio
16
Q
Describe a barbell portfolio
A
- bonds are initially purchased at both ends of the term structure (assuming 1-30 barbell) and then each year new one year bonds are purchased to maintain the short end as the old ones mature. at the same time, as the maturity of the long bonds decreases to 29 years, they are sold and replaced by new 30 year bonds (if yield curve is rising it would be sold at a slight premium
- offers more flexibility for accommodating cash than laddered
17
Q
Describe a laddered portfolio
A
- bonds are initially purchased with each maturity up to 30 years in equal proportions
- after Y1, the original one year bonds mature and are replaced by the original two year bonds which now have one year to maturity
- portfolio is replaced by replacing the longest maturity bond
18
Q
What are the two methods used to replicate a bond index?
A
- cellular (stratified sampling)
2. tracking error minimization
19
Q
Describe cellular replication method
A
- the attributes that can describe a bond universe are maturity, coupon, and credit risk
- the percentage of the bond universe that exists within each cell is applied to the funds total capital and representatives of each cell are bought in proportion
- a bond index fund is achieved by creating a cellular portfolio designed with cells in each of the three attributes containing representative bonds in proportions that match the market proportions of the bonds in each cell
- drawback: matching some cells is more critical than matching others because volatility associated with them is higher and also this method ignores correlations between cells
20
Q
Describe tracking error minimization method
A
- uses historical data to model the tracking error variance for each bond in an index, then minimizes the model’s total tracking error
- a bond’s tracking error is statistically estimated as a function of its cash flows, duration, and other sector characteristics
- quadratic programming is applied
- drawback: limited to historical data (can miss modern change that leads to volatility) and this method is dependent on good historical data
21
Q
Describe immunization
A
- a means of protecting a bond portfolio from interest rate risk
- essentially, purchasing zero coupon bonds (ie. T bills) tha are due to reach maturity at the time of any cash payout will totally immunize a portfolio against interest rate changes (this is known as a dedication strategy)
22
Q
Describe matching duration
A
- durations of loans and deposits are matched to eliminate the gap that causes spreads to narrow and widen
- if the portfolios of assets and liabilities have equal durations then both portfolios will change in value equally and the financial institution’s net position is immunized
23
Q
Describe target date immunization
A
- used for the pension industry where payout and maturity need to match
- to be successful interim interest payments are reinvested at the floating rate and at the same rate acting on the bond
24
Q
Describe contingent immunization
A
- compromise between active and passive mgmt
- manager follows an active strategy until a trigger point (point where the portfolio’s value reaches the level at which a zero-coupon bond will mature to the target amount)
25
Describe a rate anticipation swap
- funds are moved from one end of the yield curve to the other
- if IRs are expected to fall, locking in higher rates for a longer period will be profitable
26
Describe horizon analysis
- analyst chooses a horizon over which the IR change is expected to evolve and at the end of which a new yield curve is predicted
- swapping two bonds for that period entails a difference in price for the two bonds at the end of the horizon
- if no change in the level of interest rates is expected, investors can ride the yield curve
27
What is the motivation behind a bond swap?
- potentially profit from the correct analysis of the proper value of the yield spread between the two fixed income securities
- the PM then structures and executes the trade or swap to capture this assumed market opportunity
28
At what point in time will the fixed income swap be reversed?
if either of the following occurs:
- the yield spread for the swap has moved in a favourable direction and has reached the PMs target spread, wherein they decide to reverse the trade and realize the profit
- the yield spread has not moved in a favourable direction and the PM decides to reverse the trade the take the loss
29
Reversing a fixed income swap involves what two steps?
1. selling the FI security that was purchased at the initiation of the swap
2. purchasing the fixed income security that was sold at the initiation of the swap
30
What is a box trade?
- involves the simultaneous execution of a pair of related fixed income security swaps
- they are related in that the pair of swaps involves the securities of the same two bond issuers
- it is called a box trade because the pair of bond swaps is commonly depicted as a box on a yield curve diagram
31
What is the obejective of a box trade?
- to profit from the potential market revaluation of the respective yield spreads for either or preferably both of the two fixed income swaps
- used when a PM believes the yield curve for the higher yielding issuer will either steepen or flatten relative to that of the lower-yielding issuer (they believe the yield spreads for each of the two pairs of fixed income swaps have reached a sufficiently attractive magnitude)
32
The combination of the pair of swaps that constitute a box trade must satisfy what 3 parameters of the total fixed income portfolio?
1. No change in the portfolio's overall duration
2. No change in the portfolio's overall credit risk exposure
3. No change in the amount of the portfolio's assets invested in each of the two credits involved in the box trade
33
A properly structured box trade does not result in any changes to the total portfolio's __________, overall _________, and amount of __________. The structure of the box trade only provides exposure to the _______ in the ___________ between the two issuers
- interest rate exposure
- credit risk exposure
- exposure to specific issuers
- change
- relative yields
34
What are the two most popular types of box trades used by Canadian institutional fixed income PMs?
1. Intermarket domestic box trade (between two CDN bond issuers)
2. Intramarket box trade (involves bonds issues by CDN and USD governments)
35
What is the textbook definition of securitization?
-the process of turning relatively illiquid assets into tradable securities
36
Describe ABS
- receivables assembled into packages of loans that are then securitized and sold to investors
- a type of bond with CFs that are supported by the CFs from a specified pool of underlying assets
- pooling adds liquidity to otherwise illiquid assets
- provide a vehicle of the placement of ST funds with a slightly higher yield while retaining security and liquidity
37
Describe the credit enhancements needed for the SPV to create ABS's
- needed to upgrade risk profile of the underlying receivables
- increases the rating on the investor certificates and lowers ABS issuer's funding costs
38
Describe external vs. internal credit enhancements
External: Third party guarantee to provide first-loss protection including bond insurance, pool insurance, and letters of credit
Internal: Senior/subordinated structure (tranches)
39
What is the "cash flow waterfall"?
-the schedule followed by an ABS that prioritizes the manner in which the interest and principal are paid
40
What is overcollateralization?
-the principal amount of an issued ABS is less than the principal amount of the underlying pool of assets backing it
41
Describe MBS
- first created in USA by "Ginnie Mae" and later imitated in Canada
- CAD MBS are insured by CMHC under the National Housing Act
- MBS is a portfolio of mortgages assembled and sold in tranches to increate mortgage capital for lenders
- overs secure higher yielding medium term investments that are comparable to government bonds
- allow investors to invest in real estate with out facing the risk of default or liquidity issues
42
What are the three factors that determine prepayment risk?
1. Housing turnover
2. Cash out refinancing (incentive for a borrower to monetize their property's price appreciation)
3. Rate/term financing (obtaining new mortgage at a lower rate or shorter term)
43
Describe a collateralized mortgage obligation
-MBS pool is further divided into tranches that make payments based on different segments of the mortgage cash flows
44
Define a collateralized debt obligation (CDO)
- security that repackages a collection of underlying assets and sells multiple classes (tranches) of the assets pool's interest to investors
- allows the restructuring of the pool's credit risk into new tranches with different risk profiles than the underlying
- two main types (cash and synthetic)
45
What are the three main components that are similar to an ABS?
1. An originator, which is typically a bank
2. Investors ready to buy the credit risk
3. An SPV
46
Describe how a cash CDO works
- originator sells the collateral to the SPV for cash
- collateral is now off the originator's balance sheet and on the SPV's balance sheet
- SPV pools all of the assets and sells them in tranches (three main tranches are senior, mezzanine, and equity)
47
Describe a synthetic CDO
- a credit derivative variant of the cash CDO
- the originator (financial institution) retains ownership of the underlying assets and buys protection from the sPV using a CDS, thus swapping the credit risk over to the sPV
- this allows the originator to unload the credit risk while retaining the assets
- SPV uses proceeds from CDO tranches to invest in high quality, low risk assets that generate CF to service CDO payment requirements
- compared to cash CDOs they can be compiled in the marketplace much sooner, are cheaper, and offer more variety
48
Describe how and why CDOs are used by financial institutions
- used to take unwanted debt off statement of financial position (enhancing on-book debt quality)
- repackages some harder to sell debt, making it easier to sell in more investor specific tranches, thereby increasing the liquidity and market appeal of underlying assets
- investors benefit from CDOs by accessing risk specific tranches that suit their needs
49
Describe forward rate agreements (FRAs)
- over-the-counter contracts for hedging interest rates
- usually 6-12 month periods (max 2yr)
- settled by an exchange of cash to satisfy the closing position with respect to the interest rate agreed on
50
Describe interest rate futures
- contracts used by banks, corporations, and individuals to hedge interest rate risk for future payments
- an alternative to swaps
- CAD investors can hedge through the Bourse de Montreal but usually there will be more liquidity using US exchanges
51
What is the hedge ratio formula used for IR futures?
HR= (MV of portfolio / MV of future's contract) x (duration of portfolio / duration of future's contract)
52
What is basis risk?
- at maturity of futures contract basis must be zero
- basis risk is the risk that the basis will not behave as expected over the life of the hedge (an unexpected shift in the basis can decrease effectiveness of hedge)
53
What is the major advantage of a swap arrangement?
-the ability to modify the lending terms in response to anticipated interest changes without having to incur the transaction costs of buying and selling securities
54
Describe credit derivatives
- financial instruments that derive their value from an underlying credit asset or pool of credit assets and are designed to transfer and manage credit risk
- underlying asset = reference asset
- payouts are a function of an issuers creditworthiness
- credit derivatives offer credit holders or speculators a way to make an investment decision based on an issuer's credit risk that is separate from the investment decisions they make based on other risks such as duration and currency
55
What is the objective of credit derivatives
-to transfer credit risk between the protection buyer (reducing credit risk/short the credit) to the protection seller (acquire credit risk/long the credit)
56
What are the 3 inherent advantages of credit derivatives?
1. allows the manager of the reference asset to keep a portfolio's holdings intact
2. credit can be sold short easily using a credit derivative
3. give investors synthetic exposure to certain assets without the stress of administering them
57
Why do banks use credit derivatives to hedge and therefor e buy protection from counter parties?
1. To enhance credit risk management by decoupling the credit positions from their risk profile
2. To retain ownership of loans given their increased risk level
3. To reduce regulator capital requirements by reducing the risk budget proportion attributable to the portfolio's credit component
58
Describe a credit default swap (CDS)
- the exchange of two cash flows: a fee payment and a conditional payment, which are only made if a credit event occurs
- protection buyer pays a premium, protection seller only pays if there is a credit event
59
What are the 5 types of "credit events"?
1. downgrade in credit rating below a specified level
2. financial debt restructuring
3. bankruptcy or insolvency
4. default on a payment obligation
5. technical default
60
What is the difference between physical settlement and cash settlement?
Physical: protection buyer remits the asset to the protection seller against the full face value payment (can be advantageous for the seller)
Cash: protection buyer retains the asset and receives the difference between the face value and recovery value (administratively easier)
61
What are 4 advantages of securitization?
1. potential for reduces funding costs
2. protection of underlying assets
3. diversification of funding sources
4. acceleration of earnings for financial reporting purposes
62
What are the 2 biggest disadvantages of securitization?
1. lack of transparency of the underlying assets
| 2. pricing of the securitization
63
What are the ratings non-investment grade vs. investment grade bonds?
Investment grade: Baa3/BBB or higher
| Non-investment grade: Ba1/BB+ or lower
64
What are the two main issuers of high yield bonds? (name and describe)
1. An original issuer- bond issuer with a non-investment grade credit rating at the time of underwriting
2. A so-called fallen angel- a bond issuer that once had an investment-grade credit rating on its bond outstanding, but has recently fallen into financial difficulty
65
A non-investment grade is typically assigned to new issue bonds for one of 3 reasons:
1. Issuer is highly leveraged relative to competitors/industry
2. Issuer has no demonstrable operating track record, but has above average growth and profitability
3. Issuer is currently experiencing financial difficulties but does not have any bonds outstanding presently
66
Some industry commentators believe a third source of high yield bond is....
-those issued by either the acquiring entity of the target company of a leveraged buyout
67
What are the two factors for successfully investing in high yield bonds?
1. Investors must conduct a proper and detailed fundamental analysis on high-yield bonds and their respective issuers
2. Investors must diversify their holdings to compensate for the risks associated with individual bond issues
68
What are the three main global bond credit-rating agencies?
1. Moody;s
2. S&P
3. Fitch
69
What are Moody's four main aspects of fundamental credit analysis?
1. Fundamental analysis
2. Covenants
3. Franchise/collateral value
4. Management quality
70
Defaults are defined as bond issues where one of the following has occurred:
1. a missed payment of interest or principal due has not been paid within the normal 30 day grace period
2. the issuer has filed for bankruptcy protection or liquidation
3. a corporate restructuring has been announced
71
What are the two main types of default rates?
1. dollar- denominated (based on the dollar amount of bonds that have defaulted)
2. issuer-denominated (based on the number of issuers that have defaulted)
72
Define recovery rate
-the amount of value/funds eventually realized by creditors as a percentage of the bond's face face or default amount
73
What are the three most common coupon structures for high yield bonds?
1. Deferred coupon (like a step up bond)
2. Extendable reset bonds
3. Payment-in-kind (PIK) (can pay with an identical bond to the original PIK issue in the amount equal to the coupon)
74
The performance benchmark of an ETF and its respective investment guidelines and restrictions are chosen with what three risk factors in mind?
1. Interest rate risk
2. credit risk
3. currency risk
75
The extent to which an ETF fund attains a smaller tracking error is dependent on what two factors (both of which are within the manager's control)?
1. Management fees
| 2. Investment management techniques (do they use replication, statistical sampling, or synthetic replication)
76
What is a TRS and why is it important?
- TRS= total return swap
- used often in the ETF universe because it is completely customizable and because it allows an ETF's tracking error to be known in advance
PMT 2019
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