Questions 31 through 36 relate to Fixed Income Portfolio Management.
Allied Advisors Case Scenario
The Flagstone College endowment fund recently received a significant donation and has
decided to allocate the new funds to fixed income. Flagstone selected Allied Advisors to
manage the fixed income portfolio and is currently evaluating Allied’s recommendations
on structuring the portfolio. Greg Thorne, fixed income portfolio manager with Allied
Advisors, is meeting with the endowment fund’s trustees. Jerome Moir, a trustee, makes
the following statements:
Statement 1: “We want to use portfolio returns to fund as many scholarships as
possible; the endowment fund has no specific liabilities to meet.”
Statement 2: “The endowment fund’s investment policy statement indicates a medium
term time horizon and seeks to avoid capital losses.”
Thorne responds: “Irrespective of whether you have specific liabilities to meet, a bond
market index must be selected that will serve as a benchmark.”
Thorne then presents the trustees with four benchmarks that could be used to evaluate the
performance of a fixed income portfolio. The characteristics of the benchmarks are
outlined in Exhibit 1.
Exhibit 1
Fixed Income Benchmark Indices
Duration
Benchmark Index
(years) Bond Sectors Represented
Barclays 1-3 year
1.8 Investment grade corporate and U.S.
Government/Corporate
Treasury
Barclays Aggregate 4.9 Investment grade corporate, ABS, MBS,
U.S. Treasury
Barclays U.S. High Yield 4.8 Corporate below investment grade
Barclays Long
8.7 Investment grade corporate and U.S.
Government/Corporate
Moir asks Thorne to present the historical performance of one of Allied’s portfolios
relative to the benchmark index. Thorne’s comparison is shown in Exhibit 2.
By accessing this mock exam, you agree to the following terms of use: This mock exam is provided to
Exhibit 2
Allied Representative Portfolio vs. Benchmark
Portfolio
Benchmark
*
Year
Return
Return
2004 9.70% 9.40%
2005 -3.50% -3.75%
2006 5.40% 6.00%
2007 0.75% 1.00%
2008 6.95% 6.25%
*Returns are net of management fees of 0.15% annually.
Moir also is interested in the risks that Allied takes in spread sectors. He asks for
additional information on the amount of spread risk in Allied’s portfolio relative to the
benchmark. Thorne responds with the information shown in Exhibit 3.
Exhibit 3
Contribution to Spread Duration
Portfolio Benchmark
% of
Contribution to
Spread Duration
Portfolio
Sector
Treasury 44.0 0.0 45.0 0.0
Corporate 22.5 1.96 23.0 1.38
Mortgage 14.0 0.42 17.0 0.53
Asset backed 19.5 0.49 15.0 0.40
Total 100.0 2.87 100.0 2.31
Moir then asks Thorne for his interest rate forecast for the coming year. Thorne
responds, “At Allied we expect long rates to underperform short rates causing a twist in
the yield curve.”
Finally, Moir asks Thorne to illustrate how he evaluates the total return of a new trade.
Thorne presents an analysis for a model trade of a 6 percent coupon bond with five years
to maturity currently trading at par, with the next coupon payment due in six months. In
his analysis, Thorne assumes he can sell the bond at $101.50 at the end of a six-month
holding period.
31. Is Thorne’s statement regarding the selection of a bond market index as a
benchmark most likely correct?
A. Yes
B. No, because if the portfolio has a liability to meet, then the liability becomes
the benchmark
C. No, because the selection of a bond market index is only required if a full-
blown active management strategy is followed
32. Based on Statement 2 made by Moir and the information presented in Exhibit 1,
the most appropriate benchmark for Flagstone’s endowment fund is the:
A. Barclays Aggregate.
B. Barclays U.S. High Yield.
C. Barclays 1-3 year Government/Corporate.
33. The strategy of the portfolio whose returns and risk characteristics are presented
in Exhibits 2 and 3 is best described as:
A. enhanced indexing by minor risk factor mismatches.
B. active management by larger risk factor mismatches.
C. enhanced indexing by matching primary risk factors.
34. Given the information in Exhibit 3, a mismatch of risk exposures between the
portfolio and the benchmark should most likely be attributed to the:
A. mortgage sector.
B. corporate sector.
C. asset backed sector.
35. Given Thorne’s interest rate forecast, which method for managing interest rate
risk relative to the benchmark will be most effective?
A. Key rate duration
B. Effective duration
C. Convexity adjustment
36. The total return for the trade Thorne illustrates is closest to:
A. 2.23%
B. 3.00%.
C. 4.50%.
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