Question

discuss the risks and returns associated with using liability management to meet liquidity needs.

a)Suppose the manager of a DI's liquid assets portfolio anticipates that interest rates will rise over the next few years. How might this manager structure the liquid assets portfolio to take advantage of this situation?

b)What factors should the manager take into consideration before implementing any strategies you have recommended in part (a)?

Answer 1

a) There is an inverse relationship between the bond price and interest rates i.e. If the interest rate rises, the bond price falls. If the interest rate decreases, the bond price rises.

The bond price falls when the interest rate rises is because example. i.e. When interest rate is say 8%, i have a bond purchased at $100. Now if interest rate rises to say 8.25%, the value of the $100 bond will be lower as investors already have access to 8.25% bonds and there is less demand for my $100 bond with less coupon rate.

Similar is the case when interest rate falls i.e. When interest rate is say 8%, i have a bond purchased at $100. Now if interest rate decreases to say 7.75%, the value of the $100 bond will be higher as investors now have access to 7.75% bonds and there is more demand for my $100 bond with higher coupon rate.

Thus when interest rates are going to increase, the fund manager should ideally go for short term maturity bonds so that he can reinvest the amount from the bonds maturing at higher yields i.e. interest rates once the interest rate increases. Thus the fund manager would be able to get higher returns for his investors. This is how he can take advantage of the situation. When the interest rates reach a particular peak, the fund manager should shift to long-term bonds because the impact of interest rate cut is more or longer term bonds. Thus the price for long term bonds would increase in the event of interest rate cut and the fund manager can leverage the power of Capital Gains and get his investors handsome returns.

b)
Before implementation of any strategy the fund manager should take into consideration the time horizon and the philosophy of the fund house. Taking on additional risk in terms of the credit rating of bonds may prove detrimental. Thus the fund manager should stay true to the investment thesis and only take the amount of risk commensurate with the returns. Also the fund manager should keep in mind the liquidity factor for the bonds, particularly the long-term bonds during interest rate cut.
The fund manager should also do appropriate due diligence in terms of the liquidity profile of the entity whose bonds are being bought, so that in the scenario of a drastic downgrade of bonds, the fund manager's strategy does not go haywire.