portfolio management- chapter 13
TRANSCRIPT
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Chapter 13
Bond Selection
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Prof. Rushen Chahal
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To preserve their independence, we must not let ourrules load us with perpetual debt. We must make
our election between economy and liberty, orprofusion and servitude.
- Thomas Jefferson
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Outline
Introduction
The meaning of bond diversification
Choosing bonds Example: monthly retirement income
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Introduction
In most respects selecting the fixed-income
components of a portfolio is easier than
selecting equity securities
There are ways to make mistakes with bond
selection
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The Meaning of
Bond Diversification
Introduction
Default risk
Dealing with the yield curve Bond betas
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Introduction
It is important to diversify a bond portfolio
Diversification of a bond portfolio is different
from diversification of an equity portfolio Two types of risk are important:
Default risk
I
nterest rate risk
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Default Risk
Default riskrefers to the likelihood that a firm
will be unable to repay the principal and
interest of a loan as agreed in the bond
indenture
Equivalent to credit riskfor consumers
Rating agencies such as S&P and Moodys
function as credit bureaus for credit issuers
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Default Risk (contd)
To diversify default risk:
Purchase bonds from a number of different
issuers
Do not purchase various bond issues from a single
issuer
E.g., Enron had 20 bond issues when it went bankrupt
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Dealing With the Yield Curve
The yield curve is typically upward sloping
The longer a fixed-income security has until
maturity, the higher the return it will have to
compensate investors
The longer the average duration of a fund, the
higher its expected return and the higher itsinterest rate risk
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Dealing With the
Yield Cu
rve (contd)
The client and portfolio manager need to
determine the appropriate level of interest
rate risk of a portfolio
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Bond Betas
The concept of bond betas:
States that the market prices a bond according to
its level of risk relative to the market average
Has never become fully accepted
Measures systematic risk, while default risk andinterest rate risk are more important
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Choosing Bonds
Client psychology and bonds selling at a
premium
Call risk Constraints
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Client Psychology and
Bonds Selling at A Premiu
m Premium bonds held to maturity are expected
to pay higher coupon rates than the market
rate of interest
Premium bond held to maturity will decline in
value toward par value as the bond moves
towards its maturity date
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Client Psychology & Bonds Selling
at A Premiu
m (contd)
Clients may not want to buy something they
know will decline in value
There is nothing wrong with buying bonds
selling at a premium
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Call Risk
If a bond is called:
The funds must be reinvested
The fund manager runs the risk of having to make
adjustments to many portfolios all at one time
There is no reason to exclude callable bondscategorically from a portfolio
Avoid making extensive use of a single callablebond issue
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Constraints
Specifying return
Specifying grade
Specifying average maturity
Periodic income
Maturity timing
Socially responsible investing
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Specifying Return
To increase the expected return on a bond
portfolio:
Choose bonds with lower ratings
Choose bonds with longer maturities
Or both
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Specifying Grade
A legal listspecifies securities that are eligible
investments
E.g., investment grade only
Portfolio managers take the added risk of
noninvestment grade bonds only if the yield
pickup is substantial
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Specifying Grade (contd)
Conservative organizations will accept only
U.S. government or AAA-rated corporate
bonds
A fund may be limited to no more than a
certain percentage of non-AAA bonds
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Specifying Average Maturity
Average maturity is a common bond portfolio
constraint
The motivation is concern about rising interest
rates
Specifying average duration would be an
alternative approach
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PeriodicIncome
Some funds have periodic income needs that
allow little or not flexibility
Clients will want to receive interest checks
frequently
The portfolio manager should carefully select the
bonds in the portfolio
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Maturity Timing
Maturity timing generates income as needed
Sometimes a manager needs to construct a bondportfolio that matches a particular investment
horizon
E.g., assemble securities to fund a specific set ofpayment obligations over the next ten years Assemble a portfolio that generates income and
principal repayments to satisfy the income needs
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Socially Responsible Investing
Some clients will ask that certain types of
companies not be included in the portfolio
Examples are nuclear power, military
hardware, vice products
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Example: Monthly
RetirementI
nc
ome The problem
Unspecified constraints
Using S&Ps Bond Guide Solving the problem
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The Problem
A client has:
Primary objective: growth of income
Secondary objective: income
$1,100,000 to invest
Inviolable income needs of $4,000 per month
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The Problem (contd)
You decide:
To invest the funds 50-50 between common
stocks and debt securities
To invest in ten common stock in the equity
portion (see next slide)
You incur $1,500 in brokerage commissions
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The Problem (contd)
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Stock Value Qrtl Div. Payment Month
3,000 AAC $51,000 $380 Jan./April/July/Oct.
1,000 BBL 50,000 370 Jan./April/July/Oct.
2,000 XXQ 49,000 400 Feb./May/Aug./Nov.5,000 XZ 52,000 270 March/June/Sept./Dec.
7,000 MCDL 53,000 0 --
1,000 ME 49,000 370 Feb./May/Aug./Nov.
2,000 LN 51,000 500 Jan./April/July/Oct.
4,000 STU 47,000 260 March/June/Sept./Dec.
3,000 LLZ 49,000 290 Feb./May/Aug./Nov.
6,000 MZN 43,000 170 Jan./April/July/Oct.
Total $494,000 $3,010
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The Problem (contd)
Characteristics of the fund:
Quarterly dividends total $3,001 ($12,004annually)
The dividend yield on the equity portfolio is 2.44% Total annual income required is $48,000 or 4.36%
of fund
Bonds need to have a current yield of at least
6.28%
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Unspecified Constraints
The task is meeting the minimum required
expected return with the least possible risk
You dont want to choose CC-rated bonds
You dont want the longest maturity bonds you
can find
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Using S&Ps Bond Guide
Figure 13-1 is an excerpt from the Bond Guide:
Indicates interest payment dates, coupon rates,
and issuer
Provides S&P ratings
Provides current price, current yield
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Using S&Ps
Bond Guide (contd)
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Solving the Problem
Setup
Dealing with accrued interest and
commissions Choosing the bonds
Overspending
What about convertible bonds?
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Setup
You have two constraints:
Include only bonds rated BBB or higher
Keep the average maturities below fifteen years
Set up a worksheet that enables you to pick
bonds to generate exactly $4,000 per month
(see next slide)
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Setup (contd)
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Security Price Jan. Feb. March April May June
3,000 AAC $51,000 $380 $380
1,000 BBL 50,000 370 370
2,000 XXQ 49,000 $400 $4005,000 XZ 52,000 $270 $270
7,000 MCDL 53,000
1,000 ME 49,000 370 370
2,000 LN 51,000 500 500
4,000 STU 47,000 260 260
3,000 LLZ 49,000 290 290
6,000 MZN 43,000 170 170
Equities $494,000 $1,420 $1,060 $530 $1,420 $1,060 $530
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Dealing With Accrued
Interest and Commissions
Bond prices are typically quoted on a net basis
(already include commissions)
Calculate accrued interest using the mid-term
heuristic
Assume every bonds accrued interest is half of
one interest check
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Choosing the Bonds
The following slide shows one possible solution:
Stock cost: $494,000
Bond cost: $557,130
Accrued interest: $9,350
Stock commissions: $1,500
Do you think this solution could be improved?
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Bonds
Security Price Jan. Feb. March April May June
$80,000 Empire
71/2s02
$86,400 $3,000
$80,000 Energen
8s07
82,900 $3,200
$100,000 Enhance
61/4s03
105,500 $3,370
$80,000 Enron
65/8s03
84,500 $2,650
$90,000 Enron
6.7s06
97,200 $3,010
$100,000Englehard 6.95s28
100,630 $3,470
Bonds subtotal $557,130 $3,000 $3,200 $3,370 $2,650 $3,010 $3,470
Total income $4,420 $4,260 $3,900 $4,070 $4,070 $4,000
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Overspending
The total of all costs associated with the
portfolio should not exceed the amount given
to you by the client to invest
The money the client gives you establishes
another constraint
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What About
Convertible Bonds?
Convertible bonds can be included in a
portfolio
Useful for a growth of income objective
People buy convertible bonds in hopes of price
appreciation
Useful if you otherwise meet your income
constraints
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