Practice Problems PRACTICE PROBLEMS The following information relates to Questions 1-6 Cécile Perreaux is a junior analyst for an international wealth management firm, Her supervisot, Margit Daasvand, asks Perreaux to evaluate three fixed-income funds as part of the firm's global fixed-income offerings. Selected financial data for the funds Aschel, Permot, and Rosaiso are presented in Exhibit 1. In Perreaux’s initial review, she assumes that there is no reinvestment income and that the yield curve remains unchanged. it 1 Selected Data on Fixed-Income Funds Aschel Permot_——_—Rosalso Current average bond price 117.00 391.50 $94.60 Expected average bond price in one $114.00 396.00 $97.00 year (end of Year 1) Average modified duration 707 738 699 Average annual coupon payment $463 $6.07 $6.36 Present value of portfolio assets $136.33 $68.50 s7438 (callions) Bond type" Fixed-coupon bonds 9595 388 ox loating-eoupon bonds % 3a%, 178, 3% 289% 21% 65%, 15% 208 35% 5% S58 om 20% 20% Nat rated om om 10%, Value of portoli's equity (millions) soa Value of borrowed funds (millions) $2.0 2.80% Return on invested fonds 6.20% * Bond type and Quality ae shown a percentage of total for each nd, After further review of the composition of each of the funds, Perreau notes the following. Note 1 Aschel is the only fund of the three that uses leverage, Note 2 Rosaiso is the only fund of the three that holds a significant number of bonds with embedded options. © 2017 CFA Insttte, Al righ reserved.Reading 22. Introduction to Fixed-Income Portfolio Management Daasvand asks Perreaux to analyze immunization approaches to liabilty-based ‘mandates for a meeting with Villash Foundation. Villash Foundation is a tax-exempt client. Prior to the meeting, Perreaux identifies what she considers to be two key features of a cash flow-matching approach. Feature L It requires no yield curve assumptions, Feature 2 Cash flows come from coupons and liquidating bond portolio positions Two years later; Daasvand learns that Villash Foundation needs $5,000,000 in cash to meet liabilities, She asks Perreaux to analyze two bonds for possible liquidation. Selected data on the two bonds are presented in Exhibit 2. ees Bond 1 nd 2 (Current market value $5,000,000 $5,000,000 Capital guinvtoss 400,000, Coupon rate 205% Remaining maturity 8 years Investment view Overvalued Income tax rate 39%, Capital guns tax rate 308% 1. Based on Exhibit 1, which fund provides the highest level of protection against inflation for coupon payments? A Aschel B Permot © Rosaiso 2. Based on Exhibit 1, the rolling yield of Aschel over a one-year investment hori 2on is closest to: A 256%, B 054K, 5.66%, 3° The levered portfolio return for Aschel A 7.25%, B 771%, € 96%, 4 Based on Note 2, Rosaiso is the only fund for which the expected change in price based on the investor's views of yields and yield spreads should be caleu- lated using: A convexity, 8 modified duration effective duration closest to 5 Is Perreaux correct with respect to key features of cash flow matching? A Yes. B_ No, only Feature 1 is correct.Practice Problems © No, only Feature 2 is correct, 6 Based on Exhibit 2, the optimal strategy to meet Villash Foundation’s cash, needs is the sale of: A 100% of Bond 1 B_ 100% of Bond 2, © 50% of Bond 1 and 50% of Bond 2. The following information relates to Questions 7-12 Celia Deveraux is chief investment officer for the Topanga Investors Fund, which invests in equities and fixed income. ‘The clients in the fund are all taxable investors. “The fixed-income allocation includes a domestic (US) bond portfolio and an externally ‘managed global bond portfolio. “the domestic bond portfolio has a total return mandate, which specifies a long- term return objective of 25 basis points (bps) over the benchmark index. Relative to the benchmark, small deviations in sector weightings are permitted, such risk factors as duration must closely match, and tracking error is expected to be less than 50 bps per yeat: “The objectives for the domestic bond portiolio include the ability to fund future liabilities, protect interest income from short-term inflation, and minimize the cor- relation with the fund's equity portfolio, ‘The correlation between the fund's domestic bond portfolio and equity portfolio is currently 0.14, Deveraux plans to reduce the fund's equity allocation and increase the allocation to the domestic bond portfolio. She reviews two possible investment strategies. Strategy 1 Purchase AAA rated fixed-coupon corporate bonds with a modified duration of two years and a correlation eoeticient with the equity porto lio of 0.15 Strategy 2 Purchase US government agency loating-coupon bonds with a modi- fied duration of one month and a correlation coefficient with the equity portfolio of -0.10, Deveraux realizes that the fund's return may decrease if the equity allocation of the fund is reduced. Deveraux decides to liquidate $20 million of US Treasuries that are currently owned and to invest the proceeds in the US corporate bond sector, To fulfil this strategy, Deveraux asks Dan Foster, a newly hired analyst for the fund, to recommend ‘Treasuries to sell and corporate bonds to purchase. Foster recommends ‘Treasuries from the existing portfolio that he believes are overvalued and will generate capital gains. Deveraux asks Foster why he chose only overvalued bonds with capital gains and did not include any bonds with capital losses. Foster responds with two statements ‘Statement 1 Taxable investors should prioritize selling overvalued bonds and always sell them before selling bonds that are viewed as fairly valued or undervalued. Statement 2 Taxable investors should never intentionally realize capital losses. Regarding the purchase of corporate bonds, Foster collects relevant data, which are presented in Exhibit 1 39Ete eda Reading 22. Introduction to Fixed-Income Portfolio Management PALER BCRAIERMUAQERUATERESOR ORE: fay Eugen een Bond Characteristics Bond? Bond2 Bond 3 Credit quality AA AA Issue size § millions) 10 % ‘Maturity (years) 5 7 7 Total issuance outstanding (S millions) 1,000 1,500 1.000 ‘Months since issuance Now issue 3 6 Deveraux and Foster review the total expected 12-month return (assuming no reinvestment income) for the global bond portfolio, Selected financial data are pre- sented in Exhibit 2 Puree rn ee) Notional prineipal of portfolio (in millions) 200 Average bond coupon payment (per €100 par value) e. Coupon frequency Annual Current average bond price 98.5 Expected average bond price in one year (assuming an unchanged yield €98.62 curve) Average bond convexity 2 Average bond modified duration 5.9 Expected average yield and yield spread change 045% Expected credit losses 043% Expected currency gains (€ appreciation vs. 8) 0.65% Deveraux contemplates adding a new manager to the global bond portfolio, She reviews three proposals and determines that each manager uses the same index a its benchmark but pursues a different total return approach, as presented in Exhibit 3. Income Portfoli Sector Weights (%) Manager A Manager B Manager C Index Government 535 525 W78 5a Agency/quasi-agency 162 164 13a 160Practice Problems it (Con Sector Weights (36) Manager A Manager B Manager ¢ Index Corporate 200 222 251 198 MBS 103 89 137 101 ‘Manager A Manager ‘Manager C Index Average maturity (years) 763 784 855 756 Moified duration (years) 523 525 516 522 Average yield () 198 208 2a 199 Tamover (N) 207 20 290 205 7 Which approach to its total return mandate is the fund's domestic bond portfo- lio most likely to use? A Pure indexing B_ Enhanced indexing © Active management 8 Strategy 2 is most likely preferred to Strategy 1 for meeting the objective of: A protecting inflation. B_ funding future liabilities. © minimizing the correlation of the fund's domestic bond portfolio and equity portfolio. 9 Are Foster's statements to Deveraux supporting Foster's choice of bonds to sell correct? A Only Statement 1 is correct B_ Only Statement 2is correct, Neither Statement 1 nor Statement 2 is correct. 10 Based on Exhibit 1, which bond most likely has the highest liquidity pre A Bond 1 B Bond 2 © Bond 3 11. Based on Exhibit 2, che total expected return of the fund's global bond portiolio is closest to: A 090%, B 2.20%, © 3.76%, 12 Based on Exhibit 3, which manager is most likely to have an active management total return mandate? A Manager A B Manager B © Manager2 Reading 22. Introduction to Fixed-Income Portfolio Management SOLUTIONS 1 Bis correct. Permot has the highest percentage of floating-coupon bonds and inflation-linked bonds. Bonds with floating coupons protect interest income from inflation hecause the reference rate should adjust for inflation, Inflation- linked bonds protect against inflation by paying a return that is directly inked to an index of consumer prices and adjusting the principal for inflation. Inflation-linked bonds protect both coupon and principal payments against inflation. “The level of inflation protection for coupons = % portfolio in floating-coupon bonds + % portfolio in inflation-linked bonds: Aschel = 2% + 3% = 5% Permot BAN + 28% = 62% Rosaiso = 17% + 21% = 38% ‘Thus, Permot has the highest level of inflation protection with 62% of its portfo- lio in floating-coupon and inflation linked bonds. 2. Bis correct. ‘Ihe rolling yield is the sum of the yield income and the rolldown return, Yield income is the sum of the bond's annual current yield and inter- est on reinvestment income. Perreaux assumes that there is no reinvestment income for any of the three funds, and the yield income for Aschel will be cal- ‘culated a follows: Yield income = Annual average coupon payment/Current bond price '$3.63/$117.00 = 00310, oF 3.10%. ‘The rolldown return is equal to the bonds percentage price change assuming ‘an unchanged yield curve over the horizon period, ‘Ihe rolldown return will be ‘calculated as follows RAT ALE (Bond priceyn4etorizon pecoa ~ Bond price yceinsing-of- nian pried) Bond price peginning-of-horizon period _ ($114.00 - $117.00) 7 ‘$117.00 = 00256, or -2.56% Rolling yield = Yield income + Rolldown return = 3.10% — 2.56% = 0.54% 3 Bis correct. The return for Aschel is 7.71%, calculated as follows (oe + ¥n) Va x70) Z Ff $42.00 mi $94.33 million 6.20% + (6.20% ~ 2.80%) 27.71%Solutions 8 4 Cis correct. Rosaiso is the only fund that holds bonds with embedded options. Effective duration should be used for bonds with embedded options. For bonds with embedded options, the duration and convexity measures used to calculate the expected change in price based on the investors views of yields and yield spreads are effective duration and effective convexity. For bonds ‘without embedded options, convexity and modified duration are used in this calculation. 5 Biscorrect, Cash flow matching has no yield curve or interest rate assump- tions. With this immunization approach, cash flows come from coupon and principal repayments that are expected to match and offset liability cash flows, Because bond cash inflows are scheduled to coincide with lability cash pay- outs, there is no need! for reinvestment of cash flows. ‘Thus, cash flow matching is not affected by interest rate movements. Cash flows coming from coupons and liquidating bond portfolio positions is a key feature of a duration-matching approach, 6 A iscorrect. The optimal strategy for Villas isthe sale of 100% of Bond 1, ‘which Perreaux considers to be overvalued, Because Villash isa tax-exempt foundation, tax considerations are not relevant and Perreaux’s investment views drive her trading recommendations. 7 Bis correct. ‘The domestic bond portfolio’ return objective is to modestly out- perform the benchmark. Its risk factors, such as duration, are to closely match the benchmark. Small deviations in sector weights are allowed, and tracking terror should be les than 50 bps year. These features are typical of enhanced indexing, 8 Ais correct, Floating-coupon bonds provide inflation protection for the interest income because the reference rate should adjust for inflation The purchase of fixed-coupon bonds as outlined in Strategy 1 provides no protection against inflation for either interest or principal. Strategy 1 would instead be superior to Strategy 2in funding future liabilities (better predictability as to the amount ‘of cash flows) and reducing the correlation between the funds domestic bond portfolio and equity portfolio (better diversification). 9 Cis correct, Since the fund's clients are taxable investors, there is value in harvesting tax losses. These losses can be used to offset capital gains within the fund that will otherwise be distributed to the clients and cause them higher tax payments, which decreases the total value of the investment to clients. “The fund thas to consider the overall value of the investment to its clients, including taxes, ‘which may result in the sale of bonds that are not viewed as overvalued. Tax- ‘exempt investors’ decisions are driven by their investment views without regard to offsetting gains and losses for tax purposes 10 Cis correct, Bond 3 is most likely to be the least liquid of the three bonds presented in Exhibit 2 and will thus most likely require the highest liquilty premium, Low credit ratings, longer time since issuance, smaller issuance size, smaller issuance outstanding, and longer time to maturity typically are associ- ated with a lower liquidity (and thus a higher liquidity premium). Bond 3 has the lowest credit quality and the longest time since issuance of the three bonds, Bond 3 also has a smaller issue size and longer time to maturity than Bond 1. “The total issuance outstanding for Bond 3 is smaller than that of Bond 2 and ‘equal to that of Bond 1Reading 22. Introduction to Fixed-Income Portfolio Management 11. Bis correct. ‘The total expected return is calculated as: ‘Total expected return = Rolling yield + £(Change in price based on inves tor’ yield and yield spread view) — E(Credit losses) + B(Curreney gains or losses) Rolling yield = Yield income + Rolldowa return ‘Return Component Yield income + Rolldown return, = Rolling yield + E(Change in price based ‘on investor’ yield and yield spread view) ~ E(Credit losses) + E(Curcency gains oF losses) «= Total expected return Formula Calculation ‘Annual coupon payment/Current bond price €2.25/€98.45 = 2.29% (Gontrenscconmeget Bo PiStntiinepnd) (OSE ORAS C8AE- 017% Bor ition pea Yield income + Rolldown return 2.29% + 0.17% = 2.46% [MD x AYield] + [4 Convexity « (veld) [-5.19 « 0.0015] + [35x 22 x (0.00157 Given Given 2.20% 1 Ciscorrect. "The sector weights, risk and return characteristics, and turnover for Manager C differ significantly from those of the index, which is typical of an active management mandate, In particular, Manager C’s modified duration of 6.16 represents a much larger deviation from the benchmark index modi- fied duration of 5.22 than that of the other managers, which is a characteristic unique to an active management mandate.