Module 8: Fixed Income Portfolio Management
Fixed Income Portfolio Management in CFA Level 3 focuses on actively managing bond portfolios to control risk and optimize returns.
Unlike earlier levels, the focus here is not just on valuation but on:
- managing interest rate risk
- positioning portfolios based on yield curve expectations
- controlling credit exposure
This module is important for portfolio managers working in fixed income funds, pension funds, and institutional portfolios.
Duration management is one of the most important tools used to measure and control interest rate risk in bond portfolios.
Interest Rate Risk
Interest rate risk refers to the sensitivity of bond prices to changes in interest rates.
Key Relationship
- when interest rates rise, bond prices fall
- when interest rates fall, bond prices rise
Duration as a Risk Measure
Duration measures how much a bond’s price changes for a change in interest rates.
Interpretation
- higher duration means higher sensitivity to interest rate changes
- lower duration means lower risk
Portfolio Duration Management
Portfolio managers adjust duration based on interest rate expectations.
Strategies
If interest rates are expected to rise
→ reduce portfolio duration
If interest rates are expected to fall
→ increase portfolio duration
Immunization Strategy
Immunization aims to match the duration of assets and liabilities.
This helps protect the portfolio from interest rate changes.
Yield curve strategies involve positioning the bond portfolio based on expected changes in the yield curve.
Types of Yield Curve Movements
Parallel Shift
All interest rates move in the same direction.
Steepening
Long term rates rise faster than short term rates.
Flattening
Short term and long term rates converge.
Bullet Strategy
In a bullet strategy, investments are concentrated around a single maturity.
Characteristics
- focuses on a specific maturity point
- lower reinvestment risk
- less diversification across maturities
When to Use
Used when the yield curve is expected to remain stable.
Barbell Strategy
In a barbell strategy, investments are concentrated in short term and long term maturities.
Characteristics
- combines short and long term bonds
- higher flexibility
- benefits from yield curve changes
When to Use
Used when interest rate volatility is expected.
Comparison
Bullet Strategy
Concentrated at one maturity
Barbell Strategy
Spread across short and long maturities
Portfolio managers choose strategies based on interest rate expectations.
Credit strategies focus on managing credit risk and return tradeoffs in bond portfolios.
Managing Credit Exposure
Credit exposure refers to the risk of default by bond issuers.
Portfolio managers adjust exposure based on:
- economic conditions
- credit spreads
- issuer quality
Investment Grade vs High Yield
Investment Grade Bonds
Lower risk and lower return
High Yield Bonds
Higher risk but higher return
Credit Spread Strategies
Credit spreads represent the difference in yield between corporate bonds and government bonds.
Strategy Based on Spread Expectations
If credit spreads are expected to narrow
→ increase exposure to lower quality bonds
If credit spreads are expected to widen
→ shift toward higher quality bonds
Diversification of Credit Risk
Portfolio managers diversify across:
- industries
- issuers
- regions
This reduces the impact of default risk.
This module is important because it helps candidates:
- manage interest rate risk effectively
- apply yield curve strategies
- control credit exposure
- construct bond portfolios aligned with objectives
In CFA Level 3, questions often require candidates to recommend portfolio strategies based on interest rate and credit market expectations, making this a high scoring and application based module.