Practice - Fixed Income
Cécile is a junior analyst for an international wealth management firm. Her supervisor, Margit, asks Cécile to evaluate three fixed-income funds as part of the firm’s global fixed-income offerings. Selected financial data for the funds Aschel, Permot, and Rosaiso are presented in Exhibit 1. In Cécile’s initial review, she assumes that there is no reinvestment income and that the yield curve remains unchanged.
Exhibit 1:
Selected Data on Fixed-Income Funds
Aschel
Permot
Rosaiso
Current average bond price
$117.00
$91.50
$94.60
Expected average bond price in one year (end of Year 1)
$114.00
$96.00
$97.00
Average modified duration
7.07
7.38
6.99
Average annual coupon payment
$3.63
$6.07
$6.36
Present value of portfolio’s assets (millions)
$136.33
$68.50
$74.38
Bond type*
Fixed-coupon bonds
95%
38%
62%
Floating-coupon bonds
2%
34%
17%
Inflation-linked bonds
3%
28%
21%
Quality*
AAA
65%
15%
20%
BBB
35%
65%
50%
B
0%
20%
20%
Not rated
0%
0%
10%
Value of portfolio’s equity (millions)
$94.33
Value of borrowed funds (millions)
$42.00
Borrowing rate
2.80%
Return on invested funds
6.20%
*Bond type and quality are shown as a percentage of total for each fund.
Q.
Based on Exhibit 1, which fund provides the highest level of protection against inflation for coupon payments?
Solution
B is correct. Permot has the highest percentage of floating-coupon bonds and inflation-linked bonds. Bonds with floating coupons protect interest income from inflation because the reference rate should adjust for inflation. Inflation-linked bonds protect against inflation by paying a return that is directly linked to an index of consumer prices and adjusting the principal for inflation. Inflation-linked bonds protect both coupon and principal payments against inflation.
The level of inflation protection for coupons equals the percentage of the portfolio in floating-coupon bonds plus the percentage of the portfolio in inflation-linked bonds:
Aschel = 2% + 3% = 5%.
Permot = 34% + 28% = 62%.
Rosaiso = 17% + 21% = 38%.
Thus, Permot has the highest level of inflation protection, with 62% of its portfolio in floating-coupon and inflation-linked bonds.
Q.
Based on Exhibit 1, the rolling yield of Aschel over a one-year investment horizon is closest to:
Q.
The leveraged portfolio return for Aschel is closest to:
A.7.25%.
B.7.71%.
C.8.96%.
After further review of the composition of each of the funds, Cécile makes the following notes:
Note 1
Aschel is the only fund of the three that uses leverage.
Note 2
Rosaiso is the only fund of the three that holds a significant number of bonds with embedded options.
Q.
Based on Note 2, Rosaiso is the only fund for which the expected change in price based on the investor’s views of yields to maturity and yield spreads should be calculated using:
Solution
C is correct. Rosaiso is the only fund that holds bonds with embedded options. Effective duration should be used for bonds with embedded options. For bonds with embedded options, the duration and convexity measures used to calculate the expected change in price based on the investor’s views of yields to maturity and yield spreads are effective duration and effective convexity. For bonds without embedded options, convexity and modified duration are used in this calculation.
Margit asks Cécile to analyze liability-based mandates for a meeting with Villash Foundation. Villash Foundation is a tax-exempt client. Prior to the meeting, Cécile identifies what she considers to be two key features of a liability-based mandate.
Feature 1
It matches expected liability payments with future projected cash inflows.
Feature 2
It can minimize the risk of deficient cash inflows for a company.
Q.
Is Cécile correct with respect to key features of liability-based mandates?
Solution
A is correct. Liability-based mandates are investments that take an investor’s future obligations into consideration. Liability-based mandates are managed to match expected liability payments with future projected cash inflows.
These types of mandates are structured in a way to ensure that a liability or a stream of liabilities can be covered and that any risk of shortfalls or deficient cash inflows for a company is minimized.
Two years later, Margit learns that Villash Foundation needs $5 million in cash to meet liabilities. She asks Cécile to analyze two bonds for possible liquidation. Selected data on the two bonds are presented in Exhibit 2.
Exhibit 2:
Selected Data for Bonds 1 and 2
Bond 1
Bond 2
Current market value
$5,000,000
$5,000,000
Capital gain/loss
$400,000
–$400,000
Coupon rate
2.05%
2.05%
Remaining maturity
8 years
8 years
Investment view
Overvalued
Undervalued
Income tax rate
39%
39%
Capital gains tax rate
30%
30%
Q.
Based on Exhibit 2, the optimal strategy to meet Villash Foundation’s cash needs is the sale of:
Solution
A is correct. The optimal strategy for Villash is the sale of 100% of Bond 1, which Cécile considers to be overvalued. Because Villash is a tax-exempt foundation, tax considerations are not relevant and Cécile’s investment views drive her trading recommendations.
Celia is chief investment officer for the Topanga Investors Fund, which invests in equities and fixed income. The clients in the fund are all taxable investors. The fixed-income allocation includes a domestic (US) bond portfolio and an externally managed global bond portfolio.
The domestic bond portfolio has a total return mandate, which specifies a long-term return objective of 25 basis points (bps) over the benchmark index. Relative to the benchmark, small deviations in sector weightings are permitted, such risk factors as duration must closely match, and tracking error is expected to be less than 50 bps per year.
Q.
Which approach to its total return mandate is the fund’s domestic bond portfolio most likely to use?
A.Pure indexing
B.Enhanced indexing
C.Active management
Solution
B is correct. The domestic bond portfolio’s return objective is to modestly outperform the benchmark. Its risk factors, such as duration, are to closely match the benchmark. Small deviations in sector weights are allowed, and tracking error should be less than 50 bps year. These features are typical of enhanced indexing.
The objectives for the domestic bond portfolio include the ability to fund future liabilities, protect interest income from short-term inflation, and minimize the correlation with the fund’s equity portfolio. The correlation between the fund’s domestic bond portfolio and equity portfolio is currently 0.14. Celia plans to reduce the fund’s equity allocation and increase the allocation to the domestic bond portfolio. She reviews two possible investment strategies.
Strategy 1
Purchase AAA rated fixed-coupon corporate bonds with a modified duration of two years and a correlation coefficient with the equity portfolio of –0.15.
Strategy 2
Purchase US government agency floating-coupon bonds with a modified duration of one month and a correlation coefficient with the equity portfolio of –0.10.
Q.
Strategy 2 is most likely preferred to Strategy 1 for meeting the objective of:
Solution
A is correct. Floating-coupon bonds provide inflation protection for the interest income because the reference rate should adjust for inflation. The purchase of fixed-coupon bonds as outlined in Strategy 1 provides no protection against inflation for either interest or principal.
Strategy 1 would instead be superior to Strategy 2 in funding future liabilities (better predictability as to the amount of cash flows) and reducing the correlation between the fund’s domestic bond portfolio and equity portfolio (better diversification).
Saw wrongly, A is 'preferred to' B, means A is selected. Like cat is preferred to dog, means cat is preferred, or more liked than dog
Celia realizes that the fund’s return may decrease if the equity allocation of the fund is reduced. Celia decides to liquidate $20 million of US Treasuries that are currently owned and to invest the proceeds in the US corporate bond sector. To fulfill this strategy, Celia asks Dan, a newly hired analyst for the fund, to recommend specific Treasuries to sell and corporate bonds to purchase.
Dan recommends Treasuries from the existing portfolio that he believes are overvalued and will generate capital gains. Celia asks Dan why he chose only overvalued bonds with capital gains and did not include any bonds with capital losses. Dan responds with two statements.
Statement 1
Taxable investors should prioritize selling overvalued bonds and always sell them before selling bonds that are viewed as fairly valued or undervalued.
Statement 2
Taxable investors should never intentionally realize capital losses.
Celia realizes that the fund’s return may decrease if the equity allocation of the fund is reduced. Celia decides to liquidate $20 million of US Treasuries that are currently owned and to invest the proceeds in the US corporate bond sector. To fulfill this strategy, Celia asks Dan, a newly hired analyst for the fund, to recommend specific Treasuries to sell and corporate bonds to purchase.
Dan recommends Treasuries from the existing portfolio that he believes are overvalued and will generate capital gains. Celia asks Dan why he chose only overvalued bonds with capital gains and did not include any bonds with capital losses. Dan responds with two statements.
Statement 1
Taxable investors should prioritize selling overvalued bonds and always sell them before selling bonds that are viewed as fairly valued or undervalued.
Statement 2
Taxable investors should never intentionally realize capital losses.
Q.
Are Dan’s statements to Celia that support Dan’s choice of bonds to sell correct?
Solution
C is correct. Since the fund’s clients are taxable investors, there is value in harvesting tax losses. These losses can be used to offset capital gains within the fund that will otherwise be distributed to the clients and result in higher tax payments, which decreases the total value of the investment to clients.
The fund has to consider the overall value of the investment to its clients, including taxes, which may result in the sale of bonds that are not viewed as overvalued.
Tax-exempt investors’ decisions are driven by their investment views without regard to offsetting gains and losses for tax purposes.
Regarding the purchase of corporate bonds, Dan collects relevant data, which are presented in Exhibit 1.
Exhibit 1:
Selected Data on Three US Corporate Bonds
Bond Characteristics
Bond 1
Bond 2
Bond 3
Credit quality
AA
AA
A
Issue size ($ millions)
100
75
75
Maturity (years)
5
7
7
Total issuance outstanding ($ millions)
1,000
1,500
1,000
Months since issuance
New issue
3
6
Q.
Based on Exhibit 1, which bond most likely has the highest liquidity premium?
Solution
C is correct. Bond 3 is most likely to be the least liquid of the three bonds presented in Exhibit 1 and will thus most likely require the highest liquidity premium.
Low credit ratings, longer time since issuance, smaller issuance size, smaller issuance outstanding, and longer time to maturity typically are associated with lower liquidity (and thus a higher liquidity premium).
Bond 3 has the lowest credit quality and the longest time since issuance of the three bonds.
Bond 3 also has a smaller issue size and a longer time to maturity than Bond 1.
The total issuance outstanding for Bond 3 is smaller than that of Bond 2 and equal to that of Bond 1.
Celia and Dan review the total expected 12-month return (assuming no reinvestment income) for the global bond portfolio. Selected financial data are presented in Exhibit 2.
Exhibit 2:
Selected Data on Global Bond Portfolio
Average bond coupon payment (per €100 par value)
€2.25
Coupon frequency Investment horizon
Annual 1 year
Current average bond price
€98.45
Expected average bond price in one year (assuming an unchanged yield curve)
€98.62
Average bond convexity
22
Average bond modified duration
5.19
Expected average benchmark yield-to-maturity change
0.15%
Expected change in credit spread (widening)
0.13%
Expected currency gains (€ appreciation vs. $)
0.65%
Q.
Based on Exhibit 2, the total expected return of the fund’s global bond portfolio is closest to:
rolldown return = (98.62 - 98.45) / 98.45 = 0.173%
coupon return = 2.25 / 98.45 = 2.285%
0.173 + 2.285 + 0.65 + 0.15 + 0.13 = 3.388
Your additional changes wrong; the change of price for benchmark yield and credit spread were wrong
but your coupon income and rolldown return are correct
Celia contemplates adding a new manager to the global bond portfolio. She reviews three proposals and determines that each manager uses the same index as its benchmark but pursues a different total return approach, as presented in Exhibit 3.
Exhibit 3:
New Manager Proposals: Fixed-Income Portfolio Characteristics
Sector Weights (%)
Manager A
Manager B
Manager C
Index
Government
53.5
52.5
47.8
54.1
Agency/quasi-agency
16.2
16.4
13.4
16.0
Corporate
20.0
22.2
25.1
19.8
MBS
10.3
8.9
13.7
10.1
Risk and Return Characteristics
Manager A
Manager B
Manager C
Index
Average maturity (years)
7.63
7.84
8.55
7.56
Modified duration (years)
5.23
5.25
6.16
5.22
Average yield to maturity (%)
1.98
2.08
2.12
1.99
Turnover (%)
207
220
290
205
QuestionQ.
Based on Exhibit 3, which manager is most likely to have an active management total return mandate?
Solution
C is correct. The sector weights, risk and return characteristics, and turnover for Manager C differ significantly from those of the index, which is typical of an active management mandate. In particular, Manager C’s modified duration of 6.16 represents a much larger deviation from the benchmark index modified duration of 5.22 than that of the other managers, which is a characteristic unique to an active management mandate.
Danny Moynahan Case Scenario
Danny Moynahan, CFA, is a fixed-income portfolio manager at Reagan Investment Advisory (Reagan). His wife, Abigail Boyle, is a professor at a local university not far from their home. She is currently teaching an investments class. Over dinner one evening, she asks her husband if he will come and talk to her class about managing fixed-income portfolios. She believes it will be a useful experience for her students to hear from someone working in the investment industry. He agrees, and they plan for him to make his presentation the following week.
The next day at his office, with permission from his superior, Tom Gayle, Moynahan works on his presentation to the class. He plans to put together six pages for his discussion. He reviews the presentation materials he previously used at a conference to see if any of it would be useful. He decides page 1 should discuss the benefits of including fixed-income securities in a portfolio and highlights the following three points:
Point A: Adding fixed-income securities to a portfolio is an effective way of obtaining the benefits of diversification, especially because fixed-income correlations with other asset classes are low.
Point B: The regular nature of fixed-income cash flows enables investors to fund future obligations, unless there is a credit event.
Point C: Fixed-income securities can always provide a hedge for inflation, which results in superior risk-adjusted real portfolio returns.
Which of the points outlined on page 1 of Moynahan’s presentation is least likely correct?
Solution
B is correct. Point C of Moynahan’s presentation is incorrect. Some fixed-income securities, such as inflation-linked bonds, provide a hedge for inflation that results in superior risk-adjusted real portfolio returns. However, not all fixed-income securities act as a hedge against inflation.
A is incorrect because the statement regarding fixed-income cash flows is accurate.
C is incorrect because the statement regarding diversification benefits of fixed-income securities is accurate.
Overview of Fixed-Income Portfolio Management Learning Outcome
Discuss roles of fixed-income securities in portfolios and how fixed-income mandates may be classified
On page 2, Moynahan decides to outline the three total return approaches he utilizes to manage Reagan’s fixed-income portfolios. He puts together the following exhibit:
Exhibit 1
Features of Total Return Portfolios
Benchmark
Portfolio 1
Portfolio 2
Portfolio 3
Quality:
AAA/AA/A (% of portfolio)
76.0
74.9
75.8
76.3
BBB/BB (% of portfolio)
24.0
25.1
24.2
23.7
Average
AA–
AA–
AA–
AA
Key Rate Duration:
1–5 years
2.5
2.4
2.4
2.5
5–10 years
1.8
1.9
1.9
1.8
10–15 years
1.5
1.4
1.5
1.5
Credit Spread Duration
1.45
1.55
1.43
1.50
Turnover (%)
8%
5%
6%
Country Exposure
Developed Markets
90.0
86.4
91.2
87.0
Emerging Markets
10.0
14.0
9.8
13.0
Securities Lending
N/A
Not Allowed
Allowed
Not Allowed
How should Moynahan most likely label the management approaches for each of the portfolios described in Exhibit 1 on page 2 of his presentation?
Solution
A is correct. Moynahan should label the portfolios on page 2 as follows: Portfolio 1 = Active Management, which allows for larger risk factor mismatch to the benchmark. Portfolio 2 = Pure Indexing, which involves attempting to replicate a bond index as closely as possible. Portfolio 3 = Enhanced Indexing, which is closely linked to the benchmark but attempts to generate a modest amount of outperformance versus the benchmark.
Portfolio 1
Portfolio 2
Portfolio 3
Quality
Enhanced Indexing or Active Management
Pure Indexing
Enhanced Indexing or Active Management
Duration
Active Management
Pure Indexing or Enhanced Indexing
Enhanced Indexing or Active Management
Credit Spread
Active Management
Pure Indexing
Enhanced Indexing
Turnover
Active Management
Pure Indexing
Enhanced Indexing
Country Exposure
Active Management
Pure Indexing
Enhanced Indexing
Securities Lending
No Impact
No Impact
No Impact
Determination
Active Management
Pure Indexing
Enhanced Indexing
B is incorrect because the ordering of portfolios given is incorrect. The correct ordering is: Portfolio 1 = Active Management, Portfolio 2 = Pure Indexing, Portfolio 3 = Enhanced Indexing.
C is incorrect because the ordering of portfolios given is incorrect. The correct ordering is: Portfolio 1 = Active Management, Portfolio 2 = Pure Indexing, Portfolio 3 = Enhanced Indexing.
Overview of Fixed-Income Portfolio Management Learning Outcome
Discuss roles of fixed-income securities in portfolios and how fixed-income mandates may be classified
Moynahan titles page 3, “Liquidity in the Fixed-Income Market.” He wants to ensure that the class appreciates the differences in liquidity between fixed-income and equity securities. He stresses that liquidity across fixed-income securities varies greatly and that compared to equities, fixed-income markets are generally less liquid. Also, liquidity influences fixed-income pricing, but illiquidity enhances the portfolio’s yield to maturity. Lastly, dealers will narrow bid–ask spreads on thinly traded securities as a consequence of their illiquidity.
Are Moynahan’s comments regarding fixed-income liquidity most likely correct?
Solution
C is correct. Moynahan’s comment on the bid–ask spread of thinly traded securities is incorrect. Dealers widen bid–ask spreads for thinly traded securities to reflect their illiquidity.
A is incorrect because Moynahan’s comment regarding fixed-income trading and narrowly traded securities is incorrect.
B is incorrect because the comment regarding fixed-income pricing and yield to maturity is correct.
Overview of Fixed-Income Portfolio Management Learning Outcome
Describe bond market liquidity, including the differences among market sub-sectors, and discuss the effect of liquidity on fixed-income portfolio management
Tom Gayle, Moynahan’s superior, stops by Moynahan’s office.
Moynahan shares his presentation with Gayle, who suggests that page 4 include a discussion about expected returns. They decide to outline an example of a recent bond trade where they bought a $100 par value bond at a premium.
Moynahan presents a decomposition of the bond’s expected returns detailing various components and focuses on roll down return.
He adds the following footnote: “The roll down return demonstrates how the price of a bond typically moves closer to par regardless of yield curve changes over the strategy horizon.”
Is the footnote Moynahan includes on page 4 most likely correct?
Solution
C is correct.
The footnote Moynahan includes on page 4 is incorrect with respect to roll down return.
The roll down return is equal to the bond’s percentage price change assuming an unchanged yield curve over the strategy horizon.
The roll down return results from the bond “rolling down” the yield curve as the time to maturity decreases. As time passes, a bond’s price typically moves closer to par.
A is incorrect. Moynahan’s footnote regarding the yield curve is not accurate.
B is incorrect. Moynahan’s footnote with respect to bond prices is accurate.
Overview of Fixed-Income Portfolio Management Learning Outcome
Describe and interpret a model for fixed-income returns
Moynahan and Gayle continue their discussion about the presentation and debate several potential subjects to include on page 5.
Gayle suggests assessing the use of leverage in the portfolios.
They decide to present a scenario where the portfolio is fully invested, but given their outlook for a decline in interest rates, they want to increase the portfolio’s investment exposure. The portfolio and the benchmark both currently have the same duration.
What trades can Moynahan most likely make to accomplish the objective outlined on page 5 of his presentation?
Solution
B is correct. To accomplish Moynahan’s objective of increasing the investment exposure of a fully invested portfolio, he would buy long bond futures. Futures contracts embed significant leverage because they permit the counterparties to gain exposure to a large quantity of the underlying asset without having to actually transact in the asset.
A is incorrect because entering into a fixed-rate payer swap contract would not increase the portfolio’s investment exposure.
C is incorrect because selling an overnight repurchase agreement would not increase the portfolio’s investment exposure.
Overview of Fixed-Income Portfolio Management Learning Outcome
Discuss the use of leverage, alternative methods for leveraging, and risks that leverage creates in fixed-income portfolios
On page 6, the final page of his presentation, Moynahan plans to discuss the tax implications of fixed-income investing. He wants the class to understand that the management of taxable portfolios is more complicated than that of tax-exempt portfolios. He outlines the following key considerations for managing taxable fixed-income portfolios:
Minimize interest income relative to capital gains.
Minimize capital gains relative to capital losses.
Forego attractive trading opportunity because of tax implications.
Question
Which of the considerations outlined by Moynahan on page 6 of the presentation is least likely correct?
Solution
B is correct. When managing taxable fixed-income portfolios, Moynahan should not minimize capital gains relative to capital losses because capital losses are generally only used to offset capital gains.
A is incorrect. When managing taxable fixed-income portfolios, Moynahan would want to minimize interest income relative to capital gains because capital gains are typically taxed at a lower effective tax rate.
C is incorrect. When managing taxable fixed-income portfolios, Moynahan may want to dismiss attractive relative value trades due to tax implications.
Overview of Fixed-Income Portfolio Management Learning Outcome
Discuss differences in managing fixed-income portfolios for taxable and tax-exempt investors
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