Finance- Bond Strategies

Bond Management Strategies and Mortgage Backed Securities

Prasanna Sant (36)

Parveen Shaikh (37)

Barkha Sharma (38)

Pragya Sharma (39)

Sujata Shetty (40)

What is a Bond• A bond is a promise to repay the principal along with interest (coupons) on

a specified date (maturity). Some bonds do not pay interest, but all bonds require a repayment of principal.

• When an investor buys a bond, he/she becomes a creditor of the issuer.

• If a business wants to expand, one of its options is to borrow money from individual investors, pension funds, or mutual funds.

• The buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities.

• The yield from a bond is made up of three components: coupon interest, capital gains and interest on interest (if a bond pays no coupon interest, the only yield will be capital gains).

Bond strategies• Bond strategies are strategies that help the investor balance their bond

portfolios to achieve their desired result.

• There are two type of categories under Bond Strategies

Passive Strategy

Buy & Hold Strategy Bond Indexing

Active Strategy

Forecasting interest rates Identifying mispriced bonds Yield spread strategies Yield curve strategies

Passive Bond Strategies• Passive bond management is based on the belief that the bond market is

fairly efficient and therefore passive investment managers do not attempt to 'beat the market'.

• Strategies that once they are formed do not require active management or changes.

• Buy & Hold Strategy:- A buy-and-hold trading strategy is the most passive of all investment

strategies; all that is required is that the investors replace bonds that have deteriorating credit ratings, have matured, or have been called

- Buy-and-hold investors restrict their ability to earn above-average returns

- They minimize the deadweight losses represented by transaction costs

Passive Bond Strategies .. (contd)• Bond Indexing is constructing a bond portfolio whose returns over time

replicate the returns of a bond index.

• There are three major bond indexes:• Salomon Brothers Broad Investment Grade (BIG). • Barclays Capital Aggregate Bond Index. • Merrill Lynch Domestic Master Index.

• Maturity greater than one year • Key considerations while selecting an index:

• Investor’s risk tolerance• The investor’s objective• Regulatory considerations

Active Bond Strategies• Active bond strategies are based on the premise that the portfolio manager

has superior skill and knowledge relative to other market participants and that the bond market is inefficient.

Forecasting Interest Rates

Positioning the bond portfolio to

reflect their outlook at future

levelsLengthening the

duration if interest rates are going to

fall and shortening if the interest rates are

rising

Identifying Mispriced

BondBonds that are over or under

valuedCan substitute a

similar bond temporarilyYields are affected by

market liquidity

Yield Spread Strategies

Purchase higher-yielding/sell

lower-yielding

Purchase lower-yielding/sell

higher-yielding

Yield Curve Strategies

Upward SlopingDownward

slopingFlat Yield

3 Main Yield Curve Shifts• Bullet Strategies:

Maturities of the securities in the portfolio are concentrated at one point on the yield curve

• Barbell Strategies:

The bond holdings are heavily concentrated in both very short- and long-term maturities

Provide liquidity in the short-term along with representation in long-term, higher yielding bonds

The aim of a barbell strategy is to earn more interest than intermediate-term bonds would provide without taking on more risk

• Bond Ladders:

In this strategy an equal amount is invested in a series of bonds with staggered maturities.

The bonds are all held to maturity, with the proceeds of maturing bonds reinvested in the most distant maturity.

The investor's portfolio remains constantly staggered to that predetermined date to maintain the ladder.

Classical Immunization• Immunization is a strategy of minimizing market risk by selecting a bond or bond

portfolio with a duration equal to the horizon date. • When a bond’s duration is equal to the liability’s duration, the direct interest-on-

interest effect and the inverse price effect exactly offset each other.

• As a result, the rate from the investment (ARR) or the value of the investment at the horizon or liability date does not change because of an interest rate change.

• The foundation for bond immunization strategies comes from a 1952 article by F.M. Redington:

• “Review of the Principles of Life – Office Foundation,” Journal of the Institute of Actuaries 78 (1952): 286-340.

• Redington’s immunization strategy is referred to as classical immunization.

Classical Immunization (example)• A fund has a single liability of $1,352 due in 3.5 years, DL = 3.5 years, and current

investment funds of $968.30. • The current yield curve is flat at 10%.

• Immunization Strategy: Buy bond with Macaulay’s duration of 3.5 years.

• Buy 4-year, 9% annual coupon at YTM of 10% for P0 = $968.30. This Bond has D = 3.5.

• This bond has both a duration of 3.5 years and is worth $968.50, given a yield curve at 10%.

• If the fund buys this bond, then any parallel shift in the yield curve in the very near future would have price and interest rate effects that exactly offset each other.

• As a result, the cash flow or ending wealth at year 3.5, referred to as the accumulation value or target value, would be exactly $1,352.

Contingent Immunization• Contingent immunization is an enhanced immunization strategy that combines active

management to achieve higher returns and immunization strategies to ensure a floor.

• In a contingent immunization strategy, a client of an investment management fund agrees to accept a potential return below an immunized market return.

• The lower potential return is referred to as the target rate, and the difference between the immunized market rate and the target rate is called the cushion spread.

• The acceptance of a lower target rate means that the client is willing to take an end-of-the period investment value, known as the minimum target value, which is lower than the fully immunized value.

• This acceptance, in turn, gives the management fund some flexibility to pursue an active strategy.

Contingent Immunization (Example)• Suppose an investment company offers a contingent immunization strategy for a

client with HD = 3.5 years based on a current 4-year, 9% annual coupon bond trading at a YTM of 10% (assume flat yield curve at 10%).

The bond has a duration of 3.5 years

and an immunization rate of 10%. • Suppose the client agrees to a lower immunization rate of 8% in return for

allowing the fund to try to attain a higher rate using some active strategy. • By accepting a target rate of 8%, the client is willing to accept a minimum target

value of $1,309,131 at the 3.5-year horizon date:

The difference between the client’s investment value (currently $1M) and

the present value of the minimum target value is the management fund’s safety margin or cushion:

The initial safety margin in this example is $62,203:

Safety Margin = Investment Value – PV (Minimum Target Value)

Safety Margin = $1,000,000 - $1,309,131/(1.10)3.5 = $62,203• As long as the safety margin is positive, the management fund will have a

cushion and can therefore pursue an active strategy.

Contingent Immunization (contd)• In practice, setting up and managing contingent immunization strategies are more

complex than this example suggests.

• Safety margin positions must be constantly monitored to ensure that if the investment value decreases to the trigger point it will be detected and the immunization position implemented.

• Active positions are more detailed, non-parallel shifts in the yield curve need to be accounted for, and if the immunization position is implemented, it will need to be rebalanced.

Duration based Asset Liability Risk Management

• Asset Liability Management (ALM) - is a strategic management tool to manage interest rate risk and liquidity risk faced by banks, other financial services companies and corporations.

• Risk - liquidity risk, interest rate risk, 

credit risk and operational risk.

• Duration Analysis - Duration is a

value-weighted measure of the maturity

of a security or other income-generating

asset that takes into consideration the amount

and timing of all cash flows expected from the asset.

Duration based ALM

• Difference between the duration of a bank's assets and the duration of its liabilities.

• Assets can be determined by taking a weighted average of the duration of all of the assets in the company’s portfolio.

• The duration of the liabilities can be determined in a similar manner.

Advantages & Limitations

Advantages Limitations

It accounts the effect of interest rate changes on the market value of the

company’s equity capital position.

It works best when interest rate changes are small and short and long term interest rates change by

the same amount.

A single number which tells the bank their overall exposure to interest rate

risk.

Prepayments by customers as well as

default payments affects Duration.

Illustration :

Consider a bank that borrows USD 100MM at 3.00% for a year and lends the same money at 3.20% to a highly-rated borrower for 5 years.

• Based upon accrual accounting, the bank earned USD 200,000 in the first year.

• Market values of Bank’s Asset & Liability:

100MM(1.032)5 / (1.060)4 = 92.72 MM

• 100MM (1.030) = 103.0MM.

• From a market-value accounting standpoint, the bank has lost

USD 10.28MM.

Mortgage Backed Securities

• Mortgage-backed securities are securities whose values are backed using mortgage loans.

• Why Do Mortgage-Backed Securities Exist?• How are Mortgages Different From Other Market

Securities?• Time Frame• Interest Rates• Derivatives• Potential• Warning

How does it work ?• The Purchase• The Individual Investor• Default and Foreclosure

Advantages & Limitations

• Advantages :• Investment Opportunities

• Limitations :• Increased Risk Taking• Potential for fraud

• Special Feature • Mortgage Backed Securities and Risk

“Collapse of U.S Economy” - MBS

Uses of MBS

Reasons for mortgage originators to finance their activities by issuing MBS

• Allow mortgage originators to replenish their funds.• Allow issuers to diversify their financing sources. • More efficient and lower cost source.• Allow issuers to remove assets from their balance sheet

Types of MBS

• Pass-Through mortgage-backed security

• Residential mortgage-backed security(RMBS)

• Commercial mortgage-backed security(CMBS)

• Pass-Through mortgage-backed security• Collateralized mortgage obligation (CMO)• Stripped mortgage-backed security (SMBS)

SECURITIZATION

• Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said debt as bonds to various investors.

Special Types of Securitization

• Master Trust• Issuance Trust• Granter Trust• Owner Trust

SECURITIZATION STRUCTURE

Motives for securitization

• Advantages to issuer• Advantages to investors • Disadvantages to issuer • Risks to investors

• Conclusion

Thank You!!!