Capturing the Correlations of Fixed-income Instruments

This paper develops a framework for managing portfolios of fixed income instruments based on traditional principles from the equities market, i.e., based on diversification. It shows, through an analysis of the high-yield bond market over the period 1987 to 1991, that fixed-income prices could be highly correlated. These correlations can be quantified and integrated, in a systematic way, in an asset/liability management framework. For vanishing fixed income securities, however, we cannot resort to statistical analysis of historical data in order to quantify correlations. The paper develops a forward-looking simulation procedure for capturing correlations. Applications are illustrated for examples from high-yield bonds and mortgage-backed securities. The superiority of the proposed approach over the traditional portfolio immunization techniques is demonstrated in the context of funding an insurance liability stream with mortgage instruments.