Bridge over ocean
11 September 2017 Financial Analysts Journal Book Review

Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies (a review)

  1. Mark S. Rzepczynski

This collection of articles covers numerous key fixed-income topics, addresses many of the practices currently emphasized by managers in this asset class, and provides useful insights into modern debt portfolio management.

Approaches to fixed-income management have evolved over the past 15 years; in several ways, they have grown closer to equity portfolio management practices. A movement is clearly observable toward isolating strategy-linked relative benchmarks and measuring portfolio-specific factor risks. Bond management has advanced significantly in quantifying market risk as well as monitoring the specific alpha or active risks of term structure, credit, and global exposures. Frank J. Fabozzi, Lionel Martellini, and Philippe Priaulet, the editors of this set of articles, provide a book with broad range. It covers numerous key fixed-income topics and addresses many of the practices currently emphasized within the asset class.

Twenty chapters or articles are presented in six major topic areas. After a brief set of background articles, the contributors discuss benchmark selection and risk budgeting, fixed-income modeling, interest rate risk, credit risk, and international bond investing. Although some repetition occurs among the diverse set of authors, the chapters contain enough technical depth that most readers will find useful insights throughout the book to enhance their understanding of portfolio management.

The first section provides a classification of active bond portfolio strategies and a review of the “total rate of return” approach. The authors present a useful framework for assessing the different methods for creating alpha in a bond portfolio. Benchmarking is discussed as a key introductory topic. The contributors describe methods for choosing a benchmark based on a portfolio objective, such as a liability stream. The measurement and implications of attribution and tracking error are also presented, together with risk-budgeting concepts. Liquidity and trading costs are an important piece of any bond strategy and are addressed in this section to remind the reader that active management is not without expenses. The authors also tackle an issue often neglected in theoretical work on portfolio construction—namely, that the implementation of a strategy is as important as its development. One article reviews active management in the context of portfolio efficiency and explores how rigorous quantitative analysis can be used to understand the bets taken.

The second section of Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies goes into depth in regard to benchmark selection and risk budgeting. It includes a thoughtful treatment of an often overlooked topic—the selection of a benchmark and how to beat it. Choosing a benchmark is an active decision even for the passive manager. Benchmark selection is also reviewed in the context of liability management and the value of customization. The discussion makes clear the importance of setting the proper objective and not focusing on commercial benchmarks. This section also deals with the need to tailor risk budgeting to management style, which can emphasize either market risk or specific alpha risk.

The book’s third section deals with fixed-income modeling through a review of the principal quantitative tools available to the bond manager. A chapter on alternative approaches to option-adjusted spread analysis effectively contrasts various modeling schemes. Although the technical details are clearly stated, the article is more a review than a manual on how to implement alternative option-adjustment models. The concept of spread duration is clearly presented to show the impact of changing credit spreads on portfolio risk.

The factor approach of breaking up the term structure into shift, twist, and flex components has become almost a standard for measuring market risk. This methodology is presented to demonstrate how tracking errors can be minimized. Approaches to fixed-income modeling are tied together in the section's last article, which illustrates how these models can be used to optimize risk and return through allocations within a risk budget.

Section four reviews the dominant risk factor in a bond portfolio—interest rate risk. Some of this work is a restatement of concepts in the previous section, but the section also offers a practical discussion of how to measure the plausibility of alternative risk scenarios by using principal components. The authors make the important point that scenario analysis has to be grounded in historical reality. Use of factor models for hedging interest rate risk is presented to show how improvement over simple duration hedging can be achieved. The final article in this section introduces concepts of simulation to measure portfolio risk, a useful application of risk budgeting and factor modeling.

Section five focuses on credit-risk modeling. Surprisingly, theoretical work on quantitative bond credit analysis was first developed in the 1970s and took almost 25 years to be generally accepted as a viable approach. Credit modeling has seen the greatest technical advance of any fixed-income area over the past five years. The introduction of credit derivatives has transformed credit analysis from the exclusive domain of fundamental analysts to a highly quantitative area of bond management. This section presents the advantages and disadvantages of structural and reduced-form models as well as the fundamental approach to analyzing credit risk. The articles progress from a discussion of modeling alternatives through tools for measuring credit risk and, finally, to the ways models can be used in bond selection. This section contains the book’s newest material and could have been improved by more examples of the differences in modeling approaches. It also would have benefited from more extensive discussion of how these techniques can be used to implement a credit risk–based strategy, but these criticisms are minor.

The final section divides international bond investing into two parts. Part one reviews the case for international bond investing and the gains from strategic and tactical international investing. It includes a review of the types of active bets that can be made through global bonds. Most of this introductory material has been covered elsewhere in greater detail. The second part is an effective discussion of how to use bond management tools to construct an emerging market bond portfolio.

Advanced Bond Portfolio Management could have covered certain topics more fully than it does. For example, there is little emphasis on modeling asset securitization or the crossover securities of high-yield and convertible debt. Additionally, more focus could have been placed on how all of these issues are aggregated to manage a portfolio and the trade-off between market and alpha risk. More empirical details or examples of how bets and risk can be structured would have been helpful because the results of various strategies provide useful information about the validity of the methodologies.

Not addressed in the book is the important topic of relevance for certain fixed-income practices. For many specific fixed-income bets, return per unit of risk is small, so the amount of risk required to produce benchmark-beating returns may not be justified. There is a reason many fixed-income managers hug their benchmarks and try to control costs. Portfolio managers must not only understand the individual bets; they must also know how the bets work together to influence the total portfolio. The editors would have rendered a great service by telling readers from which of the studies presented they will receive the most added value.

In summary, this book is effective in presenting the mechanics of bond portfolio management for those who understand basic bond math (or have a CFA charter). It is worth the price if the reader wants to get up to speed on current issues in fixed-income management. Whether the book is sufficiently thought provoking for bond market specialists is more difficult to determine. Readers must allocate their time and effort carefully among and within the chapters. The variety is plentiful, however, to provide most readers insight on important new concepts.


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