Copyright © 2019 T Leitch

Two key Benchmarks that are used in FI

• Passive Index
• Versus liability such as
  • Pension
  • Life Insurance
  • LTC
  • Hazard Liabilities

Risk Measures

• Duration
  • First pass but can be crude
  • Can be misleading on net basis
    
• Convexity is a measure of curvature of bond
  • Matching just duration leaves curvature exposure
  • Matching both leaves portfolio neutral to first two terms of Taylor series expansion in yield

Types of Fixed Income Instruments

• Corporate Bonds (5-10 years)
• Treasury Notes/Bill/Bonds (1/1-10/10+ years)
• Municipal Bonds (5-30 years)
• Asset Backed (3+ years)
• Mortgage Backed (5-30 years)

Risky Bonds - Tha Capital Stack

When bonds have default risk it is possible that the issuer might issue bonds with different risk of loss

• Corporate
  • Senior
  • Junior
  • Preferred
  • Equity
• Municipal
  • Revenue
  • General Obligation
• Asset Backed (CMO/CDO/CLO)
  • Equity
  • Junior(s)
  • Senior

Corporate Bonds

• Carry default risk
• In default, investors have claim to assets
• For corporate bonds with specific assets, they are claimed first by bondholder and then if there is still a shortfall, bond holder goes in general collateral pool

Mortgage Backed

• Backed by home mortgages
  • Have prepay options
    • 30 year loan can be paid back at once w/o penalty
    • Investor bears reinvestment risk
    • Investor is short the option
    • Depending on tranche, can be highly or lowly sensitive to rate changes
• Commercial Backed (CMO)
  • Typically prepay penalties
  • More like corporate risk

Callable Bonds

• Bond can be called by company
• Regions of positive and negative convexity
• Not preferred by investors with significant reinvestment risk (i.e. life insurers)

Yield Curve Management

• Eurodollar Futures hedge at to 10+ years
• Swap market is reasonably liquid out to 50 years
  • Received fixed rate on swap is same risk profile as owning a bond
  • Most long duration liability hedging (>15 years) is done in the swap market
    • Hedge the forward purchase of a bond
    • This leaves just the credit spread risk open

Credit Spread Managment

• Index credit derivatives are available to 10 years
• This can be used to hedge or create hybrid investments
• These have become very liquid and are used by market makers to buy bond pools more aggressively through risk reduction

Default: A Counterinutitive Event