Frank J. Fabozzi


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Frank J. Fabozzi is editor of the Journal of Portfolio Management , an Adjunct Professor of Finance at Yale University's School of Management, and a consultant in the fixed-income and derivatives area.

From 1986 to 1992, he was a full-time professor of finance at MIT's Sloan School of Management. Frank is a Chartered Financial Analyst and Certified Public Accountant who has edited and authored many acclaimed books in finance.

Books

Frank Fabozzi has written and edited many books on fixed income and equity markets. His Handbook of Fixed Income Securities , published by McGraw-Hill, is now in its sixth edition.

Bond investing

Introduction

The investment world can be divided into retail investors (i.e. individual investors) and institutional investors (e.g. insurance companies, mutual fund managers, depository institutions). The investing rules below focus on the institutional investor. One can probably trace some well known financial fiascos by institutional investors to a violation of one or more of these rules.

  1. Know your benchmark.

    Institutional investors manage money relative to a benchmark. The benchmark may be either some market index or future liabilities that are contractually determined. The institutional investor should clearly understand the characteristics of the benchmark. A strategy that is appropriate for one institutional investor may be disastrous for another because of different benchmarks. Moreover, understanding the benchmark means that the primary risks that drive returns are identified and they are the risks that the institutional investor can focus on to control risk and attempt to outperform the benchmark.

  2. Securities are only appropriate relative to a strategy.

    The fundamental principle of modern portfolio theory is that the risk of an individual security is not its risk in isolation but the contribution of risk to a portfolio. This means that given the benchmark and given the strategy that is consistent with that objective, an investor should focus on how much an individual security adds to the risk of the strategy. At professional conferences I have heard two portfolio managers from the same investment management firm give two very different views of the same bond structure. Both were right given that one managed money relative to a bond index and the other relative to actuarially determined liabilities.

  3. For bond investors, modeling risk is an important risk that should never be underestimated.

    For bond investors, the valuation of bonds introduced into the market in the last two decades have been difficult to value. Their valuation depends on several assumptions. To value these securities and to assess how they will perform under different scenarios in order to control risk, it is necessary to assess the impact of these assumptions to cope with modeling risk.

  4. Hedging is not the same as risk control.

    Too often institutional investors state they want to hedge risk. Hedging risk means eliminating risk and unless markets are inefficient, the elimination of risk means that the potential return will be approximately equal to the risk-free return. Institutional investors who manage portfolios want to control the primary risks associated with the benchmark based on their view of the primary risk factors.

  5. For bond funds, understand what duration means and how it is measured.

    A commonly used measure of interest rate risk for a bond portfolio is duration. Unfortunately, too often duration is interpreted as some temporal measure (i.e., in terms of years ). Duration is simply a measure of the sensitivity of the change in the value of a bond (or a portfolio) to a change in interest rates.

    A useful working definition is that duration is the approximate percentage change in the value of a bond (or a portfolio) for a 100 basis point change in rates. So, for example, a duration of 4 for a bond means that the value of the bond will change by approximately 4% for a 100 basis point change in rates.

    For portfolios that include complex securities (that is, securities that have considerable cash flow uncertainty), the calculation of a bond's duration is difficult and therefore there is modeling risk associated with the computed duration.

  6. Yield is not return.

    A yield measure calculated for a bond - yield to maturity, yield to call, or cash flow yield - is only a measure of the potential return from investing in a bond under limited circumstances.

  7. Understand why a yield spread exists.

    The practice in the bond market is to calculate the yield on a security and then compare that yield to a benchmark security. The difference is called the yield spread. An investor should understand what characteristics of a security (i.e., what risks) the yield spread is seeking to compensate the investor for and determine if that spread is adequate given the risks.

  8. Always perform attribution analysis when evaluating managers.

    In analyzing the performance of a portfolio manager it is important to decompose the actual return into the reasons why that return was generated. This activity is called attribution analysis.

  9. Watch with great concern money managers with far superior returns than the rest.

    A client employing the services of several money managers to invest in a specific sector (e.g. bonds) should be most concerned with the manager that generated a return that is considerably better than the rest. Using attribution analysis the client can determine the reason for the superior performance and should clearly understand the risks accepted by the manager. The client may find that the particular risks (or equivalently, bets) are not the ones that the client wants to accept in the future.

www.frankfabozzi.com

'The most highly paid people in the country work on Wall Street. They become highly paid because they persuade people to buy and sell securities. It would be hyperbole to say that they had no interest in the fate of the transaction - but only a little bit.'

”Robert A.G. Monks



Global-Investor Book of Investing Rules(c) Invaluable Advice from 150 Master Investors
The Global-Investor Book of Investing Rules: Invaluable Advice from 150 Master Investors
ISBN: 0130094013
EAN: 2147483647
Year: 2005
Pages: 164

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