FIXED INCOME PORTFOLIOS

FIXED INCOME PORTFOLIO:

Fixed Income Portfolio is the same as equity portfolio with the difference that it consists of fixed income financial instruments such as bonds, debentures, money market instruments etc. Since it mainly consists of bonds, it is also called Bond Portfolio.

1.Fixed Income Portfolio Process:

Just like other portfolios, the following five steps are involved in a fixed income portfolio:

1. Setting up objective

2. Drafting guideline for investment policy

3. Selection of Portfolio Strategy - Active and

Passive

4. Selection of financial instruments and other assets

5. Evaluation of performance with benchmark

2.Calculation of Return on Fixed Income Portfolio:

First and foremost step in evaluation of performance of a portfolio is calculation of return.

Although there can be many types of measuring returns as per requirements but some of the commonly used measures are :

(i) Arithmetic Average Rate of Return

(ii) Time Weighted Rate of Return

(iii) Rupee Weighted Rate of Return

(iv) Annualized Return

3. Fixed Income Portfolio Management Strategies:

There are two strategies

(i) Passive Strategy

(ii) Active Strategy

3.1 Passive Strategy:

As mentioned earlier Passive Strategy is based on the premise that securities are fairly priced

commensurate with the level of risk.

Though investor does not try to outperform the market but it does not imply they remain totally inactive.

Common strategies applied by passive investors of fixed income portfolios are as follows:

(i) Buy and Hold Strategy:

This technique is a do nothing technique and investors continue with initial selection and do not attempt to churn bond portfolios to increase return or reduce the level of risk.

However, sometime to control the interest rate risk, the investor may set the duration of fixed income

portfolio equal to benchmarked index.

(ii) Indexation Strategy:

This strategy involves replication of a predetermined benchmark well known bond index as closely as possible.

(iii) Immunization:

This strategy cannot exactly be termed as purely passive strategy but a hybrid strategy.

This strategy is more popular among pension funds. Since pension funds promised to pay fixed amounts to retired people in the form of annuities any inverse movement in interest may threaten the fund's ability to meet their liability timely.

By building an immunized portfolio the interest rate risk can be avoided.

(iv) Matching Cash Flows:

Another stable approach to immunize the portfolio is Cash Flow Matching. This approach involves buying of Zero Coupon Bonds to meet the promised payment out of the proceeds realized.

3.2 Active Strategy

As mentioned earlier Active Strategy is usually adopted to outperform the market. Following are

some of active strategies:

(1) Forecasting Returns and Interest Rates:

This strategy involves the estimation of return on the basis of change in interest rates. Since interest rate and bond values are inversely related if portfolio the manager is expecting a fall in the interest rate of bonds he/she should buy with a longer maturity period.

On the contrary, if he/she expected a fall in interest then he/she should sell bonds with a longer period.

Based on short term yield movement following three strategies can be adopted:

(a) Bullet Strategy:

This strategy involves concentration of investment in one particular bond.

This type of strategy is suitable for meeting the fund after a point of time such as meeting education expenses of children etc. For example, if 100% of funds meant for investing in bonds is invested in a 5-years Bond.

(b) Barbell Strategy:

As the name suggests this strategy involves investing equal amounts in short term and long term bonds. For example, half of the fund meant for investment in bonds is invested in 1-year Bonds and the balance half in 10-year Bonds.

(c) Ladder Strategy:

This strategy involves investment of equal amount in bonds with different maturity periods. For example if 20% of funds meant for investment in bonds is invested in Bonds of periods ranging from 1 year to 5 years.

Further estimation of interest ratio is a daunting task, and quite difficult to ascertain.

There are several models available to forecast the expected interest rates which are based on:

(i) Inflation

(ii) Past Trends

(iii) Multi Factor Analysis

It should be noted that these models can be used as estimates only, as it is difficult to calculate the

accurate changes.

There is one another techniques of estimating expected change in interest rate called ‘Horizon

Analysis’.

This technique requires that analyst should select a particular holding period and then predict yield curve at the end of that period as with a given period of maturity, a bond yield curve of a selected period can be estimated and its end price can also be calculated.

(2) Bond Swaps:

This strategy involves regularly monitoring bond processes to identify mispricing and try to exploit this situation.

Some of the popular swap techniques are as follows:

(a) Pure Yield Pickup Swap -

This strategy involves switching from a lower yield bond to a higher yield bond of almost identical quantity and maturity.

This strategy is suitable for a portfolio manager who is willing to assume interest rate risk as in switching from short term bond to long term bonds to earn a higher rate of interest, he may suffer a capital loss.

(b) Substitution Swap -

This swapping involves swapping with similar type of bonds in terms of coupon rate, maturity period, credit rating, liquidity and call provision but with different prices.

This type of difference exists due to temporary imbalance in the market. The risk a portfolio manager carries if some features of swapped bonds may not be truly identical to the swapped one.

(c) International Spread Swap –

In this swap portfolio manager is of the belief that yield spreads between two sectors is temporarily out of line and he tries to take advantage of this mismatch.

Since the spread depends on many factor and a portfolio manager can anticipate appropriate

strategy and can profit from these expected differentials.

(d) Tax Swap –

This is based on taking tax advantage by selling existing bond whose price decreased at capital loss and set it off against capital gain in other securities and buying another security which has features like that of disposed one.

(3) Interest Rate Swap:

Interest Rate Swap is another technique that is used by Portfolio Managers.

3.1 Interest Rate Swaps :

In an interest rate swap, the parties to the agreement, termed the swap counterparties, agreeto specified notional principal amount of the swap, which is never actually exchanged.

3.2 Swap Dealers :

The intermediary collected a brokerage fee as compensation, but did not maintain a continuing

role once the transaction was completed. The contract was between the two ultimate swap users,

who exchanged payments directly.

3.3. A fixed/floating swap is characterized by

 a fixed interest rate;

 a variable or floating interest rate which is periodically reset;

 a notional principal amount upon which total interest payments are based; and

 the term of the agreement, including a schedule of interest rate reset dates (that is, dates

when the value of the interest rate used to determine floating-rate payments is determined)

and payment dates.

A swap is negotiated on its "trade date" and settlement takes effect two days later called

"settlement date."

3..4 Price Quotation

The convention in the swap market is to quote the fixed interest rate as an All-In-Cost (AIC), which

means that the fixed interest rate is quoted relative to a flat floating-rate index.

3.5 Types of Swap

(a) Plain Vanilla Swap:

Also called Generic Swap or Coupon Swap and it involves the exchange of a fixed rate loan to a floating rate loan over a period of time and that too on notional principal. Floating rate basis can be LIBOR, MIBOR, Prime Lending Rate etc.

(b) Basis Rate Swap:

Also, called Non-Generic Swap. Similar to plain vanilla swap with the

difference that payments is based on the difference between two different variable rates. For

example one rate may be 1 month LIBOR and other may be 3-month LIBOR. In other words two

legs of swap are floating but measured against different benchmarks.

(c) Asset Swap:

Like plain vanilla swaps with the difference that it is the exchange fixed rate

investments such as bonds which pay a guaranteed coupon rate with floating rate investments

such as an index.

(d) Amortising Swap:

An interest rate swap in which the notional principal for the interest

payments declines during the life of the swap. They are particularly useful for borrowers who have

issued redeemable bonds or debentures. It enables them to interest rate hedging with redemption

profile of bonds or debentures.

4 Swaptions

An interest rate swaption is simply an option on an interest rate swap. It gives the holder the right

but not the obligation to enter into an interest rate swap at a specific date in the future, at a

particular fixed rate and for a specified term.

There are two types of swaption contracts: -

• A fixed rate payer swaption (also called Call Swaption) gives the owner of the swaption

the right but not the obligation to enter into a swap where they pay the fixed leg and receive

the floating leg.

• A fixed rate receiver swaption (also called Put Swaption) gives the owner of the swaption

the right but not the obligation to enter into a swap in which they will receive the fixed leg,

and pay the floating leg.

4.1 Principal features of Swaptions

A. A swaption is effectively an option on a forward-start IRS, where exact terms such as the

fixed rate of interest, the floating reference interest rate and the tenor of the IRS are

established upon conclusion of the swaption contract.

B. A 3-month into 5-year swaption would therefore be seen as an option to enter into a 5-year

IRS, 3 months from now.

C. The 'option period' refers to the time which elapses between the transaction date and the

expiry date.

D. The swaption premium is expressed as basis points.

E. Swaptions can be cash-settled; therefore at expiry they are marked to market off the

applicable forward curve at that time and the difference is settled in cash.

4.2 Pricing of Swaptions

The pricing methodology depends upon setting up a model of probability distribution of the forward

zero-coupon curve which undoes a Market process.

4.3 Uses of Swaptions

(a) Swaptions can be applied in a variety of ways for both active traders as well as for

corporate treasurers.

(b) Swap traders can use them for speculation purposes or to hedge a portion of their swap

books.

(c) Swaptions have become useful tools for hedging embedded optionality which is common to

the natural course of many businesses.

(d) Swaptions are useful to borrowers targeting an acceptable borrowing rate.

(e) Swaptions are also useful to those businesses tendering for contracts.

(f) Swaptions also provide protection on callable/puttable bond issues.