Fixed Income

At the November 3, 2010 meeting, the US Federal Reserve divulged its widely anticipated second round of Quantitative Easing (QE2 plan), formally announcing it would purchase an additional USD600bln in US Treasuries by the end of the second quarter 2011. In the aftermath of the announcement the US yield curve continued to steepen given the Fed’s planned purchases of intermediate maturities. In this analysis we highlight equity sector and industry observations during three steep curve regimes using Barra US Equity Model (USE3) data.

Publication: MSCI Research Bulletin
Authors: MSCI Applied Research

High fiscal deficits, a sharp rise in the issuance of sovereign debt from major developed economies, rising inflation expectations, and possible changes in central bank rates could cause the yield curves from around the world to change significantly. This poses challenges for fixed income professionals who need to address possible non-parallel changes to the term structure. This paper illustrates the capabilities of Shift-Twist-Butterfly (STB) factor models to help address these challenges. We provide a longer-term perspective on term structure changes in the Euro zone, US and Japan. Through four portfolio case studies, we show that the use of risk measures, such as duration, convexity or key rate durations, has limitations. These can be overcome by the complementary use of advanced fixed income risk models based on STB interest rate risk factors.

Publication: MSCI Barra Research Insight
Authors: ANAND Iyer, VANNEREM Philippe

In this paper, we examine the influences of risk aversion on various aspects of portfolio optimization.  Our main message is that the risk aversion parameters in the Barra Optimizer provide users with the flexibility to control or adjust the risk levels of their optimal portfolios.  They are valuable tools for portfolio managers to explore and customize their portfolio optimization results and investment processes.

Publication: MSCI Barra Research Insight, February 2010
Authors: LIU Scott, XU Rong

This paper describes a model for calculating spread values and effective durations of Danish mortgage-backed bonds. Mortgage backed bonds differ in various aspects from garden-variety bonds: In addition to interest rate risk, they are exposed to both borrower and bank credit risk, and to mortgage specific prepayment risk, i.e., the fact that some mortgagors prepay the principal of their loans ahead of schedule when it becomes financially advantageous for them to do so.

Publication: MSCI Barra Model Insights
Authors: CHEYETTE Oren, POSTLER Boris

In the last few years, at least two governments (Japan and France) have begun issuing floating rate bonds where the reference rate is a long-term yield – a 10 year bond yield in both cases.  For these long-term yield floaters, valuation methods for ordinary floaters do not work perfectly. This article describes issues related to modeling the volatility and exposures for these types of bonds.

Publication: MSCI Barra Model Insights
Authors: MSCI Barra

The European credit market, consisting mainly of euro and sterling denominated debt, is second only to the US domestic market in terms of size, influence and liquidity. Not surprisingly, European securities are becoming common in global portfolios. The recent turmoil in credit markets has shown once again that understanding risk is or should be a critical aspect of portfolio management. However, as the European credit market is a mosaic of widely different instruments, issuers, and currencies, identifying and forecasting the risk of European fixed income securities is not a simple task. This chapter will take the reader through the process of building a European risk model and discuss the important sources of risk in generic fixed income portfolios. Our intention is not to cover the whole spectrum of securities but to address some typical modeling challenges such as accommodating different benchmarks and securities, and providing a wide coverage without compromising accuracy. With a general framework in place, the model can be easily extended to cover more markets or bond types

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Authors: BREGER Ludovic

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Authors: CHEYETTE Oren

This paper provides a model for allocating capital and measuring performances for financial institutions. The methodology relates the economic valuation of the balance sheet to the market value of the firm. In so doing, each business unit is evaluated on an economic basis, and the capital allocated to these units is related to the risk premiums that the market demands. The paper's results have broad applications for corporate managers, risk managers, and other market participants in managing financial institutions to increase shareholders' value.

Publication: Research Paper
Authors: HO Thomas S.Y.

The Barra Cosmos System(tm) helps fixed income portfolio managers to manage portfolios, control risk, and develop portfolio strategies. Additionally, Cosmos-Japan offers money managers the capability of "stress-testing" their portfolios with their defined scenarios of changing term structure and sector/quality spreads. Finally, Cosmos-Japan in forms trading and hedging strategies required to maintain a portfolio's desired risk characteristics.

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Authors: KONDAMANI Arjun

Today's fixed income markets are characterized by complex instruments and increased volatility. In this  environment, bond portfolio management must increasingly rely on sophisticated models to accurately gauge fixed income risk. Building these models requires considerable sophistication. Using them, however, should be straightforward. A good model should simplify the investment process and  increase investor insight.

Publication: The Handbook of Fixed Income Securities
Authors: KAHN Ronald N.

With the release of the The Barra Cosmos System(tm) global bond model, many GLOBO users will be switching to the new system. Here we explain the basic design of the term structure and risk models underlying the Cosmos system, highlighting the similarities and differences between GLOBO and Cosmos. The beta version of Cosmos was released in early December 1995 with the product release date scheduled for early 1996. Comparative tests have borne out the fact that the core of the GLOBO and Cosmos models are quite similar. A GLOBO to Cosmos utility will provide for the easy transfer of portfolios from the old model to the new one.

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Authors: CARRICO Chad, CONKEY Peter, GOLDBERG Lisa, WRIGHT Eric

Valuation of mortgage-backed securities (MBSs) using option-theoretic methods presents some puzzles. First, the option-adjusted spreads (OASs) of passthroughs are significantly larger than the spreads of agency debt, even though they are comparable credits. Second, the OASs of interest-only (IO) and principal-only (PO) strips are typically very different from those of the passthroughs they were created from - IOs generally have large positive OASs while POs have negative OASs. These results are inconsistent with the no-arbitrage principles which underlie the valuation model. I argue in this paper that these puzzles arise from our failure to properly account for the market's pricing of risk due to unpredictable changes in prepayments unrelated to interest rate changes. I also demonstrate that it is possible to construct a prepayment model inferred purely from market prices of MBSs which, when used in a standard valuation model, automatically takes account of the market price of prepayment risk. A theoretical motivation is provided for the construction of this model.

Publication: The Journal of Portfolio Management
Authors: CHEYETTE Oren

Barra has developed a new model for forecasting prepayments of fixed rate agency mortgages. The purpose of this work was to improve the goodness-of-fit of our current model, and to strengthen our effective duration estimates for mortgage backed securities (MBS). This note describes the structure of  the new model, and compares it to the current model and to Street models.

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Authors: BLANTER Elena, CHEYETTE Oren, CHOI Sam

Adjustable Rate Mortgage-backed Securities (ARMS) are a large and increasingly popular segment of the U.S. bond market. On August 1, 1995, ARMS became a part of B2's database, and are now comprehensively modeled for risk and valuation analysis. The three general thrusts of this paper will be to: Give an overview of the ARMS market; Describe some of the structural properties of ARMS, and; Illustrate some of B2's functionality related to this new asset class.

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Authors: CHOI Sam

Barra, in association with RBC Dominion Securities, Inc. of Canada, released on December 6, 1993 a new Canadian fixed-income index, the DS Barra Canadian Bond Market Index. The new index provides the investment community with a benchmark that isfair, accurate and replicable and represents the investable fixed-income market in Canada. Because the constituents are known, the DS Barra Canadian Bond Market Index and sub-indices will allow portfolio managers to perform analyzes and test strategies more easily and efficiently than ever before.

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Authors: MARTIN Eric

Neural nets have gained wide publicity over the past few years through their application to a spectrum of investment problems. Called by John Denker "the second best way of doing just about anything," neural nets have proven themselves to be a powerful analytic tool in problems involving high signal-to-noise ratios. But in  problems of low signal-to-noise ratios, in particular the search for investment strategies, their applicability is controversial.

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Authors: BASU Archan, KAHN Ronald N.

Option-based valuation is essential to understanding the analysis of fixed-income securities with embedded options. The product of option-based valuation, option-adjusted spread, is now commonly used to understand the characteristics of one type of fixed-income security with embedded options, collateralized mortgage obligations. The author provides examples of the application of OAS analysis to CMOs and suggests a solution to the puzzle of large IO/PO strip OASs.

Publication: The Journal of Portfolio Management
Authors: CHEYETTE Oren

Barra's fixed-income Performance Attribution program (PERFAT) explains portfolio return due to changes in the term structure as a combination of returns from three basic, intuitive term structure movements. A shift is the parallel movement of the curve, a twist is the steepening or flattening of the curve, and a butterfly is the reshaping of the curve. (Barra's Portfolio Risk Characterization program (PORCH) quantifies portfolio risk from each type of movement.) Shift, twist and butterfly provide a powerful intuitive framework for thinking about  term structure risk and return. Results show that our definitions of the shapes of these movements and our methodology for estimating the magnitudes of  the movements allows them to capture a significant portion of each month's term structure change.

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Authors: DAVIS Mark

This paper provides a look at the theoretical underpinnings of Barra's Nikko/Japanese Convertible Bond Model. The model begins with the Barra/Nikko Japanese Government Bond (JGB) Model and the Black-Scholes stock option model, and empirically extends these models to fit the observed features of the Japanese CB market. The empirical extensions include a model of corporate bond yield spread, a model of CB implied volatility dependent on parity and maturity, and an explicit liquidity premium. The Barra/Nikko Japanese Convertible Bond Model is easy to use, even though its quantitative components are quite sophisticated and complex.

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Authors: MATSUMAE Toshi

The authors examine the many risk factors operating in the rapidly transforming Canadian bond market. They also present a multifactor risk model of the Canadian bond market, which provides a quantitative, accurate, and intuitive framework for analyzing Canadian bond portfolio risk.

Publication: Journal of Portfolio Management
Authors: GULRAJANI Deepak, KAHN Ronald N.

CMOs were created to address prepayment risks inherent in a mortgage. Of the various tranches, planned amortization class (PACs) are carved out of a CMO deal in such a way so as to provide the most stability and certainty of cash flows. As a result, most investors think of PACs as straightforward tranches with minimal call and extension risk. Although most PACs are fairly secure, it is useful to be aware of the features of the deal structure that could have a  significant impact on performance.  In this article we will first look at the commonly used measures for predicting the behavior of  PACs, namely, PAC structuring ranges and effective PSA collars. Next, we will illustrate the idea of interest rate collars as a better measure for characterizing the prepayment risks inherent in a PAC. We will then explore some features of the deal structure that affect the performance of a PAC. We will establish the need for thorough analysis within the context of  the whole deal, for even straightforward tranches like PACs, to account for tranche                            interdependencies in complex deals.

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Authors: BHANSALI Roveen

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Authors: ALGERT Steve, LEVERONE Mike

Performance analysis focuses on the central goal of investment management: achieving superior                                         performance. A rigorous multi-factor approach to bond analysis can identify sources of fixed-income return,  estimate their statistical significance, and analyze manager skill and value added.

Publication: The Journal of Portfolio Management
Authors: KAHN Ronald N.

Floating rate notes, or "floaters," are bonds whose coupon is tied to a prevailing interest rate, such as the six-month T-bill rate. Since their coupon is not fixed, they offer investors a  unique tool to control risk and return  In particular, floaters offer a long stream of cash flows with low duration (term structure risk exposure). Many, such as mortgage-backed floaters, offer a higher yield than a comparable short-term security while maintaining high quality. Finally, floaters allow an investor to take on active spread bets while taking on little or no term structure risk. To benefit from these attributes, an investor must understand the nature of floaters from their simple form (the default-free floater) to the more complex (floaters with a corporate spread).

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Authors: MITROFF Andrea

How much of a particular portfolio's return was due to term structure changes such as parallel shifts, twists,  and butterflies? What share of return resulted from changes in sector and quality spreads? These questions are important both to pension fund sponsors, who must evaluate their managers, and to managers striving to improve their investment strategies. This paper presents the theoretical underpinnings of bond performance analysis and analyzes the significance of returns attributed to investment factors. We illustrate the practical side with the following case study, which shows the application of bond performance theory as represented by Barra's PERFAT (Performance   Attribution) program. We used PERFAT, an application of our U.S. Fixed Income Model, to generate a report for a sample portfolio.

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Authors: DAVIS Mark

When constructing portfolios, institutional investors typically think of mortgages in terms of "generics," (aggregations of large numbers of mortgage pools by coupon and issue year). Mortgage valuation has similarly been centered on generics. But investors cannot purchase generics; they can only purchase the individual mortgage pools. How closely can mortgage pools track generics?(1) Little work has been done in this area, but we  have conducted some preliminary research into the interesting questions surrounding this  subject. What is the relationship between pool-specific prepayment and return? How can we measure pool-specific risk, or how closely will the return to a mortgage pool track the generic? What is the best way to track a generic? And can we find factors that forecast the differences in future prepayment of pools within a generic?

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Authors: MULLER Peter

The argument that convexity can generate exceptional return assumes that the term structure always shifts in parallel. This article examines whether the deviation from  the parallel shift assumption is sufficient to negate this conclusion. The analysis used in this article is return attribution analysis, a technique long used to analyze equity returns.

Publication: Journal of Portfolio Management
Authors: KAHN Ronald N., LOCHOFF Roland

What's a Bond Beta? Barra's Portfolio Risk Characterization (PORCH) program reports both an individual bond's and a portfolio's beta. What does it mean? Why use Beta?

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Authors: LOCHOFF Roland

This article describes a valuation technique for callable bonds and sinking funds. In this article, we do not consider refinancing costs; however (1) their effect on the bond price is small, and (2) we can make a good first order approximation as to their effect on price without having to consider them in the estimation process. In Part II, which will appear in next month's Barra U.S. Newsletter, we will explain how the risk associated with calls and sinking funds can be estimated.

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Authors: Source: Barra Newsletter

This article illustrates the importance of the term structure method by presenting three term structure estimation examples, with particular emphasis on the key questions of closeness of fit and robustness. These examples involve different ultimate goals, and hence different setups and techniques.

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Authors: Source: Barra Newsletter

This article discusses several considerations involved in estimating U.S. Treasury term structures by comparing the concept of the Treasury term structure to the traditional Treasury yield curve, and addresses important considerations behind choosing a term structure estimation procedure. We also discuss the central role the term structure of interest rates plays in U.S. Treasury market analysis.

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Authors: Source: Barra Newsletter

One number does not a portfolio make. Barra has long advocated that the beta of a portfolio is a far better measure of a portfolio's risk relative to a benchmark than the relative durations of the portfolio and the benchmark.

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Authors: Source: Barra Newsletter

In the May 1989 Barra U.S. Newsletter ("A Barra View of Active Management"), we began a series on active management by talking about utility as the key concept in Barra's approach to this management style. We took as an example a highly quantitative manager using a dividend discount model as their sole source of active management information. This month, we use a completely different manager style as an example. This month's manager does not quantify judgements in terms of expected returns. We consider this manager to be non-quantitative in the sense that their judgements are expressed in a non-quantitative fashion. Will a manager with a non-quantitative way of expressing their views be able to build improved portfolios by increasing utility?

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Authors: Source: Barra Newsletter

Convertible bonds are an important and exciting segment of the Japanese financial markets. Issuance is rapidly increasing and secondary market trading volume is very high. Barra is now actively studying the particular features and inherent risks and returns of this market, as well as investigating how to analyze value and risk in Japanese convertible bonds.

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Authors: Source: Barra Newsletter

A popular technique in the fixed income world is linking the percentage price change of a bond (for a given change in yield) to the bond's duration and convexity. This technique makes use of a Taylor series expansion and the idea that duration and convexity are variants of the first and second derivatives of the valuation equation. Much has been made elsewhere of the drawbacks of using duration and convexity as the only measures of a bond's risk, or even as measures of the bond's interest rate risk. This article explores the paradoxes that arise in modelling optionable bonds and the representation of price changes through a Taylor series expansion.

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Authors: Source: Barra Newsletter

Three previous Newsletter articles summarized sessions of our October, 1987, Fixed Income Seminar. One focused on Barra's Japanese Bond Model, one highlighted our improved methods of valuing call options, and one discussed securitization. This article continues the series with an examination of some of the questions associated with term structure estimation and discuss Barra's current research in this area.

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Authors: Source: Barra Newsletter

A substantial proportion of pension portfolios worldwide are invested in bonds. This large allocation clearly indicates that sponsors should carefully scrutinize the risk and monitor the returns of their bond positions. Unfortunately, bond portfolios are not as simple to analyze as they once were. Investment in more complex instruments has caused considerable problems for both sponsors and money managers. One reason for this is that the traditional tool for analyzing bond portfolios, duration, is less effective in volatile environments and when bonds have embedded options. A more direct approach -- the use of a multiple-factor model – is described here in the context of an immunization strategy. The multiple-factor model is shown to directly solve many of the shortcomings of the traditional approaches.

Publication: Investing Management Review
Authors: RUDD Andrew