Chapter 14Factor-Based Fixed Income Portfolio Construction and Evaluation

Chapter 13 introduced fundamental fixed income terminology and discussed sources of bond portfolio risk. In this chapter, we describe analytical frameworks for fixed income portfolio management and focus on the use of factor models for fixed income portfolio construction and risk decomposition.

We begin the chapter with a list of commonly used fixed income factors that represent potential sources of risk, as we described in Chapter 12. We then review analytics-based bond portfolio construction strategies, including stratification and optimization-based approaches. Finally, we present a detailed example of the use of factor models for portfolio construction and risk decomposition.

14.1 Fixed Income Factors Used in Practice

In Chapters 9 and 12, we explained that the main groups of factors used in equity portfolio management include fundamental, macroeconomic, and statistical. Many of the factors used in equity portfolio construction impact fixed income securities' returns as well. In this section, we elaborate on factors most useful for fixed income portfolio construction, including interest rate levels, credit quality, currency rates, the volatility of interest rates, and the possibility of prepayments.1

14.1.1 Term Structure Factors

Changes in the term structure—the curve representing the relationship between yields and time to maturity—are a very significant component of the overall risk of a fixed ...

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