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Schweser QBank 201702 relative value methodolog bond portfolio management

Relative-Value Methodologies for Global Credit Bond Portfolio
Management
Test ID: 7428059

Question #1 of 40

Question ID: 466066

Which of the following strategies would normally result in the best bond performance?
ᅞ A) Buy callable bonds rather than bullets, if a strong bullish bond market is
expected.
ᅚ B) If a bear bond market is expected, buy callable bonds instead of bullets.
ᅞ C) Buy callable bonds when interest rates decline.
Explanation
Callable bonds generally outperform bullets in a bear bond market because the probability of a call is reduced. As interest
rates increase, the value of the embedded option decreases, with a resultant decrease in the differential yield between callable
and noncallable bonds. In a bull bond market the call option acts as a resistance point limiting the price appreciation of callable
bonds.

Question #2 of 40


Question ID: 466060

ᅞ A) Marketability.
ᅞ B) Efficiency.
ᅚ C) Liquidity.
Explanation
Liquidity is the ability to buy or sell quickly at a fair price.

Questions #3-8 of 40
Edward Justice, CFA, is an analyst for Sierra Funds (Sierra). Justice is investigating the use of relative value methodologies for
global corporate bond portfolio management and needs assistance from several Sierra Fund managers and traders. He
explains that relative value analysis involves comparing bonds and bond portfolios on characteristics such as sector, issue,
and structure. He adds that firms may use a top-down or a bottom-up approach to the analysis. Sierra prefers a top-down
approach.
Sierra manages an employee pension fund for Ice Dreams, Inc. (Ice Dreams). Sierra has been doing very little trading in Ice
Dreams' account and has avoided specific structures and foreign bonds entirely. Due to a recent increase in interest rates,
there are several accounting losses in the portfolio at this time. Sierra traders have been getting conflicting advice from buy
side and sell side analysts and at this point are unsure of the optimal trading strategies for the pension fund. Justin James, a
Sierra trader, believes that it is a great time to trade. He suggests that trading out of telecommunications industy bonds and
into pharmaceutical industry bonds may enhance returns in the Ice Dreams portfolio. He also believes that insurance industry
bonds will see a ratings upgrade in the near future and is contemplating shifting a portion of the portfolio into insurance
industry bonds.


Bond manager Mike Steere is interested in the implications of issues such as changes in dominant product structure and new
issue supply for fixed-income portfolio managers. In an attempt to understand these issues, he asks Justice several questions.
He is specifically interested in the implications of cyclical and secular changes for fixed-income portfolio managers.
Dan Baker is interested in the terminology related to different yield spreads. He states that swap spreads are the difference in
the fixed and floating rates in a swap. Ashley Carlton, a Baker colleague at Sierra adds "the option adjusted spread is the
spread on corporate securities after removing any embedded options when comparing them to mortgage-backed and U.S.
Agency issues."
Alexis Jones, a Sierra Funds bond trader is considering the following swap deal.
On January 1, 2001, TTT Corporate 7.0s of 2006 traded at a bid side price of 120 basis points over the 5-year U.S.
Treasury yield of 6.20% at a time when LIBOR was 5.90%.
On the same day, 5-year LIBOR-based swap spreads were at 100 basis points (to the U.S. Treasury).
Assume that a bond manager bought the TTT issue and simultaneously enters into this 5-year swap.
Jones indicates that a key advantage of the swaps spread framework for evaluating corporate bond purchases is "the
applicability of swap spreads across the quality spectrum." William Greavey adds that another key advantage of the framework
is "the convergence to a single spread standard derived from swap spreads. " Both Jones and Greavey believe that the swaps
spread framework is an important tool for traders and analysts alike when evaluating corporate bonds.



Question #3 of 40

Question ID: 466082

Regarding yield spreads, Carlton and Baker are, respectively:
ᅚ A) correct; incorrect.
ᅞ B) incorrect; correct.
ᅞ C) incorrect; incorrect.
Explanation
Carlton is correct about the OAS and Baker is incorrect regarding the swap spread. A swap spread is the spread paid by the
fixed-rate payer over the rate on the on-the-run Treasury with the same maturity as the swap. The option adjusted spread is
the effective spread for the class after removing any embedded options. (Study Session 9, LOS 21.e)

Question #4 of 40

Question ID: 466083

In answer to Steere's queries, Justice is most likely to indicate that all of the following are implications of both cyclical and
secular changes in the corporate bond market EXCEPT:
ᅞ A) asset/liability managers with long horizons may be willing to pay a premium for
long-term bonds.
ᅚ B) effective duration and aggregate interest-rate risk sensitivity will increase.
ᅞ C) securities with embedded options will command a premium price due to their scarcity
value.
Explanation
Secular changes show that bullet and intermediate structures dominate the corporate bond market. Implications associated
with these product structures:
Securities with embedded options will command a premium price due to their scarcity value.


The percentage of long-term issues will decline. Thus, effective duration and aggregate interest-rate risk sensitivity will
decline. Asset/liability managers with long horizons may be willing to pay a premium for long-term bonds.
Credit-based derivatives will become increasingly used to achieve desired exposure to credit sectors, issuers, and
structures.
(Study Session 9, LOS 21.b)

Question #5 of 40

Question ID: 466084

Regarding a swaps framework to evaluate corporate bond purchases, Jones and Greavey are, respectively:
ᅞ A) correct; correct.
ᅞ B) correct; incorrect.
ᅚ C) incorrect; correct.
Explanation
Jones is incorrect and Greavey is correct. Many market practitioners expect a worldwide convergence to a single spread
standard derived from swap spreads. Swap spreads facilitate the comparison of securities across fixed-rate and floating-rate
markets, particularly for investment-grade securities. On the negative side, individual investors may not understand swap
spreads and they are not applicable across the entire quality spectrum. (Study Session 9, LOS 21.e)

Question #6 of 40

Question ID: 466085

In the trade Jones is considering, the fixed rate corporate bond's spread over LIBOR would be closest to:
ᅚ A) 20 basis points.
ᅞ B) 10 basis points.
ᅞ C) 50 basis points.
Explanation
The fixed rate corporate bond's spread over LIBOR would be:
Receive from BSC (6.20% + 120 bp)

7.40%

- pay on swap (6.20% + 100 bp)

7.20%

+ receive from swap

LIBOR

Net

LIBOR + 20 bp

(Study Session 9, LOS 21.e)

Question #7 of 40

Question ID: 466086

Justice is contemplating the differences between callable bond and bullet bond strategies. Which of the following statements
does NOT accurately describe the relationship between callable bonds and bullet strategies? Callables:
ᅚ A) outperform bullets when rates increase due to positive convexity.
ᅞ B) outperform bullets in bear bond markets because the probability of an early call
diminishes.


ᅞ C) do not fully participate when bond markets rally due to the "resistance" level set by the
call price.
Explanation
Callable bonds:
Underperform bullets when rates decline due to their negative convexity.
Do not fully participate when bond markets rally due to the "resistance" level set by the call price.
Outperform bullets in bear bond markets because the probability of an early call diminishes.
(Study Session 9, LOS 21.e)

Question #8 of 40

Question ID: 466087

James' trading strategies regarding telecommunications and pharmaceutical industry bonds, and with respect to insurance
industry bonds are, respectively:
ᅞ A) yield/spread pickup trades; credit upside trades.
ᅞ B) structure trades; credit defense trades.
ᅚ C) sector rotation trades; credit upside trades.
Explanation
The first trade that James describes, swapping out of telecommunications bonds and into pharmaceutical bonds because of a
belief that the pharmaceutical bonds will perform better, is known as a sector rotation trade. Expecting insurance company
bonds to be upgraded, and trading on that expectation, is known as a credit-upside trade. (Study Session 9, LOS 21.d)

Question #9 of 40

Question ID: 466061

Which of the following statements about the rationale for trading in the secondary bond market is least accurate?
ᅚ A) The popularity of credit-defense trades is not related to expected levels of
economic uncertainty.
ᅞ B) The reason to engage in a sector-rotation trade is to shift out of a sector that is
expected to underperform on a total return basis, and buy into a sector that is
expected to outperform in total return.
ᅞ C) Altering the duration of a portfolio because of anticipated yield curve changes is
labeled a curve adjustment trade.
Explanation
Credit-defense trades result from a bond manager's desire to reduce the portfolio's exposure to expected credit downgrades.
As such, during periods of anticipated economic uncertainty, credit-defense trades normally increase.

Question #10 of 40
Which of the following statements about swaps is CORRECT?

Question ID: 466069


ᅚ A) In the European market, swap spreads serve as a good proxy for credit
spreads.
ᅞ B) A swap spread is the spread paid by the fixed-rate payer over the seasoned Treasury
rate.
ᅞ C) A swap spread refers to the difference in yield between corporate issues of different
quality ratings.
Explanation
It is because of the relative homogeneity of the European bond market that swap spreads are a good proxy for credit spreads.
European issues are generally high in quality and intermediate in maturity. Swap spreads involve the on-the-run Treasury rate,
not seasoned issues.

Question #11 of 40

Question ID: 466054

Which of the following statements about bullet maturity bonds is CORRECT?
ᅞ A) A majority of bullet maturity bonds have sinking funds.
ᅚ B) Bullet and intermediate structures are currently dominant in all but the high yield
segment of the corporate bond market.
ᅞ C) A call feature is an integral part of a bullet maturity bond.
Explanation
Bullet and intermediate structures currently dominate all but the high yield segment of the corporate bond market. Bullet
maturities cannot be callable, putable, or have sinking funds.

Question #12 of 40

Question ID: 466075

With regard to credit analysis, the quality of collateral and the servicer are most relevant to which types of securities?
ᅞ A) Corporate securities.
ᅚ B) Asset-backed securities.
ᅞ C) Municipal securities.
Explanation
The quality of collateral and the servicer is most relevant to the analysis of asset-backed securities.

Question #13 of 40
Which of the following statements about spread analysis is CORRECT?
ᅚ A) Using quality-spread analysis, a bond portfolio manager would buy an issue
that has a wider spread than what is justified by its intrinsic value.

Question ID: 466070


ᅞ B) Percentage yield analysis uses the ratio between corporate bond yields and
government yields and is the only spread analysis that is based on maturity rather
than duration.
ᅞ C) With quality-spread analysis, one risk when purchasing a security is the spread
differential narrowing during the holding period.
Explanation
If an issue trades at a spread that is (believed by the manager to be) higher than is warranted by its intrinsic value, the
expectation is that this spread will decrease over time as this fact becomes understood by the market. The risk is that the
manager has misjudged the quality of the issue, and that the spread could remain high or even widen further.

Question #14 of 40

Question ID: 466076

ᅞ A) The capacity of corporate issuers to support cash flows needs.
ᅞ B) Global economic and political instability.
ᅚ C) The expansion in the universe of global bonds.
Explanation
In order to be effective, managers must establish and support an effective credit analysis system within their managerial
domains to assure that appropriate information is available to make the best possible choices. This is becoming increasingly
difficult as the global bond universe expands.

Question #15 of 40

Question ID: 466077

Which of the following statements about classic relative-value analysis is least accurate?
ᅞ A) The analytical process has substantially changed due to the recent increases
in the amount of available information and technology.
ᅞ B) Sector, issuer, and structural analysis are the core of relative-value analysis.
ᅚ C) Classic relative-value analysis only uses a top-down micro type approach.
Explanation
Both the top-down and bottom-up approaches are used with classic relative-value analysis.

Question #16 of 40

Question ID: 466064

Expectations that an issue will experience a quality upgrade that is not already reflected in the current spread could result in
which type of trade?
ᅚ A) Credit-upside.
ᅞ B) Credit defense.
ᅞ C) Sector rotation.


Explanation
A credit-upside trade is motivated by a bond portfolio manager's expectation that an issuer will experience a credit upgrade,
and belief that this is not already reflected in the market value of the issue.

Question #17 of 40

Question ID: 466078

Which of the following comments about relative-value analysis is least accurate?
ᅞ A) Relative-value analysis is used to rank issues in terms of their expected
performance based upon total returns.
ᅚ B) Relative-value analysis is consistent with the concept that bond markets are efficient.
ᅞ C) Relative-value analysis gives bond portfolio managers an analytical structure that
allows them to develop a strategic perspective on the global corporate market.
Explanation
If bond markets were perfectly efficient then relative-value analysis would not lead to superior returns on a consistent basis.

Question #18 of 40

Question ID: 466056

For the management of a fixed-income portfolio, which of the following is an important implication of the increasing supply of corporate
bonds within the last decade?

ᅞ A) The average bond duration has increased.
ᅚ B) Portfolio managers have more ways to satisfy their risk and return objectives.
ᅞ C) The relative performance of corporate bonds has decreased.
Explanation
Greater supply means more issues from which managers can choose. The greater the number of issues provides managers with more
opportunities to select securities that match their investment objectives, whether that be to fund some liability stream, or attempt to
outperform some benchmark return.

Question #19 of 40
In classic relative-value analysis the top-down approach refers to:
ᅞ A) looking for undervalued assets and ranking them from most to least
undervalued.
ᅞ B) ranking the holdings in a corporate bond portfolio according to the relative market
value of each asset class, beginning with the highest value.
ᅚ C) using large-scale economic information to allocate funds to various corporate asset
classes.

Question ID: 466050


Explanation
Large scale (i.e. macro) economic information concerns data such as inflation, interest rate changes, and the level and
direction of the overall economy (both domestic and foreign). Top-down analysis seeks to allocate funds to those issues that
would benefit the most from the expected large-scale economic changes/trends.

Question #20 of 40

Question ID: 466055

Which of the following statements about bond markets is least accurate?
ᅞ A) Although duration tilts can be accomplished with corporate bonds, many bond
managers prefer the use of Treasuries to play the yield curve.
ᅞ B) Qualitative issues that differentiate the management of an international bond portfolio
versus a purely domestic one, include, differences in time zones and differences in
market structure and conventions.
ᅚ C) Technological advancements, together with increased competition among corporate
bond traders, will lead to less liquid global corporate bond markets because the
number of issues available will not increase at a fast enough pace to keep up with the
increased level of demand.
Explanation
Liquidity will most likely increase in the future because technological advances in trading systems and communication of
information, together with greater competition among bond traders, will lead to higher volumes of bond trading, an important
element in liquidity.

Question #21 of 40

Question ID: 466074

A bond manager deciding against making an otherwise desired secondary transaction because of a desire to minimize
portfolio turnover is most likely an example of what type of portfolio constraint?
ᅚ A) Buy and Hold.
ᅞ B) Seasonality.
ᅞ C) Exposure Limits.
Explanation
A disposition toward lower trading volume can lead to buy-and-hold behavior.

Question #22 of 40

Question ID: 466071

Which of the following market conditions would suggest the use of callable bond structures in a corporate bond portfolio?

ᅚ A) Bear bond market.
ᅞ B) Increasing interest rate volatility and a bull bond market.
ᅞ C) Bull bond market.


Explanation
In a bear bond market interest rates are increasing causing bond values to decrease thus the probability of an early call decreases.
Callable bonds are issued with a higher coupon rate as compared to noncallable bonds to compensate the purchaser for the probability of
the bond being called. In a rising interest rate environment callable bonds will not fall in price as much as a comparable option free bond
due to the negative convexity of the callable bond in the callable region of the bond. Thus, if portfolio managers expect interest rates to
increase, they should buy callable structures instead of option-free bonds in order to capture the higher return of the callable bond since it
will not fall in value as much as the non-callable bond.

Question #23 of 40

Question ID: 466048

Which of the following is the major emphasis of the bottom-up approach of classic relative-value analysis? Identifying:

ᅚ A) individual issues that are expected to outperform their peer groups.
ᅞ B) high-convexity issues.
ᅞ C) optimal allocations to individual issuers.
Explanation
Bottom-up approaches focus on security by security analyses in the attempt to find those individual issues expected to outperform
others.

Question #24 of 40

Question ID: 466062

Which of the following is the best rationale for purchasing an issue in the secondary market?

ᅞ A) Increasing credit risk for a particular bond.
ᅚ B) Expectations of an upgrade in an issuer's credit quality.
ᅞ C) High-default rates in a particular sector.
Explanation
An upgrade in credit quality will result in less credit-premium demanded by investors. Since discount rates and prices move in opposite
directions for bonds, credit upgrades will result in an increase in price that will generate a greater total return from the investment.

Question #25 of 40

Question ID: 466059

ᅞ A) Treasury issues.
ᅚ B) private placements.
ᅞ C) large-sized issues.
Explanation
Many investors are willing to give up additional return in exchange for greater liquidity. Private placement issues typically have


relatively low liquidity.

Question #26 of 40

Question ID: 466080

With mean-reversion analysis:
ᅞ A) if the current yield spread is greater than the historic mean, the market value of
the security will be higher than if the spread were negligible.
ᅞ B) statistical tools cannot be utilized to determine if the yield spread is significantly
different from the historical mean.
ᅚ C) if the current spread of a sector or issue is significantly greater than the historical
mean spread, then buy the sector or issue.
Explanation
Mean-reversion analysis is the most used tool for the analysis of spreads between individual issues and across industry
sectors and assumes that spreads will revert to their historic means. If a current spread is greater than its historic mean, then
as the issue reverts to its mean, its yield will decline and its market value will therefore increase.

Question #27 of 40

Question ID: 466079

Which of the following tools is thought to suffer from methodological deficiencies thereby rendering it inaccurate, and
therefore, of little use?
ᅚ A) Percentage yield spread analysis.
ᅞ B) Structural analysis.
ᅞ C) Mean-reversion analysis.
Explanation
Percentage yield spread analysis uses the ratio of yields of corporate to government issues of similar duration. However, as so
many other factors such as supply and demand, profitability, and liquidity have an effect on corporate yields, this analysis has
little usefulness.

Question #28 of 40

Question ID: 466067

In terms of a long-term investor, which of the following is a potential criticism of not investing in securities with low liquidity? These
securities:

ᅞ A) are less risky.
ᅚ B) have to provide higher returns as a compensation for low liquidity.
ᅞ C) offer arbitrage opportunities more frequently.
Explanation
Less liquid securities must provide a liquidity premium to compensate for the low liquidity.


Question #29 of 40

Question ID: 466049

In the bond market, relative-value analysis refers to the:
ᅚ A) methodologies employed to generate rankings of fixed income securities
according to various attributes such as sectors and expected performance.
ᅞ B) relative risk and return characteristics between a corporations' common stock and its
debt issues.
ᅞ C) relative market value of each holding to the total value of the portfolio.
Explanation
Relative-value analysis refers to several related methodologies used to rate and rank fixed-income securities.

Question #30 of 40

Question ID: 466063

Estimates are that more than 50% of all secondary bond trading is due to which type of trade?
ᅞ A) Curve adjustment.
ᅞ B) New issue swaps.
ᅚ C) Yield/spread pickup.
Explanation
The motivation behind yield/spread pickup trades is to increase yield within specified duration and credit quality bounds. This
motivation is estimated to account for more than 50% of all secondary trades.

Question #31 of 40

Question ID: 466051

Which of the following is an example of a bottom-up approach of classic relative value analysis that would indicate an
undervalued issue?
ᅞ A) The manager of a corporate bond portfolio expects the increased debt usage of
Corey, Inc., together with the prospect of greater competition and lower profit
margins, will lead to a decrease in the credit rating of Corey bonds. These
expectations are not reflected in the current market value of the bonds.
ᅚ B) Due to continued strong earnings growth of XMP Corporation, their bond's credit
rating is expected to be upgraded. The manager of a corporate bond portfolio does
not believe this is reflected in the current market value.
ᅞ C) General economic conditions indicate the inflation rate will decline over the next year,
with the expectation this will result in reducing the required yield for outstanding bonds
in all maturity classes.
Explanation
If a bond's credit rating is upgraded, the required yield will decline and the market value of the bond will increase. If this event


is not currently reflected in the value of the bond then it represents an undervalued security.

Question #32 of 40

Question ID: 466072

One portfolio constraint contributing to market inefficiency in global credit markets is seasonality. Considering the trading
patterns of a given mutual fund, which of the following is least likely to reflect seasonality?
ᅞ A) Relatively low secondary trading following a portfolio rebalancing.
ᅞ B) Relatively low secondary trading at the end of a month.
ᅚ C) Relatively high secondary trading following a new primary issue.
Explanation
Seasonality has to do with monthly, quarterly, or yearly data that appears at regular time intervals. Secondary trading following
a new primary issue would not have anything to do with a seasonal pattern of repeating time intervals. The other choices are
standard reasons to slow (or speed) transactions on a regular periodic basis that would represent a seasonality pattern.

Question #33 of 40

Question ID: 466068

Which of the following is a potential criticism of a strategy that invests in securities that are "neglected" by the market? This type of
security:

ᅞ A) is often overpriced.
ᅚ B) often has low liquidity.
ᅞ C) has a lower risk-return tradeoff.
Explanation
Since these securities are "neglected," liquidity is low and transaction costs high.

Question #34 of 40

Question ID: 466073

The capacity to pay is a relatively more important factor in which of the following types of credit analysis?
ᅞ A) Sovereign.
ᅞ B) Long-term municipal.
ᅚ C) Corporate.
Explanation
Capacity to pay, often measured by the adequacy of cash flows available to meet interest payments, is the key factor in
corporate credit analysis.

Question #35 of 40

Question ID: 466058


Investors that desire to sacrifice liquidity in exchange for increased returns are least likely interested in which of the following
types of bonds:
ᅚ A) Treasury issues.
ᅞ B) smaller-sized issues.
ᅞ C) private placements.
Explanation
Some investors are willing to give up liquidity by investing in issues that possess relatively higher expected returns. Treasury
issues do not fall into this category because they have relatively high liquidity, and little or no liquidity yield premium.

Question #36 of 40

Question ID: 466052

Which of the following statements about cyclical and secular changes in the primary bond market is least accurate?
ᅞ A) Relative corporate bond returns frequently perform best when the supply of
bonds is relatively plentiful.
ᅞ B) One factor that can cause structural changes in the bond market is the desire of
issuers to minimize financing costs under different yield curve and spread scenarios.
ᅚ C) Structural changes in the composition of the bond market can occur rapidly.
Explanation
Structural changes occur slowly and have long-term implications for bond portfolio investment decisions. These changes are
the result of issuers attempting to minimize their funding costs under different yield curve and spread scenarios.

Question #37 of 40

Question ID: 466047

Which of the following best describes the basis for relative-value analysis?

ᅞ A) Identifies mispricings.
ᅚ B) Generates rankings of expected returns.
ᅞ C) Identifies the value of corporate bonds relative to government bonds.
Explanation
Relative value refers to the ranking of fixed-income investments by sectors, structures, issuers, and issues in terms of their expected
performance during some future interval.

Question #38 of 40

Question ID: 466057

For the management of a fixed-income portfolio, which of the following is an important implication of the change in the dominant product
structure in the primary corporate bond market within the last decade?

ᅞ A) Intermediate maturity bonds are scarce and, therefore, demand a premium price.


ᅞ B) Option-free bonds are scarce and, therefore, demand a premium price.
ᅚ C) Securities structured with embedded options are scarce and, therefore, demand a premium
price.

Explanation
Intermediate structures that are not callable, putable, or sinkable have come to dominate the market.

Question #39 of 40

Question ID: 466053

Which of the following statements about bond market characteristics is least accurate?
ᅚ A) Callable issues are no longer dominant in the high-yield segment of the
corporate bond market.
ᅞ B) Bond managers adjust their portfolios in response to, or in anticipation of, structural
changes in the composition of the bond market.
ᅞ C) During the 1990s, new bond issuances had narrower spreads and relatively strong
returns.
Explanation
In the high-yield market segment, callable issues are still dominant, although this may change in time. Bullet and intermediate
structures now dominate the other segments.

Question #40 of 40

Question ID: 466065

On-the-run Treasuries are frequently perceived to have superior liquidity. Based on this rational, many bond managers
engage in:
ᅞ A) curve adjustment trades.
ᅚ B) new issue swaps.
ᅞ C) credit defense trades.
Explanation
Relatively large new issues, particularly Treasuries that have just been issued (on-the-run), are believed to have superior
liquidity-a rationale for including more of them in the portfolio.



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