Question #59

Volatility in short-term rates is most likely linked to monetary policy, whereas volatility in long-term rates is most likely linked to uncertainty about the real economy and inflation. (Module 25.6, LOS 25.j) Martha Garret, CFA, manages fixed-income portfolios for Jones Brothers, Inc. (JBI). JBI has been in the portfolio management business for over 23 years and provides investors with access to actively managed equity and fixed-income portfolios. All of JBI's fixed-income portfolios are constructed using U.S. debt instruments. Garret's primary portfolio responsibilities are the Quasar Fund and the Nova Fund, both of which are long fixed-income portfolios consisting of Treasury securities in all maturity ranges. The Quasar Fund holdings as of March 15 are provided in Exhibit 1. A comparison of key rate durations for the Quasar Fund and Nova Fund is provided in Exhibit 2. Exhibit 1: Quasar Fund Bond Maturity (years) Coupon Yield Par Value Market Value Duration A 2 5.0% 5.0% 4,000,000 4,000,000 1.86 B 5 4.5% 6.0% 3,500,000 3,278,851 4.32 C 15 8.0% 7.0% 2,750,000 3,000,468 8.90 D 30 6.5% 4.0% 6,450,000 9,238,340 15.90 Exhibit 2: Key Rate Durations for Quasar Fund & Nova Fund Fund Maturity (years) 2 5 15 30 Quasar Fund 0.90 1.20 1.80 6.10 Nova Fund 0.40 2.50 3.40 1.10 Of particular importance to Garret and her colleagues is the degree of interest rate risk exposure unique to each portfolio under JBI's management. Driving the increased awareness of the portfolios' interest rate exposure is the double-digit growth in assets under management that JBI's fixed-income portfolios have experienced in the past five years. Interest in the company's fixed income portfolios continues to grow and as a result, all portfolio managers are required to attend weekly meetings to discuss key portfolio risk factors. At the last meeting, Miranda Walsh, a principal at JBI, made the following comments: "The variance of daily interest rate changes has been trending higher over the past three months, leading us to believe that a period of high volatility is approaching in the next 12 to 18 months. However, the reliability is questionable because the volatility estimates were derived using an option pricing model, which assumes constant interest rates." "Also, the Treasury spot rate curve currently has a similar shape to the yield curve on Treasury coupon securities, which according to the market segmentation theory of interest rate term structure, indicates a relatively high level of demand from investors for intermediate term securities. Overzealous trading by investors unwilling to move into other maturity ranges may create mispricing and opportunities for arbitrage." After the meeting, Walsh and JBI's other principals met to discuss a new international portfolio opportunity. At Walsh's suggestion, the principals selected Garret as the lead portfolio manager for the new fund, which will be titled the Atlantic Fund. One of the other portfolio managers, Greg Terry, CFA, suggested to Garret that she utilize the MRR swap curve as a benchmark for the Atlantic fund rather than using local government yield curves. Terry justifies his suggestion by claiming that "the lack of government regulation in the swap market makes swap rates and curves directly comparable between different countries despite fewer maturity points with which to construct the curve as compared to a government yield curve. Furthermore, credit risk in the swap curves of various countries is similar, thus avoiding the complications associated with different levels of sovereign risk embedded in government yield curves." Intrigued by the idea of using the swap curve, Garret has her assistant begin gathering a range of current and forward MRR rates.