G I O A MARCH 2009 FIXED INCOME BOOT CAMP. Kevin Webb, CFA. Sr. Vice President. Cantor Fitzgerald

Transcription

1 G I O A MARCH 2009 FIXED INCOME BOOT CAMP Kevin Webb, CFA Sr. Vice President Cantor Fitzgerald

2 Assumptions There are no free lunches: - You must take more risk to obtain possibility of more reward. Optimize, not Maximize: - Will try to find the best risk-adjusted answers. Use all of the available data: - Will draw conclusions with all data that is available. Selfishness is good: - An invisible hand can lead selfishness to be productive. Opportunity Costs are real costs: - Decisions can have costs in the form of money you didn t earn. Intuition to informed decisions: - Will use models to move to more informed decision making.

3 Build A Model What is a Model? Definition: A simplified representation (usually mathematical) used to explain the workings of a real world system or event.

4 Build A Model Why a Model? Intuition to informed decision: The theory of economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions Keynes, J. M Introduction to Cambridge economic handbooks. In D. H. Robertson,ed. Money. London and Cambridge: Cambridge Economic Handbooks.

5 Build A Model Which Type of Model? Experimental Model Mathematical- Statistical Model Visual Model

6 Example The Monty Hall Paradox

7 Intuition Good or Bad? The Monty Hall Paradox: Suppose you re on a game show, and you re given the choice of three doors. Behind one door is a car, behind the others, goats. You pick a door and the host reveals another door that has a goat. the host asks if you wish to switch to the remaining unrevealed door. should you switch? Marilyn Vos Savant, The Power of Logical Thinking (St. Martin s Press/New York,1996), p.6.

8 What are the odds? ODDS OF GETTING CAR? DOOR #1 DOOR #2 DOOR #3

9 What does intuition tell you the odds are now? Odds of getting car if you Switch to Door #2? You Pick Door #1 DOOR #2 MONTY REVEALS GOAT

10 Monty Hall Paradox: Spreadsheet Model

11 Monty Hall Paradox: Visual model You Pick Door #1 DOOR #2 Set 1 contains only the Door you picked which is 1/3 of the total doors. If you switch, set 2 contains the door you switch to and the door that Monty revealed. This MONTY REVEALS GOAT gives you 2/3 of the total doors.

12 Topic 1 The Book Yield / Total Return Paradox

13 Book Yield or Total Return? What is the paradox? A paradox between book yield and total return can exist when the portfolio is focused on providing a stable income with a focus on principal preservation but at the same time the performance of the portfolio is being judged on a total return basis. How to manage the portfolio? it s a paradox...

14 Book Yield or Total Return (A Mental Framework) Investment Philosophy Will Determine Investment Strategy If you do not act according to the way you think then you will soon think according to the way that you act. *Performance Measurement: Each can lead to different investment strategies. *Sector Allocations: The differing investment strategies can lead to very different sector allocations.

15 Book Yield or Total Return which one...depends? HAVE TO ANSWER A FEW QUESTIONS: (1) do you need growth or income? (2) Are you a trader or investor? (3) which one is more consistent with your investment policy?

16 Book Yield or Total Return (1) Growth or Income? *Do you need to spend the coupons? *Do you need to forecast a budget? *how much budget volatility can you and/or your portfolio tolerate?

17 Book Yield or Total Return (2) Trader or Investor? *Trader invests in a bond with the intention of selling before maturity to profit from a change in price. *investor seeks to take advantage of market & structure premiums. does not intend to sell before maturity to profit from a price movement in the bond.

18 Book Yield or Total Return (3) Investment Policy? *... not for speculation, but for investment, considering the probable safety of their capital as well as the probable income to be derived." * Safety of principal is the foremost objective of the investment program. Note: Taken from the GFOA Sample Investment Policy 2003 available at SampleInvestmentPolicy.pdf

19 Total Return Facts Total Return = Return from Income (Cpns & Interest-on-Interest) +/- Return from Principal For Fixed Income Indices the Return from Income is stable while Return from Principal is volatile & can be negative. For Fixed Income Indices it is assumed that all coupons are reinvested into the benchmark (i.e. not spent).

20 Total Return Breakdown Broken into 2 Parts: Total Return is broken down as follows: (1) Return from income and interest (2) return from changes in price Source: Bloomberg.

21 Total Return Breakdown 2Yr Bellwether Treasury Dec 88 to Feb 09 ANNUALIZED TOTAL RETURN = / < % ANNUALIZED COUPON RETURN = / <0 0.0% ANNUALIZED PRICE RETURN = / < % Note: Data is from Merrill Lynch GA02. Total Return Price Return Coupon Return

22 Total Return Breakdown 2Yr Bellwether Treasury June 01 to Feb 09 ANNUALIZED TOTAL RETURN = / <0 2.15% ANNUALIZED COUPON RETURN = / <0 0.0% ANNUALIZED PRICE RETURN = / < % Total Return Price Return Coupon Return Note: Data is from Merrill Lynch GA02.

23 Approximating book yield with index data Book Yield Approximation: * Using the 12 month moving average of the yield to maturity for an index is a close approximation for the coupon portion of the total return. * 12 month moving average closely captures the reality of a yearly budget cycle.

24 Approximating Book Yield Yr Bellwether Treasury Dec 88 to Feb 09 Coupon Return Avg = 5.18 Coupon Return StDev = 1.93 Yld12MoAvg Avg = 5.16 Yld12MoAvg StDev = Note: Data is from Merrill Lynch GA02. Total Return Price Return Coupon Return Yld12MoAvg

25 Total Return Breakdown Yr Bellwether Treasury June 01 to Feb 09 Coupon Return Avg = 3.34 Coupon Return StDev = 1.15 Yld12MoAvg Avg = 3.68 Yld12MoAvg StDev = Note: Data is from Merrill Lynch GA02. Total Return Price Return Coupon Return Yld12MoAvg

26 THE NUMBERS OF THE PARADOX SPENDING ANALYSIS: * USE PREVIOUS 12 MONTH MOVING AVERAGE OF YIELD AS BUDGET FORECAST FOR THE NEXT YEARS BUDGET. * RUN PORTFOLIO ON TOTAL RETURN BASIS AND MEET MONTHLY BUDGET REQUIREMENT. * LOOK AT ALL POSSIBLE 12 MONTH PERIODS & EXAMINE THE RESULTS.

27 THE NUMBERS OF THE PARADOX Analysis Results: 12/31/88 TO 02/29/09: NUMBER OF OBSERVATIONS = 231 HOW OFTEN PRINCIPAL INVADED = 94 / 40% 06/30/01 TO 02/29/09: NUMBER OF OBSERVATIONS = 93 HOW OFTEN PRINCIPAL INVADED = 35 / 37%

28 THE NUMBERS OF THE PARADOX Which Return? Time Weighted Return: is the rate of return that determines the ending value of our initial investment assuming no interim cash flows(*). the performance of the manager. Dollar Weighted Return: is the rate of return that measures how our cumulative contributions grow over the period(*). The return experienced by the investor. Accounts for cash flows. Budget Return: it s not the return on my investment but the return of my investment. * The Portable Financial Analyst, Mark Kritzman, isbn , copyright 1995, pgs

29 Date Monthly Return Income/ Growth Expenses Net Cash Flow Ending Dollars 12/31/05 1, /31/ % $1.62 $3.25 ($1.63) /28/ % $0.49 $3.25 ($2.76) /31/ % $0.96 $3.25 ($2.28) /30/ % $3.00 $3.25 ($0.25) /31/ % $1.05 $3.25 ($2.20) /30/ % $1.45 $3.25 ($1.80) /31/ % $7.29 $3.25 $ /31/ % $7.13 $3.25 $ /30/ % $5.11 $3.25 $ /31/ % $3.84 $3.25 $ /30/ % $5.04 $3.25 $1.79 1, /31/ % $0.26 $3.25 ($2.99) TOTALS $37.24 $38.98 ($1.74) (0.17%) Note: Data is from Merrill Lynch GA02.

30 Date Monthly Return Time Wgtd Rtn Dollar Wgtd Rtn 12/31/05 (1,000.00) 1/31/ % /28/ % /31/ % /30/ % /31/ % /30/ % /31/ % /31/ % /30/ % /31/ % /30/ % /31/ % TOTALS 3.81% 3.46% Note: Data is from Merrill Lynch GA02.

31 Seek to optimize, Not Maximize The Sharpe Ratio: Total Return(Index) - Risk Free Return S.R. = Standard Deviation(Index) Where, Index is the return we want to risk adjust; Risk Free is usually the 3mo tbill return.

32 Sharpe Ratio Analysis Annualized Total Return StdDev of Total Return 3Mo Tbill Sharpe Ratio 6Mo TBill Yr Tsy Yr Tsy Yr Tsy Yr Tsy Note: Data is for Time period Dec88 to Feb09 Note: Data is from Merrill Lynch GA02.

33 Seek to optimize, Not Maximize Modified Sharpe Ratio: 12MoAvgYld(Index) - 12MoAvgYld(RFR) S.R. = Effective Duration(Index) Where, Index is the return we want to risk adjust; RFR is the Risk Free Rate; & Risk Free Rate is usually the 3mo tbill return.

34 Modified Sharpe Ratio Analysis Avg of all 1YrAvg Yields Duration 3Mo Tbill Modified Sharpe Ratio 6Mo TBill Yr Tsy Yr Tsy Yr Tsy Yr Tsy Note: Data is for Time period Dec88 to Feb09 Note: Data is from Merrill Lynch GA02.

35 Book Yield / Total Return Allocation Paradox Look at 3 strategies: (1) GASB 31: To avoid GASB 31 losses keep the portfolio short. Will use 3Mo Tbill as a proxy with 0.25 duration. (2) Market Rate of Return: Will focus on Book Yield and use the Yld12MoAvg as proxy for optimal allocation for a 2Yr duration. (3) Total Return: Will focus on total return and find optimal allocation for a 2Yr duration.

36 GASB 31 & Market Rate of Return Note: Data is from Merrill Lynch Indices.

37 GASB 31 & Market Rate of Return Note: Data is from Merrill Lynch Indices.

38 GASB 31 & Market Rate of Return Note: Data is from Merrill Lynch Indices.

39 GASB 31 & Market Rate of Return Note: Data is from Merrill Lynch Indices.

40 Total Return & Market Rate of Return Note: Data is from Merrill Lynch Indices.

41 Total Return & Market Rate of Return Note: Data is from Merrill Lynch Indices.

42 Total Return & Market Rate of Return Note: Data is from Merrill Lynch Indices.

43 Total Return & Market Rate of Return Note: Data is from Merrill Lynch Indices.

44 Book Yield / Total Return Paradox Conclusions What can we say? * for book yield space: - income from portfolio is the focus - Principal volatility to be minimized - higher allocation to callable structures - Duration avg of 2Yr is optimal * for total return space: - Growth is the focus - Principal volatility is expectable - higher allocation to bullet structures - duration avg of 2Yr is optimal

45 Topic 2 Every Model for Fixed Income starts with a bond

46 Build a Bond Model

47 Preparing Excel Things to Do & Know 1st: #1: Load Add-ins & Adjust Macro Security - Analysis ToolPak/Analysis Toolpak-VBA - Solver Add-in #2: Useful Functions - Financial Functions - Lookup functions #3: Importance of Named Ranges #4: Decide on information we need

48 Load the Add-ins

49 Macro Security Level setting

50 Functions to know COUPONCD: Returns Next Coupon Date YIELD: Returns the Yield on a bond PRICE: Returns the Price of a bond MDURATION: Returns the modified duration YEARFRAC: Returns # of years between 2 dates ACCRINT: Returns accrued interest on a bond TODAY(): Returns todays date INDEX: returns value of a cell in an array MATCH: returns relative position within array VALUE: converts text # to calculable # LEN: Returns # of characters in text string MID: returns specific section of a text string FIND: finds location of text within other text

51 Named Ranges? Excel references cells with letters and numbers making formulas hard to decipher. Standard way: ACCRINT(b18, b8, b26, b6, b4, b9) Using named ranges: ACCRINT(IssueDate, FirstCouponDate, TODAY(), Coupon, ParAmount, CouponFreq) Note: Create named ranges before entering your formulas!!!

52 What information do we need to build a bond model? Bond Information: - COUPON RATE, MATURITY DATE, CALL DATE?, CUSIP, ETC. Purchase Information: - PURCHASE DATE, PURCHASE PRICE, PURCHASE YIELD, ETC. Book Information: - CURRENT BOOK VALUE, GAIN/LOSS, BOOK PRICE, ETC. Market Information: - CURRENT BID PRICE, BID YIELD, ACCRUED INTEREST, MARKET RATES, ETC. Where do we get current Market Rates From? How?

53 Excel Web Queries Excel Web Queries allow you to pull information from web pages directly into excel. the web pages that work best are usually those with pre-formatted areas. There are many places to pull market rate data. a useful one is the following link:

54 Create a New Web Query Enter the Web Address & Select Your data Note: Bonds are for illustrative purposes only.

55 Setup the New Web Query Properties Select location and make sure data is set to refresh regularly.

56 Raw query results may need to be cleaned up

57 Recommended Reading Financial Modeling by Simon Benninga Chapter 20: Duration Chapter 22: Modeling The Term Structure Chapter 23: Calculating Default-Adjusted Bond Returns Chapter 29: Excel Functions Chapter 30: Some Excel Hints Chapter 31-35: Excel Visual Basic for Applications Mastering Financial Mathematics in Microsoft Excel by Alastair L. Day Chapter 2: Basic Financial Arithmetic Chapter 3: Cash Flows Chapter 4: Bond Calculations Chapter 5: Bond Risks Chapter 16: Basic Statistics

58 Recommended Reading The Portable Financial Analyst by Mark Kritzman Chapter 1: The Noble Prize Chapter 3: Utility Chapter 5: Return & Risk Chapter 7: Duration & Convexity Chapter 8: The Term Structure of Interest Rates Quantitive Analysis of Bond Portfolios by Bruce Phelps, et. al.

59 Recommended Reading Excel Hacks by David & Raina Hawley Chapter 3: Naming Hacks Chapter 5: Charting Hacks Chapter 6: Hacking Formulas and Functions Chapter 7: Macro Hacks Chapter 8: Connecting Excel to the World The Power of Logical Thinking by Marilyn Vos Savant Chapter 1: Lessons Set in Everyday Life (Monty Hall!) Chapter 2: Lessons Set in Dollars

60 Recommended Reading Against The Gods - The Remarkable Story of Risk by Peter L. Bernstein Being Logical - A Guide to Good Thinking by D. Q. McInerny

61 Recommended Reading Winning the Loser s Game by Charles D. Ellis The Politics of Public Fund Investing - How to Modify Wall Street to Fit Main Street by Ben Finkelstein

62 Conclusion *Technology Is meant to free, not enslave. *Excel allows efficient capital for labor substitutions. *With these basic tools and techniques you can build even more impressive models and problem solving spreadsheets!!!

63 Disclaimer Information herein has been obtained from sources believed to be reliable, but Cantor Fitzgerald and Co. and its af:iliate companies (collectively Cantor Fitzgerald ) do not warrant its completeness or accuracy. This document is not an offer or solicitation for the purchase or sale of any securities or :inancial instruments. The information herein has been prepared solely for informational purposes and is not an offer to buy or sell any security or instrument or to participate in any trade strategy. No representation or warranty can be given with respect to the accuracy or completeness of the information herein, or that any future offer on securities, instruments or transactions will conform to the terms hereof. Securities or :inancial instruments mentioned herein may not be suitable for some investors. Cantor Fitzgerald may have positions or act as a market maker in securities or :inancial instruments mentioned herein (or options with respect thereto). Any scenario results presented here in are based upon information which we believe to be reliable. The security prepayments, yields, valuations, and future returns may vary signi:icantly in dynamic interest rate or otherwise volatile markets. Economic and regional factors, spread volatility, and interest rate or yield curve shifts can affect the payment patterns of MBS and bonds with embedded options, the horizon analytics, and potential reinvestment alternatives. Changes in your tax rate will affect the results shown.