andytrader

Which of the following is a difference between pure bond index matching and enhanced indexing that allows for minor risk factor mismatches? Enhanced indexing that allows for minor risk factor mismatches:

A) allows larger mismatches between the index and portfolio return.

B) is essentially an active management strategy.

C) allows only smaller mismatches between the index and portfolio return.

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Enhanced indexing with minor risk factor mismatches means that the portfolio will have the same duration as the index, but will have differential exposures from the index due to sector, quality, term structure, etc… mismatches. These differential positions will allow larger return mismatches between the portfolio and the index than that generated by the pure bond index matching approach.

andytrader

A commercial bank that borrows and then lends funds is most likely to specify its benchmark:

A) in terms of the duration of its assets.

B) in terms of its liability structure.

C) as a bond index.

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A commercial bank defines its benchmark in terms of meeting a specific amount of cash to satisfy the liabilities (deposits) on its books.

andytrader

A defined benefit pension plan is most likely to specify its benchmark:

A) as a bond index.

B) in terms of its liability structure.

C) in terms of the Lehman Brothers Aggregate Bond Index.

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The pension plan defines its benchmark in terms of meeting a specific amount of cash to satisfy the liabilities (pension benefits) on its books.

andytrader

Fixed-income investors whose objective is to generate sufficient cash to satisfy their liabilities specify the benchmark:

A) as a bond index.

B) as either a bond index or in terms of its liability structure.

C) in terms of its liability structure.

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Fixed-income investors whose objective is to generate sufficient cash to satisfy the liabilities specify the benchmark in terms of its liability structure.

andytrader

Which of the following most accurately describes the relationship between an investor's investment objectives and the benchmark chosen for performance evaluation? An investor with a:

A) liability as a benchmark has an investment strategy to match the timing and amount of the payments corresponding to the liability.

B) liability as a benchmark has an investment objective that is to earn a higher return than the cost of borrowing.

C) bond index as a benchmark has as an investment objective to outperform the bond index.

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The purpose of using the liability structure as a benchmark is to ensure meeting the liability payment streams, both in timing and amount.

andytrader

What is the investment objective for a pension sponsor who has a defined benefits based liability structure? The main objective is to:

A) minimize prepayment risk.

B) match the amount and timing of the liability.

C) outperform a bond index.

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Although the other answers are worthwhile activities in pension fund management, matching the liability structure should be the primary objective for the pension sponsor.

andytrader

Bruce Turner, CFA, is composing a fund to track a benchmark bond index. He decides to use enhanced indexing by matching primary risk factors. This method aligns the risk exposures of the portfolio by investing in:

A) all the bonds in the index in the same proportion as the index and using leverage to enhance returns.

B) a sample of bonds to match the primary index risk factors with the goal of minimizing construction and maintenance costs.

C) all the bonds in the index in the same proportion as the index and using derivatives to enhance the returns.

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Choosing a sample of bonds to match the primary risk factors is called enhanced indexing by matching primary risk factors. The goal is to match the risk factors while lowering construction and maintenance costs. The manager can also be selective when choosing the sample and try to select bonds that are the most undervalued.

andytrader

In aligning the risk exposures of a bond portfolio to those of a benchmark bond index, the purpose of matching key rate durations is:

A) to hedge twists of the yield curve.

B) to better match cash flows.

C) to make adjustments for convexity.

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Matching total duration will not necessarily hedge against changes in shape of the yield curve. Matching the durations of a few key rates along the yield curve will better hedge the fund against twists of the yield curve.

andytrader

The goal of enhanced indexing by small risk factor mismatches is to:

A) match duration while allowing the manager to tilt the portfolio in favor of other risk factors.

B) choose a subset of risk factors to match and manage, which may or may not include matching duration.

C) match duration with a sample of bonds that are presumably undervalued so as to produce a higher return.

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This is the goal of enhanced indexing by small risk factor mismatches.

andytrader

Fixed Income Asset Management, Incorporated, (FIAM) has traditionally managed fixed income portfolios for pension and endowment funds employing immunization and cash matching strategies. Recently, FIAM has accepted the responsibility for managing funds for which indexed and enhanced indexed strategies are appropriate. Ms. Debra C. Truxell, CFA, a senior manager at FIAM, has been promoted to Vice President for Index Bond Fund Management to lead the company in this new direction. To staff this effort, Truxell had to recruit several new employees. Since most of the newly hired employees had little experience with indexing strategies, Truxell thought it would be prudent to conduct a series of in-house training seminars.
Cara Moore, an expert in bond indexing strategies, presented the first seminar. She opened the session with a discussion of the risk characteristics that distinguish bond management styles. She stated the key risk factor that distinguishes indexing from active management is that indexing takes no position on duration, but may differ in terms of sector, yield expectations, and quality differences. The differences depend upon how far the portfolio falls along the indexing versus active management continuum.
Moore’s associate, James Higgins, noted that “lower costs, diversification, and stable performance are all advantages of indexing a portfolio to a large, well-diversified bond index.” He also said, “Simple replication of a bond index such as the Lehman Brothers Aggregate Bond Index is known as pure bond indexing. I recommend pure bond indexing for most passively managed portfolios because it is the most efficient means of reducing tracking error and is the easiest indexing strategy to implement in most circumstances.” Truxell supported his statement by saying, “The greatest cost benefit of indexing lies in pure bond indexing.”
During the second seminar, lead by Pilar Newman, the topic of matching based on various risk factors was addressed. One participant asked "Is it sufficient to match the duration of the indexed portfolio to the duration of the bond index to control for the primary risks of the bond index?" Newman replied, “Yes, that is precisely how portfolio managers protect against non-parallel shifts in the yield curve.” A second participant asked if modified duration is the appropriate measure of interest rate risk and Newman’s partner Martin George replied, “While modified duration accurately measures interest rate risk for bullet bonds, it does not accurately measure interest rate risk for bonds with embedded options.” Newman added that matching the sector, coupon, and maturity weights of the callable sectors of a bond index results in a better matching of the convexity of the index, which is desirable.
Nicholas Morgan, a long-time FIAM employee, is interested in implementing call exposure positioning. He understands that when bonds move from being priced to call to being priced to maturity, returns can be enhanced by increasing the portfolio’s relative exposure to call risk. He notes “bonds that are priced to maturity tend to underperform when rates fall and bonds that are priced to call tend to underperform when rates rise.” Morgan tells Truxell’s staff that they need to factor this in when implementing a call exposure enhancement strategy.Regarding bond indexing:

A) Moore is correct regarding the primary factor that distinguishes indexing from active management; Truxell is incorrect regarding the cost savings from pure bond indexing.

B) Moore is correct regarding the primary factor that distinguishes indexing from active management; Truxell is correct regarding the cost savings from pure bond indexing.

C) Moore is incorrect regarding the primary factor that distinguishes indexing from active management; Truxell is incorrect regarding the cost savings from pure bond indexing.

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Moore is correct. A full-blown active management strategy takes an aggressive approach to risk factor mismatches, including duration. Enhanced indexing maintains the same duration as the index. It is not until one moves up the risk spectrum into active strategies that a position regarding duration is taken.
Truxell is incorrect in her assessment of the cost savings from pure bond indexing. Full replication is extremely costly. In general, it is more difficult to fully replicate a bond index than a stock index. (Study Session 9, LOS 23.b)

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Regarding the statements made by Higgins about bond indexing, he is:

A) correct both with respect to the advantages of indexing and in his conclusions regarding pure bond indexing.

B) incorrect both with respect to the advantages of indexing and in his conclusions regarding pure bond indexing.

C) correct with respect to the advantages of indexing but incorrect in his conclusions regarding pure bond indexing.

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Higgins is correct regarding the advantages of indexing. Diversification, lower costs, and stable performance relative to a non-indexed portfolio are all advantages of indexing. However, pure bond indexing is expensive and difficult to implement in a fixed-income portfolio due to the illiquidity of many of the bonds in the index. Therefore, Higgins is incorrect in the conclusions he draws regarding pure bond indexing (or full replication). (Study Session 9, LOS 23.b)

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Truxell’s most likely reply to Newman’s answer to the question regarding duration matching would be:

A) “As a matter of fact this type of matching is the best way to assure that the tracking error attributable to a yield shift is minimized.”

B) “Matching the primary risk factors of the index such as duration, cash flow, sectors, quality, and callability is the most effective method".

C) “It is not sufficient. Sector cell weighting is the recommended strategy to control for primary risk factors.”

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To match the primary risk factors of an index managers commonly match several factors such as duration, cash flow, sectors, quality , and callability of the bonds in the index. Duration alone only protects against small parallel shifts in the yield curve. (Study Session 9, LOS 23.d)

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Frederick Jackson, a recent college graduate and CFA candidate, asked Truxell if she felt that return enhancements could be realized through sector exposure. Truxell accurately replied,”Yes, as a matter of fact, it is possible to increase the yield of the portfolio without a proportionate increase in risk by:

A) overweighting 1-5 year Treasuries and underweighting 1-5 year corporates.”

B) underweighting 1-5 year Treasuries and overweighting 1-5 year corporates.”

C) underweighting long-term Treasuries and overweighting long-term corporates.”

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Short term (less than 5 years) corporate bonds have the most favorable yield spread per unit of duration risk. Overweighting these issues and underweighting short duration Treasuries is known as enhanced indexing by small risk factor mismatches. (Study Session 9, LOS 23.d)

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With respect to comments made about duration:

A) George is incorrect; Newman is correct regarding matching the convexity of the index.

B) George is correct; Newman is also correct regarding matching the convexity of the index.

C) George is correct; Newman is incorrect regarding matching the convexity of the index.

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George is correct, modified duration does not effectively measure the interest rate risk of bonds with embedded options - we must use effective duration for that task. Newman is also correct regarding her statement about convexity. Matching the sector, coupon, and maturity weights of the callable sectors results in a better match of the convexity of the index. (Study Session 9, LOS 23.d)

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Regarding callable bonds, Morgan is:

A) correct in assuming that returns may be enhanced when a callable bond that is priced to call is replaced with a callable bond that is priced to maturity, however, he does not understand the relationship between interest movements and the performance of callable bonds.

B) incorrect in assuming that returns may be enhanced when a callable bond that is priced to call is replaced with a callable bond that is priced to maturity. He also does not understand the relationship between interest movements and the performance of callable bonds.

C) correct in assuming that returns may be enhanced when a callable bond that is priced to call is replaced with a callable bond that is priced to maturity, and he understands the relationship between interest rate movements and the performance of callable bonds, which will allow him to profit from rate changes.

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Morgan is correct in assuming that returns can be enhanced by increasing a portfolio’s relative exposure to call risk when a callable bond that is priced to call is replaced with a callable bond that is priced to maturity. Usually callable bonds cannot be called for 5 to 10 years after being issued and the issuer of the callable bond will pay the investor an annual spread premium compared to a straight bond. However, he is backwards when it comes to over and underperformance of callable bonds when interest rates change. Bonds that are priced to call underperform when rates decline and as rates increase they outperform non-callables. The reason is that callable bonds “cap out” when rates fall and don’t fall as much as noncallable bonds when rates rise due to negative convexity. (Study Session 9, LOS 24.e)