Bond Portfolio Management Research Articles

Bond Pricing and Basis Risk when the Short Term Interest Rate Follows a Threshold Process

Using a stochastic discount factor approach, this paper derives the exact solution for bond yields in the case that the short-term interest rate follows a threshold process with the intercept switching endogenously. The yield functions, mapping the one-month rate into n-period yields, exhibit a convex/concave shape to the left and the right of the threshold value, respectively. This particular pattern in the yield function is confirmed by US bond yield data. The intervals for which convexity or concavity prevails increase with time to maturity. The problem with the derived exact yield function is that it can actually be computed for yields with a small time to maturity only (say until six months). Approximations of our exact solution or simulation-based techniques have to be applied for longer times to maturity so far.Substantial implications arise for the risk management of bond portfolios. Risk measures reveal a nonlinear pattern at the threshold value that decays if moving away from it. Linear Gaussian and CIR type of models can not account for this type of functional form since they imply an affine yield function. Therefore, ignoring this fact leads to an under- or overestimation of risk near the threshold depending on the chosen risk measures. This new type of term structure model belongs to the regime-switching class but in contrast to the popular Markov-switching case it is determined completely by observable variables within a no-arbitrage framework. The derived solution can be applied to a wide range of threshold dynamics for the underlying state variables.

Overcoming The Challenges of Establishing A Student-Managed Fixed Income Fund

Student-managed funds (SMFs) offer unique educational opportunities. In a typical SMF, students select common stocks and manage a real portfolio, gaining practical money management experience. Until recently, establishing a fixed income SMF has been unworkable for most academic institutions. Fixed income exchange traded funds (ETFs) are relatively new financial offerings that allow non-institutional investors the ability to trade shares of an entire bond portfolio as a single security. By combining different ETFs into a fund of funds, it is possible for students to implement various bond portfolio management strategies - a valuable learning opportunity previously unavailable to most business students.

Corporate Bond Portfolio Analysis

Most corporate bond portfolio managers use fundamental credit analysis in the security selection process and some form of the efficient frontier in the construction and ongoing management of their portfolios. This traditional approach, however, does not take into account the whole distribution of potential future credit losses on the portfolio and thus does not capture the risk of extreme events. A remedy is to apply the methodology used in the construction of collateralized debt obligations to analyze and manage the tail risk in corporate bond portfolios.

Bond elasticity under liquidation risk

We derive a model for the valuation of government bonds subject to liquidation risk. We show that the value of a government bond depends on the term structures of the conditional probability of liquidation facing the portfolio manager, the bid-ask spread, and the riskless rate. We derive an expression for the elasticity of a government bond adjusted for the risk of liquidation with respect to shifts in the riskless term structure of interest rates. Failing to adjust elasticity for liquidation risk may be costly for bond portfolio managers utilizing active, rate-anticipation duration strategies based on Macaulay duration.

A theory of bond portfolios

We introduce a bond portfolio management theory based on foundations similar to those of stock portfolio management. A general continuous-time zero-coupon market is considered. The problem of optimal portfolios of zero-coupon bonds is solved for general utility functions, under a condition of no-arbitrage in the zero-coupon market. A mutual fund theorem is proved, in the case of deterministic volatilities. Explicit expressions are given for the optimal solutions for several utility functions.

Active bond strategies: What link between forecasting ability, excess return and performance?

The active management of a portfolio should not be appreciated only in term of excess profitability vis-a-vis a reference benchmark. It is a matter for a complete process where upstream is supposed to exist the manager's superior expertise. This skill is analyzed as a forecasting ability and appears by choices of asset allocation corresponding to the manager's anticipations. The article has for object to analyze the tie between forecasting ability and excess performance in an active management. It limits itself to the bond portfolio management, but takes in account the international dimension. Two types of asset allocation decisions are considered: The choice of the maturity and the choice of the markets in an environment with four currencies: The dollar, the euro, the pound sterling and the yen. A simulation on the period 1998-2001 shows the tie between forecasting ability and the hope of excess return. The opening to the international dimension shows a superior gain potential compared to a domestic active management. The comparison with a set of a priori useful information doesn't permit to transform this potential in a real excess gain in performance however. The bond portfolio management in an international context introduces a strong complexity in relation to a domestic active management. The risks of errors in anticipations accumulate themselves in a dynamic allocation between markets. The operational conclusion is to underline the interest of a management bondholders international active but restricted to constant market weights.

Convexity Analysis of Option Embedded Bonds

Interest rate risk hedge strategies usually assume that term structure of interest rates in moving under a specific way. If a real term structure is moving differently from the assumed term structure movement, the interest rate risk hedge strategies assuming the special term structure movement may incur unexpected large loss for a bond portfolio manager. Hence an interest rate risk hedge strategy which could be effective under various types of term structure movements has been strongly needed by bond portfolio managers. Duration vector strategies have been developed to satisfy this practical need. To allow various types of term structure movements, duration vector strategies assume multi-factor models for the term structure movement. When a duration vector strategy is considered as a generalization of a duration strategy which is a single factor model for the term structure movement, there will be a generalized concept which measures convexity of a bond under the duration vector model. This study identifies the convexity property of an option embedded bond portfolio under ‘key rate duration model‘ which is a kind of duration vector model suggested by Ho (1992).

Active Bond Strategies: What Link Between Forecasting Ability, Excess Return and Performance?

The active management of a portfolio should not be appreciated only in term of excess profitability vis-a-vis a reference benchmark. It is a matter for a complete process where upstream is supposed to exist the manager's superior expertise. This skill is analyzed as a forecasting ability and appears by choices of asset allocation corresponding to the manager's anticipations. The article has for object to analyze the tie between forecasting ability and excess performance in an active management. It limits itself to the bond portfolio management, but takes in account the international dimension. Two types of asset allocation decisions are considered: The choice of the maturity and the choice of the markets in an environment with four currencies: The dollar, the euro, the pound sterling and the yen. A simulation on the period 1998-2001 shows the tie between forecasting ability and the hope of excess return. The opening to the international dimension shows a superior gain potential compared to a domestic active management. The comparison with a set of a priori useful information doesn't permit to transform this potential in a real excess gain in performance however. The bond portfolio management in an international context introduces a strong complexity in relation to a domestic active management. The risks of errors in anticipations accumulate themselves in a dynamic allocation between markets. The operational conclusion is to underline the interest of a management bondholders international active but restricted to constant market weights.

On immunization, stop-loss order and the maximum Shiu measure

Some main immunization results are derived in a straightforward way using some well-known equivalent characterizations of the stop-loss order by equal means, also called convex order. In a special case, the conditions by Fong and Vasicek [A risk minimizing strategy for multiple liability immunization. Unpublished; Return maximization for immunized portfolios. In: Kaufmann, G.G., Bierwag, G.O., Toevs, A. (Eds.), Innovation in Bond Portfolio management: Duration Analysis and Immunization. JAI Press, London, pp. 227–238] and Shiu [Insur. Math. Econ. 7 (1988) 219], are extended to a necessary and sufficient condition for immunization under arbitrary convex shift factors of the term structure of interest rates. Based on a linear control problem with the Shiu measure as objective function, we analyze in detail the recent bounds by Uberti [Insur. Math. Econ. 21 (1997) 195] on the change in portfolio value of Shiu decomposable portfolios under α-convex and convex-β shift factors. In particular, we determine corresponding maximal and minimax bounds using notions of absolute maximum and minimax Shiu measure. Finally, we consider partial cash flow matching immunization strategies, which allow to reduce the maximum Shiu measure over a fixed period to the maximum Shiu measure over shorter periods.

A Primal-Dual Decomposition-Based Interior Point Approach to Two-Stage Stochastic Linear Programming

Decision making under uncertainty is a challenge faced by many decision makers. Stochastic programming is a major tool developed to deal with optimization with uncertainties which has found applications in, e.g., finance, such as asset–liability and bond–portfolio management. Computationally, however, many models in stochastic programming remain unsolvable because of overwhelming dimensionality. For a model to be well solvable, its special structure must be explored. Most of the solution methods are based on decomposing the data. In this paper we propose a new decomposition approach for two-stage stochastic programming, based on a direct application of the path-following method combined with the homogeneous self-dual technique. Numerical experiments show that our decomposition algorithm is very efficient for solving stochastic programs. In particular, we apply our decomposition method to a two-period portfolio selection problem using options on a stock index. In this model the investor can invest in a money-market account, a stock index, and European options on this index with different maturities. We experiment with our model with market prices of options on the S&P500.

Forecasting the Term Structure of Government Bond Yields

Despite powerful advances in yield curve modeling in the last twenty years, comparatively little attention has been paid to the key practical problem of forecasting the yield curve. In this paper we do so. We use neither the no-arbitrage approach, which focuses on accurately fitting the cross section of interest rates at any given time but neglects time-series dynamics, nor the equilibrium approach, which focuses on time-series dynamics (primarily those of the instantaneous rate) but pays comparatively little attention to fitting the entire cross section at any given time and has been shown to forecast poorly. Instead, we use variations on the Nelson-Siegel exponential components framework to model the entire yield curve, period-by-period, as a three-dimensional parameter evolving dynamically. We show that the three time-varying parameters may be interpreted as factors corresponding to level, slope and curvature, and that they may be estimated with high efficiency. We propose and estimate autoregressive models for the factors, and we show that our models are consistent with a variety of stylized facts regarding the yield curve. We use our models to produce term-structure forecasts at both short and long horizons, with encouraging results. In particular, our forecasts appear much more accurate at long horizons than various standard benchmark forecasts. Finally, we discuss a number of extensions, including generalized duration measures, applications to active bond portfolio management, and arbitrage-free specifications.

From data to model and back to data: A bond portfolio management problem

The bond portfolio management problem is formulated as a multiperiod stochastic program using interest rate scenarios. The scenarios are sampled from the binomial lattice from a Black–Derman–Toy model. The paper analyzes the sensitivity of the solution of the resulting large-scale mathematical program with respect to the model inputs. The numerical results are for the Italian bond market.

Unique Risk-Return Characteristics of High-Yield Bonds

As the high-yield (HY) bond market has grown in size and significance, it is important to examine its place in the total capital market and to develop a better understanding of its composition and characteristics. This article considers differences between the investment-grade and the HY bond market, unique characteristics within the HY bond market, and changes in the correlations between asset class sectors and their volatilities over time. There is strong evidence that HY bonds have a very significant equity component that makes them a different asset class from investment-grade bonds. Within the HY bond universe, BB bonds are heavily affected by market interest rates with some equity effect; B-rated bonds have more equity-like characteristics than an interest rate effect; and CCC-rated bonds have virtually no market interest rate effect. There is also clear evidence of changes in correlations among asset classes over time. There have been significant changes in volatility over time, with striking changes duing the 1990–1991 recession, the 1998 Russian credit crisis, and the year 2000 credit crunch. The authors discuss the significant implications of these results for bond analysts and portfolio managers.

Sentiment, Positioning, and Bond Returns

This paper examines the forecasting power of the Stone and McCarthy Research Associates weekly survey of U.S. bond portfolio managers from its inception in September 1991 through October 1999. The survey gathers information on bullishness and the positioning of portfolios in terms of actual durations relative to benchmark durations and the percentage of assets held in cash equivalent securities. The evidence is consistent with the contrarian investment paradigm in that extreme levels of bearishness are associated with higher subsequent excess returns on the Merrill Lynch U.S. Domestic Master Bond Index over 3-month Treasury bills. Evidence also indicates that sentiment and positioning are strongly momentum driven and become more bullish when excess returns rise more over the previous two weeks. The finding that the respondents form expectations and position their portfolios as if excess bond returns are positively autocorrelated is inconsistent with evidence that excess bond returns are not positively autocorrelated over the sample period.

CDOs as Self‐Contained Reinsurance Structures

In the convergence between the capital markets and reinsurance markets, the prime mover of insurance risk into capital markets have been investment banks. Also, among the most active leveraged underwriters of capital market credit risk are reinsurers, as opposed to hedge funds or banks. A key example of the institutional consequences of “convergence,” in particular of product design are Collateralized Debt Obligations (CDOs). CDOs combine a managed portfolio of bonds or loans with a hierarchy of claims or priority of loss payments (typical of insurance structures). Early buyers of CDOs were typically high‐yield bond portfolio managers. More recently, reinsurers have come to appreciate the “insurance nature” of these CDO structures, and multiline reinsurers have begun to support CDOs via financial guarantees.

Bond portfolio management with repo contracts: the Italian case

In this paper we present a model for management of bond portfolio including financing and investment repo contracts. Different specifications are suggested in order to reduce the problem to a linear programming problem and to consider a self-financing portfolio. The models are tested on historical data assuming a technical time scale equal to the minimum length of the contracts in the portfolio. We also compared different operative strategies on a time horizon of one month.

Sensitivity of Bond Portfolio's Behavior with Respect to Random Movements in Yield Curve: A Simulation Study

The bond portfolio management problem is formulated as a stochastic program based on interest rate scenarios. The coefficients of the resulting program are subject to errors of various kind. In this paper, we complement the theoretical stability results of by simulation experiments. Adapting the approach of to problems based on perturbed yield curves, we then provide bounds for the optimality gap for various candidate first-stage solutions.

Stability Properties of a Bond Portfolio Management Problem

The bond portfolio management problem is formulated as a multiperiod two-stage or multistage stochastic program based on interest rate scenarios. These scenarios depend on the available market data, on the applied estimation and sampling techniques, etc., and are used to evaluate coefficients of the resulting large scale mathematical program. The aim of the contribution is to analyze stability and sensitivity of this program on small changes of the coefficients – the (scenario dependent) values of future interest rates and prices. We shall prove that under sensible assumptions, the scenario subproblems are stable linear programs and that also the optimal first-stage decisions and the optimal value of the considered stochastic program possess acceptable continuity properties.

Portfolio optimization via stochastic programming: Methods of output analysis

Solutions of portfolio optimization problems are often influenced by errors or misspecifications due to approximation, estimation and incomplete information. Selected methods for analysis of results obtained by solving stochastic programs are presented and their scope illustrated on generic examples – the Markowitz model, a multiperiod bond portfolio management problem and a general strategic investment problem. The approaches are based on asymptotic and robust statistics, on the moment problem and on results of parametric optimization.

The Value of Tax Management for Bond Portfolios

Taxes are an important issue in the management of bond portfolios for investors. The author reviews the benefits of trading municipal and high yield corporate bonds for the purpose of reducing taxes, thereby maximizing after-tax returns. Expected values for tax trading in the two markets are presented. The expected value of tax management is an ingredient that financial consultants should include in their asset allocation models for individual investors. In general, the value of tax trading increases with the average maturity of the portfolio and is sensitive to the investor9s tax rates. With municipal bonds, investors should “harvest” losses and avoid gains. The value of tax managing municipal portfolios increases with maturity, but it also decreases as the investment horizon increases. Tax management of high-yield corporate bonds take advantage of the difference between the income and capital gains tax rates for individual and the timing of tax payments. Its value increases with maturity, but unlike municipal, it is not sensitive to one9s investment horizon and the strategy entails realizing gains as well as losses.