sm20 - CHAPTER 20 BOND PORTFOLIO MANAGEMENT STRATEGIES...

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CHAPTER 20 BOND PORTFOLIO MANAGEMENT STRATEGIES Answers to Questions 1. An indexing portfolio strategy is one in which the investor selects a bond portfolio that matches the performance of some bond-market index. The basic justification for this strategy is that many empirical studies have shown that portfolio managers on average can't match the risk-return performance in the bond market using active portfolio management. 2. A pure yield pickup swap is selling a bond and buying another one with a higher coupon. Normally, both current yield and yield-to-maturity are enhanced. A substitution swap is the swapping of one bond for another between which a yield spread imbalance exists. The investor expects the imbalance to disappear through the mechanism of having the yield on the purchased bond drop (through a price increase) to the level of the swapped bond, leading to attractive capital gains. A tax swap is simply a bond swap that enables an investor to realize capital losses on one bond to offset capital gains that she has realized on some other investment. 3. These active management strategies include interest rate anticipation, credit analysis, and spread analysis. Interest rate anticipation is the riskiest strategy because it relies on forecasting uncertain future interest rate behavior. The strategy involves altering the maturity (duration) structure of the portfolio to preserve capital when an increase in interest rates is anticipated and achieve capital gains when they are expected to decline. A credit analysis strategy involves attempting to project changes in quality ratings assigned to bonds. It is necessary to analyze internal changes in the firm and external changes in the environment to project rating changes prior to the actual announcement by rating agencies. Spread analysis involves monitoring the yield relationships between various bond sectors to take advantage of abnormal relationships by executing various sector swaps. Liquidity is a key factor in this strategy, as abnormal relationships are only believed to be temporary. 4. Two important variables when analyzing junk bonds include: 1) the use of cash flows in relation to debt obligations, and 2) a detailed analysis of potential asset sales. The cash flow analysis is important in determining the firm’s ability to make interest payments, as well as maintain cash for research and growth in periods of economic decline. Cash flow can also affect the firm’s borrowing capacity to provide flexibility and needed working capital. In many cases, asset sales are a critical part of the strategy for a leveraged buyout. In order to analyze the market value of these assets it is necessary to determine whether there are any prior liens against the assets, as well as the true liquidation value and a reasonable time period for the sale. 5.
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sm20 - CHAPTER 20 BOND PORTFOLIO MANAGEMENT STRATEGIES...

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