21-Bond Portfolio Man Page 661 Wednesday, February 4, 2004 1:12 PM
Bond Portfolio Management 661an optimizer can be employed to rank bond purchases in terms of the
marginal decline in tracking error per unit of each bond purchased. A
portfolio manager would then determine the bond issues that would be
purchased and the optimizer would then identify potential market-
value-neutral swaps of these bond issues against various bonds issues
currently held in the portfolio; the optimizer would indicate the optimal
transaction size for each pair of bond issues that are being swapped
ranked by the potential reduction in tracking error.
Dynkin, Hyman, and Wu illustrate how this optimization process can
be used to minimize the tracking error for the 57-bond portfolio. The
illustration is provided in Exhibit 21.5. Look at the first trade used in the
exhibit which indicates that the majority of the large position in the
Coca-Cola 30-year bond can be swapped for a Treasury note. If the pro-
posed trade (i.e., bond swap) is executed, this would result in (1) a change
in the systematic exposures to term structure, sector, and quality and (2) a
reduction in nonsystematic risk by cutting one of the largest issuer expo-
sures. From this one bond swap alone that the optimizer identifies, track-
ing error is reduced from 52 basis points to 29 basis points. Notice that as
the risk profile of the initial sample portfolio approaches that of the
benchmark (Lehman Brothers U.S. Aggregate Index), the opportunity for
major reductions in the tracking error declines.
If all five transactions shown in Exhibit 21.5 are executed, there is
the potential to reduce the tracking error to 16 basis points. The result-
ing portfolio after these transactions is effectively a passive portfolio.
Exhibit 21.6 provides a summary of the tracking error for the portfolio
if all five transactions are executed. The systematic and nonsystematic
tracking error is 10 and 13 basis points, respectively.LIABILITY-FUNDING STRATEGIES
Liability-funding strategies are strategies whose objective is to match a
given set of liabilities due at future times. These strategies provide the cash
flows needed at given dates at a minimum cost and with zero or minimal
interest rate risk. However, depending on the universe of bonds that are
permitted to be included in the portfolio, there may be credit risk and/or
call risk. Liability-funding strategies are used by (1) sponsors of defined
benefit pension plans (i.e., there is a contractual liability to make payments
to beneficiaries); (2) insurance companies for single premium deferred
annuities (i.e., a policy in which the issuer agrees for a single premium to
make payments to policyholders over time), guaranteed investment con-
tracts (i.e., a policy in which the issuer agrees for a single premium to