Performance Analysis for Fixed Income Portfolios

Paul Wild, 11.12.2002

Agenda

Fixed Income Investment Process

Key Rate Duration Concept
Option Adjusted Spreads
Performance Decomposition
Discussion

Starting Point

Investment Process

Allocation of Funds

Risk Types

Risk Types

Risk Composition

Duration

Credit

Curve

Sector / Rating

Modelling of Term Structure

Modelling of interest rate curve by several key rates along time

Linear Interpolation
Zero Coupon Spot Rates of Government Bonds
5

Option Adjusted Spreads (OAS)

By how many basis points may the yield of a bond increase such that its return
advantage as compared to a government bond will vanish?
Option Adjusted Spread
4
3.5

Discount Rate

3
2.5
2
1.5
1
0.5
0
ON

3m

6m

1y

2y

3y

4y

5y

6y

7y

8y

9y

10y

15y

20y

25y

30y

Time to Maturity
Government Rate

Mathematically: Given the discount factors Dfi from the zero coupon government
bond curve and the bonds observed market price, we need to solve the following
equation for OAS
n

CFi
BondMarketPrice =
ti
i =1 (1 + DFi + OAS )

Option Adjusted Spreads (OAS)

OAS includes

credit spread for straight bonds

option price for callable/putable bonds
separation possible by considering probable redemption
suitable option pricing models required for more complex instruments (e.g.
convertibles)

Additional intermediate steps possible: Government --> Swap --> Credit

Analysis by further grouping: industry sectors, rating classes
Important: Development over time

Interest Rate Risk

Spot Rate (%)

Key Rate Moves

5.6
5.5
5.4
5.3
5.2
5.1
5
4.9
4.8

Key Rate 1
Key Rate 2
Key Rate 3
Key Rate 4
Spot Rate

Term (years)

Calculation of portfolio (or single bond) sensitivity to change of each key rate leaving
all other things equal

Discounting of each bonds future cash-flow (according to key rate curve) to get the
present value

Numerical approximation by calculating

Pi P
KRDi = P
y i
8

Key Rate Duration Concept

Portfolio value change in response to key rate movements

P
P

KRDn
KRD1
KRD2

+
+
(
y
)
(
y
)
...
1
2

( y n )

1 + y1
1 + y2
1 + yn

As compared to the Macauley Duration approach

P
1

DMac y
P
1+ y
the KRD concept is a Multi-Factor model

KRD of Portfolio = Cap. Weighted sum of single bonds KRDs

Shift of all key rates by same amount --> parallel shift of curve
Consequence: Sum of key rate durations equals Effective Duration

Key Rate Duration Profile; Example

10

Option Adjusted Spreads (OAS)

11

Key Rate Duration Concept

KRD approach is a very powerful means for risk control

Reasonable approximation
Eg. Bullet vs. barbell exposure (with same overall duration) immediately visible
Interest rate curve is observable; i.e. factors are intuitive
Often seen approach

three factor model: Shift, Twist, Butterfly

stem from Principal Component Analysis
hardly observable (at least butterfly factor)

Approach gives framework for interest curve scenario simulation

12

Summary
Portfolio Positions + Curve

Decision Support

Cashflows and Discount Factors

Scenario Simulation
(Curve and/or Spreads)
Solve for OAS

Key Rate Shifts and KRD

13

Performance Analysis

Portfolio Return

Accretion

Rolldown Effect

Change of
Term Structure

14

Change of
Credit Spread

Performance Analysis
Return Factor
Accretion Return

Description
Accretion return is calculated by holding a cashflows yield
constant while moving the settlement date forward. The
return is due to the convergence of the price to par as the
time approaches its maturity.
Rolldown Effect Results from the predictable change in the cashflows yield
(Time Passages) as time elapses; reflects the change in the placement
along the yield curve
Changes in the In the present model, the term structure results from a set
term structure
of key rates and intermediate linear interpolation. Changes
of the term structure are detailed on the changes of each
key rate and their effect is contributed to each cashflow
affected.
Change in OAS
The OAS (on total bond level) is the spread to be added to
the government spot rate curve in order to obtain the
bonds actual market price. This spread may change over
time and thus gives a contribution to the bonds return.

15

Performance Analysis
Discounting Factor

KRb
DKRb
DFend
KRa

DFbegin

DFtermstr

DFTime

DKRa

Dt
Ta

t1

t1 + Dt

Tb

Decomposition of Discounting Factors

DFend = DFbegin + DFTime + DFtermstructure + DFOAS

16

time

Performance Analysis

CF

(1 + DF )t1
end
returnCF =
1
CF

(1 + DFbegin )t1 + t

= returnCF ,accretion + returnCF ,rolldown + returnCF ,termstructure + returnCF ,OAS

Algebraic manipulation results in additive decomposition of return

Correct overall return results on portfolio level

Calculation on level of each cashflow; capital weighted aggregation on bond position

and portfolio level
Re-calculation would be required at each time of transactions (purchases/sales)
since cashflow profile changes
17

Performance Analysis

18

Performance Analysis Cumulated

Return 2002
10.00

9.00

8.00

7.00

6.00

5.00

4.00

3.00

2.00

1.00

Term 30Y
Term 25Y
Term 20Y
Term 15Y
Term 10Y
Term 9Y
Term 8Y
Term 7Y
Term 6Y
Term 5Y
Term 4Y
Term 3Y
Term 2Y
Term 1Y
Term 6M
Term 3M
Term ON
OAS Change
Term Total
Rolldown
Accretion

Benchmark
Portfolio

19

Total

-1.00