Estimated study time: 45 minutes
Content:
Fixed income portfolio management at Level 3 requires integrating rate views, credit analysis, and portfolio construction across multiple dimensions of risk: duration, yield curve shape, credit spread, currency, and liquidity. Managers must construct portfolios relative to a benchmark — typically the Bloomberg US Aggregate or a customized liability benchmark — while managing tracking error, maintaining liquidity, and implementing interest rate views.
Duration management is the primary lever for expressing interest rate views. Modified duration measures the percentage price change per 1% change in yield. Dollar duration (DV01) measures the dollar change per 1 basis point change in yield. Portfolio duration is the market-value-weighted average of individual security durations. A manager who expects rates to fall will extend portfolio duration above the benchmark (buy longer-duration bonds); a manager who expects rates to rise will shorten duration (shift to shorter maturities, increase cash, or use interest rate futures/swaps to reduce effective duration).
Yield curve strategies go beyond parallel shifts. A bullet portfolio concentrates holdings around a single maturity point; a barbell portfolio combines very short and very long maturities; a ladder portfolio distributes holdings evenly across maturities. The relative performance of these structures depends on the shape of yield curve movements. Bullet portfolios outperform when the yield curve flattens at the concentrated maturity point. Barbell portfolios outperform when the yield curve humps (intermediate rates rise relative to short and long ends) — the barbell avoids the intermediate maturity point. Ladder portfolios provide stable income and reinvestment diversification.
Credit strategies involve moving up or down the credit quality spectrum based on spread expectations. Investment-grade credit spread tightening benefits portfolios overweighted in corporates. High-yield bonds add return potential but introduce default risk, liquidity risk, and correlation with equities. Credit analysis at the portfolio level must assess sector concentration, issuer concentration, and covariance of credit spreads — particularly important in stress scenarios where spreads across all credit sectors tend to widen simultaneously.
Managing fixed income portfolios relative to a liability benchmark (LDI context) requires matching asset cash flows to liability cash flows. Cash flow matching is the most conservative approach — buying bonds that pay exactly when liabilities are due. Duration matching (immunization) is more flexible and allows a broader investment universe. Immunization requires not just duration matching but also convexity matching and low dispersion of cash flows — these conditions ensure the portfolio holds up if the yield curve shifts non-parallel.
Key Terms:
Quiz Questions:
Q1. A fixed income manager expects the yield curve to steepen (long-term rates rising more than short-term rates). To benefit from this view, she should:
A) Extend duration by adding long-maturity bonds B) Shorten duration by selling long-maturity bonds and buying short-maturity bonds C) Build a bullet portfolio concentrated at the 10-year point D) Increase credit spread exposure to offset duration losses
Answer: B — When the yield curve steepens (long rates rising), long-duration bonds suffer the most in price. To benefit from (or at minimum, protect against) this move, the manager shortens duration — selling longs and buying shorts. A barbell would also suffer on the long end; shortening is the more direct way to position for curve steepening.
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Q2. A pension fund manager is choosing between a bullet portfolio and a barbell portfolio, both with identical duration. The pension fund's actuary predicts that intermediate rates (5-7 years) will rise more than short or long rates. Which structure performs better under this view?
A) The bullet portfolio, because it avoids short maturities B) The barbell portfolio, because it avoids the intermediate maturity segment where rates are rising most C) Both perform identically since they have the same duration D) The ladder portfolio, which distributes risk across all maturities
Answer: B — When intermediate rates rise disproportionately (a "humped" or "butterfly" yield curve move), the barbell portfolio outperforms because it avoids the intermediate segment. Same duration does not mean same performance for non-parallel yield curve shifts — the distribution of cash flows around that duration point matters greatly.
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Q3. A bond portfolio manager wants to reduce effective duration from 7.0 years to 5.0 years without selling bonds. The most cost-effective way to accomplish this is:
A) Buy call options on bond futures B) Sell interest rate futures contracts to reduce effective duration C) Purchase floating rate notes to replace fixed-rate bonds D) Increase the portfolio's allocation to high-yield bonds
Answer: B — Selling interest rate futures (short futures) reduces effective portfolio duration cost-effectively without requiring the sale of underlying bonds. Each futures contract sold reduces the portfolio's DV01 by a calculable amount. This is the standard tool for duration management in institutional fixed income portfolios.
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Q4. A corporate bond has a modified duration of 6.0 years, a spread duration of 5.8 years, and a credit spread of 120 basis points. If credit spreads widen by 50 basis points, the approximate price change from spread widening alone is:
A) −3.0% B) −2.9% C) +2.9% D) −0.6%
Answer: B — Price change from spread widening = −(Spread Duration) × (Change in Spread) = −5.8 × 0.50% = −2.9%. Spread duration, not modified duration, is the relevant sensitivity for credit spread changes.
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Q5. Under a cash flow matching strategy for a defined benefit pension plan, the manager:
A) Matches the portfolio's modified duration to the liability duration and rebalances quarterly B) Selects individual bonds whose coupon and principal payments match each liability payment date exactly C) Invests the full portfolio in zero-coupon Treasury bonds maturing in 15 years D) Uses interest rate swaps to convert floating liability payments to fixed
Answer: B — Cash flow matching is the most literal LDI strategy: bonds are selected so their cash flows (coupons + principal) arrive exactly when each liability payment is due. This eliminates reinvestment risk and interest rate risk for the matched cash flows. It is distinct from duration matching, which requires duration equality but allows the underlying cash flows to differ.
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