Role of Fixed Income in a Portfolio

Fixed income is also known as debt securities. It is one of the largest financial markets globally, alongside real estate. The fixed-income market has various segments based on credit qualities. It includes types of interest rate agreements: fixed vs. floating. Different types of bonds are present, such as straight bonds and bonds with embedded options. The market also includes various prepayment structures. Additionally, it distinguishes between private and public sector instruments, including government and corporate bonds.

Role of Fixed Income in a Portfolio

Fixed income plays a crucial role in a portfolio for various reasons:

1. Diversification: Generally, fixed income has a low correlation with equity markets. According to modern portfolio theory, combining assets with less-than-perfect correlation benefits diversification. However, it's important to note that different fixed-income market segments have varying correlations with equity markets. During financial turmoil, these low correlations can shift towards +1 as most fixed-income investors sell their riskier assets simultaneously, leading to a phenomenon known as “flight to quality.” Despite this, fixed income's diversification benefits remain significant.
2. Regular cash flows: As the name suggests, fixed-income securities often provide regular cash payments, known as coupons. These regular cash flows benefit retirees or investors relying on portfolio returns to meet ongoing expenses. Moreover, insurance firms and pension funds also benefit from fixed income's regular cash flows since they require periodic payments to policyholders and beneficiaries to fund lifestyle or basic living expenses.
3. Inflation hedge: The extent to which fixed-income instruments protect against rising costs depends on the investment's structure. Nominal, fixed-rate coupon bonds provide no inflation protection, as they continue to pay the same dollar cash flow periodically, regardless of the changing purchasing power of those dollars. On the other hand, inflation-linked and floating coupon bonds offer investors some degree of protection against unexpected inflation. These three fixed-income instruments are theoretically priced similarly based on expected inflation. However, when actual inflation differs from expected inflation, various bond types yield different returns and volatilities.

By understanding the role of fixed income in a portfolio and its diverse benefits, investors can make well-informed decisions to create balanced and effective investment strategies.

Inflation Hedging Potential of Fixed Income Bonds

$$ \begin{array}{c|c|c}
\textbf{Type of Bond} & \textbf{Coupon Payment} & \textbf{Principal} \\ \hline
\textbf{Inflation-linked} & {\text{Adjusted (Protected} \\ \text{against inflation)}} & {\text{Adjusted (Protected} \\ \text{against inflation)}} \\ \hline
\textbf{Floating coupon} & {\text{Adjusted (Protected} \\ \text{against inflation)}} & {\text{Static (Unprotected} \\ \text{against inflation)}} \\ \hline
\textbf{Fixed coupon} & {\text{Static (Unprotected} \\ \text{against inflation)}} & {\text{Static (Unprotected} \\ \text{against inflation)}} \end{array} $$

The table above presents different bond types categorized by their inflation-adjustment mechanisms. Inflation-linked securities offer the highest level of protection, as both their coupon payments and par value are adjusted to accommodate inflation. On the other hand, floating coupon bonds only adjust their coupon payments in response to varying inflation environments, providing less protection. Fixed coupon bonds, however, do not offer any protection against inflation.

Regarding returns, inflation-linked instruments perform better when actual inflation surpasses expected inflation. Conversely, fixed coupon bonds deliver superior performance when actual inflation is lower than expected inflation.

Fixed Income Mandates

Mandates describe policies or directives at a high level. In the context of fixed income, mandates describe how a portfolio is managed and the approach used in the portfolio paradigm.

Liability Based Mandates

In liability mandates, the portfolio achieves immunization when a predetermined cash outflow is counterbalanced by owning a fixed-income security that theoretically matches the outflow with its inflow into the portfolio. Several types of immunizing strategies exist:

Cash Flow Matching

This strategy involves creating a portfolio that mirrors a planned outflow schedule in timing and size. For instance, if a payment is expected at the end of the month, a bond will be owned to provide equal cash inflow simultaneously, perfectly offsetting the liability. Cash flow matching is the simplest immunization form and is usually the easiest to understand intuitively.

Duration Matching

Duration matching focuses on balancing the liability and asset portfolios so that a change in interest rates will have an equal impact on both. This goal is achieved when the duration of the two portfolios is equal.

Contingent Immunization

This technique starts with a surplus, which is the difference between the present value of the assets and liabilities in the portfolio. If the surplus is positive, the portfolio manager can actively manage the portfolio for excess returns while ensuring full payment of all liabilities. However, if the surplus disappears, active management stops, and the portfolio must be immediately immunized.

Horizon Matching

Horizon matching combines two previous techniques. Short-term liabilities are cash flow matched, while longer-term liabilities are duration-matched. Cash flow matches have less variability but may be slightly costlier due to their precise matching criteria. On the other hand, duration matching offers more flexibility and is expected to be more cost-effective for the portfolio. However, it's important to note that duration matches are not perfect. They lack the convexity effect required for exact matches in small interest rate movements.

Total Return Mandates

Total return mandates differ from seeking to fulfill specific liabilities as they become due. Instead, they focus on evaluating the portfolio's performance relative to a benchmark. The performance is measured through active return and active risk.

$$ \textbf{Active return} = \text{Portfolio return} – \text{benchmark return}. $$

$$ \textbf{Active risk} = \text{Standard deviation of the active return.} $$

Pure Indexing

Pure indexing aims to replicate the performance of a bond index, but achieving a perfect match is often impractical due to bond market illiquidity. Instead, the focus is on minimizing tracking risk. As a result, most portfolios seek to match the risk factors of the underlying index rather than its exact composition.

Enhanced Indexing

Enhanced indexing is similar to pure indexing but permits slight deviations from the benchmark, incorporating a small amount of active management.

Active Management

Active management allows for substantial deviations from the benchmark, giving the portfolio manager significant flexibility in selecting investments. The primary objective of active management is to enhance returns.

Question

Which of the following most accurately describes an inflation-linked bond?

1. Coupon payment: adjusted; par value: unadjusted.
2. Coupon payment: unadjusted; par value: adjusted.
3. Coupon payment: adjusted; par value: adjusted.

Solution

The correct answer is C:

Choice C correctly describes an inflation-linked bond. The coupon payments and the par value are adjusted for inflation in such bonds. This adjustment ensures that the purchasing power of the bondholder is preserved in an inflationary environment.

$$ \begin{array}{c|c|c}
\textbf{Type of Bond} & \textbf{Coupon Payment} & \textbf{Principal} \\ \hline
\textbf{Inflation-linked} & {\text{Adjusted (Protected} \\ \text{against inflation)}} & {\text{Adjusted (Protected} \\ \text{against inflation)}} \\ \hline
\textbf{Floating coupon} & {\text{Adjusted (Protected} \\ \text{against inflation)}} & {\text{Static (Unprotected} \\ \text{against inflation)}} \\ \hline
\textbf{Fixed coupon} & {\text{Static (Unprotected} \\ \text{against inflation)}} & {\text{Static (Unprotected} \\ \text{against inflation)}} \end{array} $$

A is incorrect. It suggests that the coupon payments are adjusted for inflation, but the par value remains unadjusted. This is not an accurate description of an inflation-linked bond. The coupon payments and the par value are typically adjusted for inflation in these bonds.

B is incorrect. It indicates that coupon payments are not adjusted for inflation, but the par value is adjusted. This is also an inaccurate description of an inflation-linked bond because, in reality, both the coupon payments and the par value are adjusted for inflation.

Portfolio Construction: Learning Module 2: Overview of Fixed-Income Portfolio Management; Los 2(a) Discuss roles of fixed-income securities in portfolios and how fixed-income mandates may be classified