Fixed Income Portfolio Construction and Analysis
Core concepts
Fixed income construction is driven by the mandate: liability-driven, index-tracking, or total-return. Candidates must know duration as the primary interest-rate risk measure, convexity as its curvature adjustment, and the distinction between modified duration and Macaulay duration. Credit analysis covers spread, default probability, recovery, and rating migration. Sector choices - government, agency, corporate, securitized - carry different liquidity and prepayment risks.
Yield curve strategies include bullet, barbell, and laddered structures, plus riding the yield curve and duration positioning. Immunization matches duration and present value of assets to liabilities, with rebalancing as time passes; cash-flow matching removes reinvestment risk at the cost of flexibility. Spread duration and key-rate duration matter when curves twist rather than shift in parallel.
Traps
- Using duration alone when the curve twists; key-rate durations are needed.
- Ignoring convexity in large rate moves.
- Treating credit spread widening as an interest-rate event.
- Forgetting that immunization requires periodic rebalancing and assumes parallel shifts.
Worked example
A bond has modified duration 6 and convexity 40. For a 100 bp yield increase, the duration effect is about −6.0%; the convexity adjustment adds roughly +0.20% (0.5 × 40 × 0.01²), giving about −5.8%. Convexity cushions the loss on rate rises and trims the gain on rate falls.
Rule of thumb: match the mandate first - duration and cash flows for liability-driven mandates, spread and sector analysis for total-return mandates - then stress the curve for twists, not just shifts.