Overview of Fixed-Income Portfolio Management

2024 Curriculum CFA Program Level III Portfolio Management and Wealth Planning

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Introduction

Investors often seek regular income from their investments as well as a predetermined date when their capital will be returned. Fixed-income investments offer both.

Fixed-income instruments include a broad range of publicly traded securities (such as commercial paper, notes, and bonds traded through exchanges as well as OTC) and non-publicly traded instruments (such as loans and private placements). Individual loans or fixed-income obligations may be bundled into a pool of assets supporting such instruments as asset-backed securities and covered bonds. Fixed-income portfolio managers combine these diverse instruments across issuers, maturities, and jurisdictions to meet the various needs of investors. We discuss the different roles of fixed-income securities in portfolios and explain the two main types of fixed-income mandates—liability-based mandates and total return mandates—as well as bond market liquidity. We also provide an overview of portfolio measures, instruments, and vehicles used in fixed-income portfolio management and introduce a model of how a bond position’s total expected return can be decomposed.

Learning Outcomes

The member should be able to:

discuss roles of fixed-income securities in portfolios and how fixed-income mandates may be classified;
describe fixed-income portfolio measures of risk and return as well as correlation characteristics;
describe bond market liquidity, including the differences among market sub-sectors, and discuss the effect of liquidity on fixed-income portfolio management;
describe and interpret a model for fixed-income returns;
discuss the use of leverage, alternative methods for leveraging, and risks that leverage creates in fixed-income portfolios;
discuss differences in managing fixed-income portfolios for taxable and tax-exempt investors.

Summary

Fixed-income investments provide diversification benefits in a portfolio context. These benefits arise from the generally low correlations of fixed-income investments with other major asset classes, such as equities.
Floating-rate and inflation-linked bonds can be used to hedge inflation risk.
Fixed-income investments have regular cash flows, which is beneficial for the purposes of funding future liabilities.
For liability-based fixed-income mandates, portfolio construction follows two main approaches—cash flow matching and duration matching—to match fixed-income assets with future liabilities.
Total return mandates are generally structured to either track or outperform a benchmark.
Total return mandates can be classified into various approaches according to their target active return and active risk levels. Approaches range from pure indexing to enhanced indexing to active management.
Bond Portfolio Duration is the sensitivity of a portfolio of bonds to small changes in interest rates. It can be calculated as the weighted average of time to receipt of the aggregate cash flows or, more commonly, as the weighted average of the individual bond durations that comprise the portfolio.
Modified Duration of a Bond Portfolio indicates the percentage change in the market value given a change in yield-to-maturity.
Convexity of a bond portfolio is a second-order effect; it operates behind duration in importance and can largely be ignored for small yield changes. When convexity is added with the use of derivatives, however, it can be extremely important to returns.
Effective duration and convexity of a portfolio are the relevant summary statistics when future cash flows of bonds in a portfolio are contingent on interest rate changes.
Spread duration is a useful measure for determining a portfolio’s sensitivity to changes in credit spreads. It provides the approximate percentage increase (decrease) in bond price expected for a 1% decrease (increase) in credit spread.
Duration times spread is a modification of the spread duration definition to incorporate the empirical observation that spread changes across the credit spectrum tend to occur on a proportional percentage basis rather than being based on absolute basis point changes.
Portfolio dispersion captures the variance of the times to receipt of cash flows around the duration. It is used in measuring interest rate immunization for liabilities.
Duration management is the primary tool used by fixed-income portfolio managers.
Convexity supplements duration as a measure of a bond’s price sensitivity for larger movements in interest rates. Adjusting convexity can be an important portfolio management tool.
For two portfolios with the same duration, the portfolio with higher convexity has higher sensitivity to large declines in yields to maturity and lower sensitivity to large increases in yields to maturity.
Interest rate derivatives can be used effectively to increase or decrease duration and convexity in a bond portfolio.
Liquidity is an important consideration in fixed-income portfolio management. Bonds are generally less liquid than equities, and liquidity varies greatly across sectors.
Liquidity affects pricing in fixed-income markets because many bonds either do not trade or trade infrequently.
Liquidity affects portfolio construction because there is a trade-off between liquidity and yield to maturity. Less liquid bonds have higher yields to maturity, all else being equal, and may be more desirable for buy-and-hold investors. Investors anticipating liquidity needs may forgo higher yields to maturity for more liquid bonds.
Investors can obtain exposure to the bond market using mutual funds and ETFs that track a bond index. Shares in mutual funds are redeemable at the net asset value with a one-day time lag.
ETF shares have the advantage of trading on an exchange.
A total return swap, an over-the-counter derivative, allows an institutional investor to transform an asset or liability from one asset category to another—for instance, from variable-rate cash flows referencing the market reference rate to the total return on a particular bond index.
A total return swap can have some advantages over a direct investment in a bond mutual fund or ETF. As a derivative, it requires less initial cash outlay than direct investment in the bond portfolio for similar performance but carries counterparty risk.
As a customized over-the-counter product, a TRS can offer exposure to assets that are difficult to access directly, such as some high-yield and commercial loan investments.
When evaluating fixed-income investment strategies, it is important to consider expected returns and to understand the various components of expected returns.
Decomposing expected fixed-income returns allows investors to understand the different sources of returns given expected changes in bond market conditions.
A model for expected fixed-income returns can decompose them into the following components: coupon income, rolldown return, expected change in price based on investor’s views of yields to maturity and yield spreads, and expected currency gains or losses.
Leverage is the use of borrowed capital to increase the magnitude of portfolio positions. By using leverage, fixed-income portfolio managers may be able to increase portfolio returns relative to what they can achieve in unleveraged portfolios. The potential for increased returns, however, comes with increased risk.
Methods for leveraging fixed-income portfolios include the use of futures contracts, swap agreements, repurchase agreements, structured financial instruments, and security lending.
Taxes can complicate investment decisions in fixed-income portfolio management. Complications result from the differences in taxation among investor types, countries, and income sources.
The two primary sources of investment income that affect taxes for fixed-income securities are coupon payments (interest income) and capital gains or losses. Tax is usually payable only on capital gains and interest income that have actually been received.
Capital gains are frequently taxed at a lower effective tax rate than interest income. If capital losses exceed capital gains in the year, they can often be “carried forward” and applied to gains in future years.

1.5 PL Credit

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