Mutual Fund Management of Bond Funds Overview Bond

Mutual Fund Management of Bond Funds

Overview Bond funds have a wide variety of holdings. The exact securities held varies by the type of bond fund. Top-down investment approaches are duration management, yield curve positioning and sector selection. Bottom-up investment approaches are issue selection and predicting calls or prepayments.

Bond Basics Defining characteristics of bonds: Issuer. Par value. Coupon rate. Maturity date. Option features. Call, put or conversion.

Bond Basics Key analytical measures: Current yield. Yield to maturity. Option-adjusted yield. Yield spread. Duration.

Bond Basics Risks of bond investments: Market or interest-rate risk. Reinvestment rate risk. Credit or default risk. Call risk. Liquidity risk. Event risk.

Bond Basics: Cash Flows:

The Price-Yield Relation

Holdings in Taxable Bond Funds (1)

Holdings in Taxable Bond Funds (2)

Holdings in Taxable Bond Funds (3)

Asset-Backed Securities Based on pools of almost any type of debt. Allow lenders to manager risk Are structured securities divided into tranches; each tranche is entitle to different segment of the risk and reward. Begin with a special purpose entity that holds a pool of loans and issues the tranches. The most junior tranche absorbs losses first, while the most senior tranche receives income first.

Structure of an Asset-Backed Security

Credit Default Swaps Are similar to insurance policies because they can provide protection against loss. The buyer of a CDS pays a premium to a counterparty. The policy pays off if the bond goes into default. Are different from insurance policies because they can be bought without being at risk of loss. In other words, they can be bought by someone who does not own the underlying bond.

Holdings in Tax-Exempt Bond Funds (1)

Holdings in Tax-Exempt Bond Funds (2)

Bond Fund Investment Strategies (1)

Duration What is Duration? A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. The bigger the duration number, the greater the interest-rate risk or reward for bond prices. The primary forms of Bond fund risk are: credit risk (default) and interest rate risk (rate fluctuations). The duration indicator addresses the latter issue.

Duration: Zero-coupon Bond The red lever represents the four-year time period it takes for a zero-coupon bond to mature. The money bag represents the future value of the bond, the amount that will be paid to the bondholder at maturity. The fulcrum represents duration, which balances the red lever at the point of the time line at which the amount paid for the bond and the cash flow received from the bond are equal.

Duration: Straight Bond Consider a bond that pays coupons annually and matures in five years Cash flows consist of five annual coupon payments and the last payment includes the face value of the bond To balance the red lever at the point where total cash flows equal the amount paid for the bond, the fulcrum must be farther to the left, at a point before maturity.

Duration: Straight Bond

Duration Factors Bonds with high coupon rates and, in turn, high yields will tend to have lower durations than bonds that pay low coupon rates or offer low yields. When a bond pays a higher coupon rate or has a high yield, the holder of the security receives repayment for the security at a faster rate.

Duration and Immunization: A strategy that matches the durations of assets and liabilities thereby minimizing the impact of interest rates. Duration, coupon rate, term to maturity and price volatility are important for those investors employing duration-based immunization strategies. What kind of organizations might employ immunization strategies? Example: straight bond, two-year term, four coupons of $50, par value of $1, 000. Option 1: Do not reinvest proceeds, receive $1200 at the end of two years. Option 2: Reinvest coupon payments, total value more than $1200 in two years. Reinvested coupon proceeds allow the bondholder to satisfy a future $1, 200 obligation in less time than the maturity of the bond, i. e. , creates a portfolio with a lower total Duration than the actual bonds.

Two Common Yield Curve Strategies

Bond Fund Investment Strategies (2)

Bond Fund Portfolio Construction

Major Bond Rating Categories

Hypothetical U. S. Treasury Yield Curve

Current Yield Curve

Difference between 3 -mo LIBOR and T-Bill

Passive and Active Bond Management Passive management / buy and hold: objective is to achieve a specific return (stable value fund) Indexing: objective is to match the performance of a bond market index Active management: objective is to beat the return of the market, defined as A bond index and/or A competitive universe of funds with similar objectives (peer group) Portfolio manager is buying and selling securities based on his or her expectations about interest rates, credit risks, etc.

Other Key Players Credit analyst Actively analyzes financial condition of issuers Utilizes ratio analysis Determines the credit risk/return profile of bond issuers Quantitative analyst Builds mathematical models to help identify potential opportunities Examines analytical building blocks of bonds Produces valuation and risk parameters Quantifies and rewards of strategies under various scenarios Trader Provides current information about the bond market Handles execution of trades