Research Report and Quantitate Analysis Fixed Income Securities

This assessment has two parts:

Quantitative Analysis of Fixed Income Securities
Yield Curve Forecasting and its Role in Bond Portfolio Management

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Each part has an equal weight in this assessment and the details are provided below.

(1) Quantitative Analysis of Fixed Income Securities

In this activity we would like you to take the role of a US investor who holds in his portfolio the following four fixed income instruments:

Five 3-year US Treasury Notes, each with coupon rate 4%, par value $10,000, paying coupons semi-annually (first coupon to be paid in half a year’s time)
One 10-year US Treasury Bond with coupon rate 10%, par value of $100,000, paying coupons annually (first coupon to be paid in one year)
Eight 5-year corporate bond, issued by Microsoft, with coupon rate 5%, par value of $15,000, paying coupons annually (first coupon to be paid in one year)
Two certificates of a simple mortgage pass-through issued by Fannie Mae; each certificate has a maturity of 7 years and the structure of annual payments (including both interest and principal) is given in the table below (first payment in one year)
YEAR

END OF I-TH YEAR PAYMENT

1

$5,000.00

2

$5,000.00

3

$10,000.00

4

$10,000.00

5

$20,000.00

6

$25,000.00

7

$30,000.00

Note: simple mortgage pass-through do not differentiate certificates in terms of their credit quality and do not include any embedded options.

Tasks for you:

Search online resources for information on the current values of interest rates in the US that could be used as a benchmark to value the above securities and present them in the form of a relevant yield curve. If some of the rates are not available, discuss how would you approximate them from the available ones. State the source of your data.
Use the yield curve from (1) to find current values of the 3-year US Treasury Notes and 10-year US Treasury Bonds and for each of these bonds compute their yields to maturity.
Discuss briefly the types of risk in Microsoft corporate bonds and mortgage pass-through certificates issued by Fannie Mae and think about how these influence the yields provided to investors by these securities. Complete your discussion with an estimation of the yield spread for each security and provide justification for these values with relevant analysis that is further backed up with appropriate quantitative analysis.
Given your estimates in (3), compute the yields to maturity for Microsoft corporate bonds and the mortgage passthrough certificates issued by Fannie Mae.
Compute the current value of your portfolio, the return you can expect on it and its duration (include Macaulay and modified duration). Provide an interpretation of your findings.
Consider now a parallel upward shift in the current yield curve of 5% (that is all interest rates increase by 5%). Illustrate, with a relevant quantitative analysis how the modified duration of the portfolio can be used to approximate a change in the value of your portfolio. Discuss briefly the quality of your approximation.

(2) Market Efficiency and the Role of Manager in Bond Portfolio Management.

In this part of the assessment we would like you to think broadly about active bond portfolio management and the role played by portfolio managers in this process.

As a starting point, we would like you to read the following:

‘Yield Curve Strategies’ by Frank J. Jones, Journal of Fixed Income (1991), issue 1(2), pp: 43-48.
‘Positioning Bond Portfolios for Rising Interest Rates’ by William Martin, Stephen MacDonald and Peter Moore, December 2017.
‘Rising Interest Rates and the Impact on Bond Portfolios’ by Larry Swedroe, January 2018

In addition, you are expected to search for other relevant readings and resources that could be useful to you in this part of the assessment.

Frank J. Jones states in his article:

“Empirical evidence suggests that approximately 95% of the total return on a Treasury portfolio is attributable to three types of changes in the yield curve. Actual yield curve changes usually occur in combinations of these three types, not singly: a parallel shift, either up or down, as shown in Figure 1A (for an upward parallel shift); a twist, rotation or change in the slope of the yield curve as shown in Figure 1B (less steepness); a butterfly, or change in the “humpedness” of the yield curve with either less of a hump (a positive butterfly), as shown in Figure 1C, or more of a hump (a negative butterfly). Of the total return of the Treasury portfolio explained by these three types of changes, 86.5% of the return has been attributable to parallel shifts in the yield curve, 9.8% to twists, and 3.6% to butterfly changes.”

According to Jones (1991), the most common changes are a combination of a downward shift and steepening, or an upward shift and flattening. In the same article it is also suggested, from observation of the US Treasury market, that returns generated from bondholdings are predominantly due to parallel shifts and steepening or flattening of the curve, while only a small proportion of the total return results from changes in the humped nature of the curve. The conclusion is that a fund manager adopting a yield curve strategy would have to accurately forecast the direction of the parallel curve shift, as well as the change in the curve spread. This places the approach, in analytical terms, in the same class as interest rate forecasting.

The above summary is, however, just a starting point in the discussion of a broader topic of the role of portfolio manager in active bond portfolio management, which we would like you to extend the analysis by addressing the following questions.

Explain intuitively how the forecasts of yield curve changes can add value to active bond portfolio management.
Are bond markets efficient? Express your views on this issue and provide appropriate argumentation backed by an overview of the relevant literature.
Given your answer to (2) and the empirical evidence provided by Frank J. Jones (cited above) describe how the information that total return on Treasury portfolio can be effectively explained by parallel shifts, twists and butterfly changes in yield curve and how this can be used by portfolio managers in managing bond portfolios.

As a general matter, discuss broadly the role of a portfolio manager in active bond portfolio management in the light of the efficient market hypothesis.

Your answers and solutions to the above two parts of this assessment should be placed in a Research Report. It should have the following structure:

Title page – report title, your name and submission date
Table of content
Main body – you should include here the answers and solutions to the two parts of this assessment presented above; a separate subsection should be devoted for each part
References
Appendix (optionally) – information that supports your analysis but is not essential to its explanation, you can list here for example the attachments and explain what each attachment contains

The suggested word count for each subsection in the main body:

Quantitative Analysis of Fixed Income Securities: 300 words (+/- 10%)
Market Efficiency and the Role of Manager in Bond Portfolio Management: 1200 words (+/- 10%)

You are expected also to prepare an Excel spreadsheet, which should include the quantitative analysis required in the first part of this assessment. Specifically, your answers related to tasks (2), (4) and (5) should be supported by relevant computations in the spreadsheet. Note however, that the spreadsheet is only a supportive document for part (1) of the assessment and all your answers and comments related to that part should be placed in the Research Report.

In total your report should have 1500 words (+/-10%). Note that equations, tables, titles, footnotes and the abstract are not included in the word limit. Please include a word count at the end of the report.

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