section 1 - The American College Online Learning Center

2. Credit qualitya. Credit quality refers to an issuer’s ability to fulfill its contractual obligation to makeinterest and principal payments to investors.3. Bond fund performancea. Price risk is realized when interest rates increase. Reinvestment risk is realizedwhen interest rates decrease. There are two approaches to immunizing a bondportfolio from interest rate risks altogether, such that price risk cancels outreinvestment risk: laddering and duration matching.b. The first strategy, known as laddering, dedicates cash inflows from bonds toparticular periods of consumption during retirement. In other words, it dedicates aportfolio of bonds to meeting specific periods of consumption over the portfoliodecumulation phase of one’s life.(1) The benefit of this strategy is that it provides for complete immunization ofinterest rate risks and it has little explicit ongoing costs.(2) The downside is that it often entails holding a concentrated portfolioof bonds that have some degree of credit risk, which means that theinvestor is unnecessarily bearing idiosyncratic risk that he is not beingcompensated for because they can be “diversified away.”c. For many investors, especially middle class investors who would be forced to holda nondiversified portfolio of bonds if they employ laddering, duration matching is asuperior alternative strategy.d. Duration matching involves seeking to calibrate one’s choice of fixed incomeproducts such that the asset-weighted duration of the fixed income products isequal to the dollar-weighted average length of time until an investor will use moneyfrom the portfolio to fund consumption.(1) Example: If the investor is considering one bond fund with an averageduration of 5 years and another with an average duration of 10 years, andthe investor’s dollar-weighted average length of time until consumption is7.5 years, then the investor will invest equal amounts of money in eachfund. The investor will need to rebalance the portfolio on an ongoing basisto keep the duration of the assets matched up with the duration of theliabilities. It is important to note that the price risk realized in period 1 giventhe scenario involving an interest rate shock is counteracted by a higherrate of return on reinvested cash flows in periods 1 through 7.5.e. The benefits of using products to achieve duration matching potentially lowerportfolio risk and also provide a simpler asset management process for thefinancial planner as much of this task is delegated to a fund manager. Thecosts are explicit, in terms of higher ongoing expenses, and also implicit. Theimplicit costs are imprecision in duration matching and also the resultant costof rebalancing. Additionally, there may be some negative tax consequencesassociated with mutual funds due to ongoing capital gains distributions.f. Now we turn to the topic of credit quality. Domian and Reichenstein (2008) showthat mutual funds that invest in high-yield bonds, also known as junk bonds, havereturn characteristics that are a hybrid of stocks and bonds. In other words, aninvestor in a high-yield bond fund can be thought of having some holdings in aninvestment-grade bond fund and some in a stock fund.(1) Example: They find that bond funds with an average credit quality of CCCare about half bond fund and half stock fund in terms of the behavior of7.7