Overview of Fixed-Income Portfolio Management

Bonds diversify equity risk, deliver scheduled cash flows and can protect against inflation, but only if the portfolio is built for the job. This module classifies fixed-income mandates, measures portfolio risk and decomposes expected bond returns, assesses liquidity and the double edge of leverage, contrasts taxable and tax-exempt investors, and compares liability-driven, cash-flow-matched and laddered portfolios.

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What you will learn

1. Explain the roles bonds play in a portfolio and classify fixed-income mandates as liability-based or total return, including pure indexing, enhanced indexing and active management.

Bonds diversify equities when growth shocks dominate, but the stock-bond correlation turns positive in inflation shocks.
Bonds provide scheduled cash flows; inflation-linked bonds protect real value, nominal bonds do not.
Liability-based mandates are judged on funding liabilities; total return mandates on performance against an index.
Pure indexing: replicate the risk profile; enhanced indexing: match primary risk factors with small tilts; active: larger deliberate factor bets.
Tracking error rises from pure indexing to enhanced indexing to active management.

2. Describe portfolio-level risk and return measures for bond portfolios and decompose a bond portfolio's expected return into yield income, rolldown, yield-change, credit and currency components.

Portfolio duration is roughly the market-value-weighted average of bond durations; BPV = market value x duration x 0.0001.
Cash flow yield (the portfolio's IRR) is more accurate than an average of bond yields.
Rolling yield = yield income + rolldown return, the return if the curve does not change.
Expected return = rolling yield - duration x change in yield + 1/2 x convexity x (change in yield)^2 - expected credit losses +/- expected currency effect.
Credit losses are probability of default x loss given default.

3. Assess the liquidity of bond markets and explain the methods, uses and risks of leverage in fixed-income portfolios.

Bond liquidity is highest for on-the-run government and large benchmark issues and lowest for small, old, low-rated or complex issues.
Many bonds are priced by matrix pricing; derivatives and ETFs can be more liquid than the underlying bonds.
Sources of leverage: futures, swaps, structured instruments, repos (with haircuts) and securities lending.
Leveraged return = unlevered return + (borrowed / equity) x (unlevered return - borrowing cost).
Main leverage risks: magnified losses, collateral calls and forced selling, rollover risk and counterparty risk.

4. Contrast fixed-income portfolio management for taxable and tax-exempt investors, including taxable-equivalent yield, the timing of gains and losses and the choice of account and vehicle.

Tax-exempt investors focus on pretax returns; taxable investors on after-tax returns.
Taxable-equivalent yield = tax-exempt yield / (1 - marginal tax rate); munis rarely suit tax-exempt investors.
Defer realized gains and harvest losses, respecting wash-sale rules.
Locate fully taxed bonds in tax-advantaged accounts where possible.
Separately managed accounts give control over tax lots; pooled funds can distribute unwanted gains.

5. Describe liability-driven investing, cash-flow matching and laddered bond portfolios, and compare their benefits and risks.

LDI manages bonds against liabilities; the more certain their amount and timing, the more precise the match.
Cash-flow matching is solved from the last liability backwards, counting longer bonds' coupons toward earlier liabilities.
Cash-flow matching minimizes rate and reinvestment risk but is costly and inflexible; duration matching is cheaper but needs rebalancing and is exposed to curve twists.
Ladders offer regular liquidity, diversified reinvestment risk and more convexity than a bullet of the same duration.
Ladders do not target a specific liability and may give up yield.

Module at a glance

Bonds diversify, provide scheduled cash flows and (if inflation-linked) hedge inflation; the stock-bond correlation turns positive in inflation shocks.
Liability-based mandates fund liabilities; total return mandates range from pure indexing through enhanced indexing to active management.
Expected return = yield income + rolldown - duration x change in yield + convexity term - credit losses +/- currency.
Bond liquidity is uneven and can vanish in stress; derivatives and ETFs are often more liquid than the bonds.
Leverage multiplies the spread over the borrowing cost and creates collateral calls, forced sales and rollover risk.
Taxable investors manage for after-tax return: taxable-equivalent yields, loss harvesting, deferral and asset location.
Cash-flow matching removes reinvestment risk at a cost; ladders give liquidity, convexity and diversified reinvestment.

This free module has 5 lessons, 18 practice questions with full explanations and 1 essay case with a model answer.

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