FIXED INCOME

ATTRIBUTION
Portfolio insights through analytical precision

may 2013

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table of contents
fixed income attribution

01 | Foreword
02 | Fixed income in demand
03 | Generating additional returns
04 | New fixed income tools
05 | Limitations of traditional attribution models
06 | Designing a new attribution solution
07 | Refining the approach
08 | Assembling the blocks
10 | A practical example
15 | Summary
16 | Appendix
18 | About
19 | Contact

Todays low-rate slowgrowth markets are

challenging institutional
investors to more carefully
analyse correlations
between investment
strategies and portfolio
performance. Fixed income
investments embody
unique characteristics that
require unique performance
attribution solutions.

1 | rb c in vest o r servic es & s tatpr o

foreword

Portfolio diversification strategies continue to include fixed

income instruments as a means to counter market uncertainty.
Moreover, demographic trends are pointing to an increased
dependency on these instruments as a risk hedgenamely Baby
Boomers who are shifting a growing share of their retirement
assets into bonds. But is there a clear understanding of the factors
influencing portfolio performance? How can fixed income
managers prepare for future economic shocks?
The answer in part, lies in reliable methodologies and
technologies that offer the transparency demanded by todays
sophisticated investors.
RBC Investor Services and StatPro are pleased to share with
you strategies and solutions that offer a new perspective
an alternative to traditional performance attribution models.
In order to best demonstrate the value of this approach, it is
important to have insight into current economic conditions and
also understand the gaps that exist with common fixed income
modeling disciplines. We also explore fixed income trends
and opportunities.
We trust you will find these insights relevant and useful as
you continue to refine your performance attribution strategies.
We look forward to your comments and feedback.
Mandeep Dhillon
Product Manager
RBC Investor Services

Dario Cintioli
Product Director
StatPro

fi xe d i nco m e at t ribu t ion | 1

fixed income in demand

composition of worldwide investment fund assets 2011:q1

Percent of total assets, end of quarter

10%

12%

Equity 40%
Money Market 18%

Bond
20%

Global demand for fixed income products continues to be strong,

largely due to the diversification benefits this asset class provides
investors. Towards the end of Q1 2011, 20 percent of worldwide
investment assets were held in fixed income. This figure has since
risen to 24 percent at the end of Q3 2012 with further allocations
held in balanced funds.

Bond 20%
Balanced-Mixed 10%
Equity
40%

Other/Unclassified 12%

Money Market
18%

Source: EFAMA International Statistical Release Q1 2011

composition of worldwide investment fund assets 2012:q3 (*)

Percent of total assets, end of quarter

11%

12%

Equity 37%
Money Market 16%
Bond 24%

Bond
24%

Balanced-Mixed 11%
Equity

Other/Unclassified 12%

Money Market

Source: EFAMA International Statistical Release - Q3 2012

(*) Including fund of funds

2 | rb c in vest o r servic es & s tatpr o

According to Mandeep Dhillon, Product Manager, Risk &

Investment Analytics with RBC Investor Services, Increasing
allocations to fixed income instruments signifies the growing
value and importance of this asset class in creating investor
value. In assessing fixed income and balanced fund assets
collectively, positions have increased from 30 percent to 35
percent during the period noted.
According to the European Fund and Asset Management
Association (EFAMA), the value of fixed income and balanced
fund assets increased from 5.97 trillion to 7.6 trillion in less
than two years, a 27 percent growth rate, while equity fund
assets increased by only four percent during the same period.
Contributing factors include a continued low growth environment
globally, increased uncertainty and volatility in equity markets
and a diminished tolerance for risk spanning many investor
typesparticularly Baby Boomers who continue to recover from
significant devaluations in their retirement savings resulting
from the financial crises and ongoing turmoil.

generating additional returns

To replicate this experience, active fixed income management

requires a thorough understanding of the risk and return drivers
affecting a portfolios value including duration, spread, as well as
sector and market allocation. It may also require an increased
allocation to non-traditional fixed income instruments such as
floating rate notes, credit default swaps, convertible bonds and,
in general, a willingness to accept greater risk through higher
yielding issues.
The acceptance of higher yielding, yet higher risk bond issues is
captured in RBC Investor Services quarterly All Plan universe,
which reveals that pension managers have been materially
overweight in their allocations to non-federal issues relative
to the index since Q3 2007.

canadian bond characteristics

Allocation to Non-Federals within Domestic Bonds

All Plan Universe
85
75
65
55
45
35
25
15
Jun 05
Sep 05
Dec 05
Mar 06
Jun 06
Sept 06
Dec 06
Mar 07
Jun 07
Sep 07
Dec 07
Jun 08
Sep 08
Dec 08
Mar 08
Jun 09
Sept 09
Dec 09
Mar 09
Jun 10
Sep 10
Dec 10
Mar 11
Jun 11
Sept 11
Dec 11
Mar 12
Jun 12
Sep 12
Dec 12

While traditional passive fixed income investing is an approach

designed to generate steady returns and diversify portfolios,
mandates that deviate from the benchmark and focus on placing
active bets have also proven to be successful. According to RBC
Investor Services Pooled Fund Survey (Q4 2012), median active
Canadian bond managers were able to add 35 basis points against
the DEX Universe over a five-year period and 15 basis points over
a 10-year period. For global bond mandates, the survey shows
median active managers outperforming the Citigroup World
Government Bond Index by 128 basis points over five years and
296 basis points over 10 years.

Non-Federals

DEX U Non-Federals

At the end of Q4 2012, the overweighting was 19 percent. The low

interest rate environment required plan sponsors to seek higher
returns (and assume greater risk) in other fixed income sectors
such as corporates, provincials and municipals to offset the rise
in pension plan liabilities. As a result, accurately measuring and
monitoring the effects of these active bets and their associated
risk factors becomes an integral component of the asset
management process.
The figures presented illustrate a continued dependence on fixed
income assets as a major component of both discretionary and
non-discretionary mandates. While the aggregate composition of
worldwide investment funds may shift as global macroeconomic
conditions improve, persistent market uncertainty and slow
economic recovery in the United States, China and the Eurozone
will continue to spur interest in fixed income assets.
It is essential then, that global fixed income investors have
access to appropriate models and robust, market-leading tools
that assist in effectively managing the risk and return attributes
of this exposure.

fi xe d i nco m e at t ribu t ion | 3

new fixed income tools

Both fixed income investment strategies and the instruments themselves are evolving as the quest
to extract greater yields in this low interest rate environment continues. Beyond standard fixed rate
bonds, instruments have been developed that target changes in credit quality, such as FRNs and
CLOs. Others, such as MBS-based derivatives, have been developed to target specific segments in the
mortgage market. CMOs and basket derivatives go further and target more implicit aspects such as
default correlation among issuers.

A common and transparent approach to pinpointing all

sources of risk and return is crucial.
But as each new development emerges, a greater level of expertise is required in order to understand
the fundamental aspects of the instruments and the nuances of each as they are used in specific
strategies. From an oversight and investor perspective, a common and transparent approach to
pinpointing all sources of risk and return is crucial. The performance attribution model selected
must be sophisticated enough to accommodate the range of market instruments as well as the
changing nature of the market. At the same time, it must have the capacity to convey the results
in an easily understood manner to facilitate timely and informed investment decisions.
While these characteristics are familiar and reflect methodologies currently employed by equity
markets, they are not as relevant to the fixed income sector. A specific attribution model for the fixed
income sector is essential.

4 | rb c in vest o r servic es & s tatpr o

limitations of traditional attribution models

Many investors and managers are familiar with traditional

performance attribution models such as the Brinson-Fachler
model that highlights a managers ability to meet or exceed stated
objectives (e.g., to outperform an index or a blended benchmark).
These models provide a clearer picture of the drivers of excess
returns and help focus on the potential sources of risk.

One alternative is a linear factor-based approach where the most

common risk factors are identified and the portfolios sensitivity
(also referred to as betas, loadings, or coefficients) to each factor
is calculated using an analytical method. The return of the
portfolio can be summed up as:
R =nFn+residual (where is the sensitivity to a risk factor)

The Brinson-Fachler model, widely used for equities, highlights

the allocation effects (i.e., tactical positioning) and the selection
effects (i.e., security selection). This model is often referred to as
a sector-based or segmented attribution method as the measure
of tactical positioning is based on a comparison of the portfolio
sector breakdown to the benchmark sector breakdown (e.g., is the
portfolio underweight in a specific sector). However, the portfolio
does not have to be decomposed by sector. It can be segmented
by geography, market-cap, or any other relevant breakdown.
Regardless of the segmentation scheme selected, it must be
consistent with the investment process and objectives. From
there, the Brinson-Fachler model quantifies security selection
skills within each segment.
To a large measure, this model does indeed pinpoint how a
managers skill adds value to a portfolio. But while sector-based
models can be customised to any investment segmentation
scheme to pinpoint outperformance, they are not consistent
with how fixed income managers make investment decisions.
Fixed income managers typically do not partition the market
into broad segments when outlining a strategy. Instead, they
investigate sources of return and risk that will make a positive
portfolio impact. For example, key drivers of bond fund returns
would include interest rate levels, credit spread movements,
steepening yield curves, etc. The challenge for a manager is
determining how to segment a portfolio that allows for many of
the dimensions of risk and return to be captured simultaneously.
A manager may be able to partition the portfolio by one
dimension (e.g., interest rate sensitivity), but how would other
dimensions be incorporated?

Most investors recognise this approach from the equity world

where the two most cited factor models are the CAPM and the
Fama-French model.
And while this approach can simultaneously incorporate many
risk factors such as spread duration and implied volatility, it
is rather restrictive when applied to complex portfolios with
non-linear securities. Even at a very basic level, it is clear that
there is an inverse relationship between interest rates and
fixed-rate bond prices. More importantly, an attribution model for
fixed income portfolios should incorporate all nuances of fixed
income instruments such as callability, putability, mortgage
prepayment assumptions, etc., most of which are not linear.
The solution lies in a fixed income attribution system that is
consistent with the fixed income investment process and captures
the key aspects of the various types of fixed income securities.
In addition, such a system must be able to display the attribution
results in a clear and transparent manner so that all portfolio
stakeholders (i.e., managers, investors, investment boards, etc.)
can contribute to important oversight decisions.

fi xe d i nco m e at t ribu t ion | 5

designing a new attribution solution

By using the fixed income investment process as the starting

point, it is possible to design a fixed income attribution solution
that is consistent with the process and also has the benefit of
incorporating the myriad of fixed income instruments. Furthermore,
using this starting point allows for a basic view of fixed income
decomposition and more detailed exploration and discussion.
The investment process uses two key building blocks for fixed
income returns: the level of interest rates and spreads and the
changes in interest rates and spreads. Finding the level of rates
and spreads is rather simple, but many fixed income managers
and traders spend substantial time and effort into modeling the
changes in rates and spreads and understanding the corresponding
repercussions. For example, many investment banks have their
own models for forecasting future interest rate environments and
how changes will affect mortgage prepayments. There are many
other contributors to return, including currency exposure and
inflation, but the starting point for most managers is the level
of rates.
The term used to describe the level of rates and spreads is carry.
Carry is the yield that an investor will receive by simply holding
the bondthe first basic contributor to fixed income returns.
Carry is typically broken up into systematic carry and specific
carry. Systematic carry is the return that can be obtained by
investing in the interbank (LIBOR) curve and the specific carry is
the return added to the systematic carry to compensate for taking
added risk associated with an issuer, seniority, sector, etc. The
combination of specific and systematic carry is analogous to the
yield-to-maturity for standard fixed-rate bonds.

Source: RBC Investor Services Investment Analytics Interactive

6 | rb c in vest o r servic es & s tatpr o

Changes in interest rates are usually modeled as changes in the

shape of the yield curve. Like carry, changes in the shape of the
yield curve are sources of investment return. When every point
in the yield curve is moved simultaneously by the same amount
(i.e., 10 bps), this movement is referred to as a shift. Other types
of movements that are common to yield curves are twist and
butterfly. Twist measures the effect of the change around one
point on the curve resulting in a steepening or flattening of the
curve. Butterfly measures the effect of a change in the curvature
of the yield curve. Together, twist and butterfly are called
non-parallel movements.
One other effect that can be included as a source of return is roll
down. Roll down measures the effect of the change in maturity
over time as the bond converges to par. A robust fixed income
system should be able to attribute changes to the shape of the
yield curve into these effects simultaneously, since these are the
most common yield curve movements.
The other major changes that should be measured and clearly
highlighted are the effect of changes in the credit spreads (or
perceived changes in the credit quality of the instrument) and
the effect of foreign currency exposures (relevant to multicurrency
portfolios).
Other contributors to return such as inflation, convexity and
optionality can be included in the overall presentation but must
be included in the calculations. However, to be clear and
transparent, it is mandatory that the major contributors of carry,
changes in yield curve shape, changes in spreads and the effects
of currency exposure are presented explicitly.

refining the approach

Fixed income investing requires a different attribution approach that pinpoints the sources of risk
and return. It is clear that traditional sector-based attribution alone cannot adequately help investors
dissect performance figures.
Factor-based models are an improvement although their linear nature does not capture the nuances
associated with fixed income instruments. For example, in a more complex portfolio, it is crucial to
capture all the optionality embedded in callable bonds, the effects of convexity and all the
implications of effective time-to-maturity for mortgage pools. To capture all these nuances, the
engine driving a fixed income attribution system requires a robust library of pricing functions. These
pricing functions can then compute risk (sensitivity) figures consistently and thoroughly. By applying
these sensitivities to actual changes in the market environment, an advanced attribution report can
be produced. In this manner, all non-linear effects are captured and the attribution model aligns with
the investment process.
A clear example is reflected in an assessment of the risk factors affecting a simple domestic fixed-rate
bond, namely interest rates and credit spreads. The pricing function attached to this bond will input
interest rates and credit spreads and a computation process will use this function to output
sensitivity numbers. The sensitivity numbers are modified duration, modified spread duration, and
convexity. These numbers will then be applied to the changes in interest rates and credit spreads that
occurred in the time period in question. The combination of these changes and the bonds sensitivity
to these changes will provide a clear picture of where returns were made.

pricing
functions

risk
sensitivity
numbers

changes
in risk
factors

Source: RBC Investor Services Investment Analytics Interactive

fi xe d i nco m e at t ribu t ion | 7

assembling the blocks

An important
element of the fixed
income investment
process is portfolio
stress testing.

The ideal building blocks of a robust and reliable attribution

report should target sources of return (i.e., the effects of carry,
rate changes, spread changes and currency exposure) and identify
what drives the underlying calculations (i.e., pricing functions
and consistent methodology for sensitivity numbers). A system
that does not incorporate these aspects may expose investors
to latent risk that may not be apparent from a traditional
performance review.
Once the building blocks are assembled, a system can be used to
highlight other more complex exposures and sensitivities, such as
credit sensitivities at different shifts and DV01s across currencies.
Another important element of the fixed income investment
process is portfolio stress testing. Regardless of the investment
strategy of a fixed income portfolio (i.e., active or passive), the
investment team must be able to quickly react to macroeconomic
and market changes that affect their holdings. To supplement the
fixed income attribution analysis and reports, stress tests (both
engineered and historical) can be applied to the portfolio. For
market shocks that are not representative of normal market
movements (e.g., extreme events from history or engineered
events that could potentially occur), a tool that employs full
pricing functions should be used. Sensitivities to these larger
market movements can be reliably used to shock each underlying
instrument in the portfolio to obtain an overall portfolio response
to market events. This is a particularly important and relevant
exercise as future market movements are not likely to occur in 10
bps, 50 bps or 100 bps increments.
An advanced model can further segregate other contributors
to return beyond the common carry, yield, and spread aspects.
For more complex securities, contribution including convexity,
inflation, and convertibility can be displayed.

8 | rb c in vest o r servic es & s tatpr o

Source: RBC Investor Services Investment Analytics Interactive

Source: RBC Investor Services Investment Analytics Interactive

Source: RBC Investor Services Investment Analytics Interactive

Source: RBC Investor Services Investment Analytics Interactive

fi xe d i nco m e at t ribu t ion | 9

a practical example

The following example illustrates the concepts discussed previously, from the perspective of both
a passive investor (with more interest in recent fund performance) and an active manager (with
interest in assessing the funds exposure to future shocks and making allocation decisions
accordingly).
The accompanying screenshots depict an attribution platform that shows the performance of a
sample global bond portfolio initially set up as a 50-50 split between government bonds and
corporate issues, from January 2012 to January 2013.
From a historical perspective, it is evident that the portfolio is yielding less in 2013 than in 2012, yet
still above US LIBOR, which could reflect a general movement in rates. What is most revealing,
however, is that a majority of the portfolio returns are coming from corporates and their associated
spread movement.
From the return breakdown, the corporate sectors weighting increased above the original 50%
allocation to 52.5% while also contributing more to the overall return. The portfolios response to
changes in credit spreads had the largest influence on the portfolios returns, as the health of
industrial companies improved. A robust system should provide drill down capabilities in order to
examine contribution sources at a more granular level, as displayed here.
While this detail provides investors with an indication as to what is generating the returns, an active
manager might prefer to use an attribution system and incorporate it into the investment process.
Typically, an investment process has three steps:
1. Set investment objectives and policies
2. Select an investment strategy
3. Allocate funds to individual assets
An attribution system can be integrated into the second step. Once the objectives are established, a
strategy needs to be chosen and implemented. This involves evaluating and forecasting market conditions
then positioning the portfolio in light of this evaluation by allocating to existing or new assets. It is
also important to assess and forecast market conditions at a macro level. Based on a summary of RBC
Economics year-end research, inflation is projected to remain flat and some yield curves are expected to
steepen slightly. For the sample portfolio, the relevant forecasts would be in regard to the health of
the economy. With inflation in check, central banks can focus on employment and growth. Therefore,
GDP, in North America in particular, is expected to rise and credit spreads are expected to narrow.

1 0 | rb c invest o r servic es & s tatpr o

Portfolio
returns are
dependent on
a variety of
contributing
factors.
Source: RBC Investor Services Investment Analytics Interactive

Source: RBC Investor Services Investment Analytics Interactive

Source: RBC Investor Services Investment Analytics Interactive

fi xe d i nco m e at t ribu t ion | 11

a practical example cont.

Source: RBC Economics Research, Economic and Financial Market Outlook

Source: RBC Investor Services Investment Analytics Interactive

Source: RBC Investor Services Investment Analytics Interactive

1 2 | rb c invest o r servic es & s tatpr o

Please refer to the Appendix for additional economic indicators and insights.
Another important assessment is to investigate the portfolios exposure based on currency. The exposure
graphs of the sample portfolio are categorised by interest exposure and credit spread exposure.
The DV01 figures on page 12 reflect interest rates, spreads and inflation. The sensitivity to spreads in
the US and Canada are higher than in the other major markets.
With market projections and portfolio exposures in hand, allocation decisions can then be made. The
decision-making process can be broken down by factor classifications with risk factors that affect a
portfolio can be classified into yield curve factors, non-yield curve factors, and issuer specific factors.
Based on the example provided, changes in the shape of the yield curve did not contribute
significantly to the overall portfolio return. However, since the economic data presented indicated
the possibility of a slight steepening of the curve in the near future in North America and the
Eurozone (and larger changes in Australia and New Zealand), and also given the general rise in rates,
portfolio positioning can be undertaken in anticipation.
A general rise in rates poses the most concern for instruments with higher duration. From the
interest rate exposure graph and the DV01 graph, North America appears to have higher duration
and is expected to experience greater losses if rates rise. There are several ways a manager can alter
the portfolio. First, existing assets can be shifted to lower-duration assets (from US to Euro, for
example). Second, existing high-duration bonds can be swapped for new bonds in the same category
but with lower duration. And finally, the manager can enter into interest rate agreements, typically
interest rate futures. To lower portfolio duration, a manager would typically short (sell) interest
rate futures.
The expected steepening of the yield curve poses different questions and challenges. Non-parallel
shifts like a steepening are resolved using three common strategies: bullet, barbell, and ladder. A
bullet strategy concentrates the portfolio around a single point on the yield curve. A barbell strategy
concentrates the portfolio around two points on the curve, typically on either side of a potential
bullet and a ladder strategy evenly allocates the assets across the yield curve points.
None of the strategies are exclusive to any yield curve change. That is, bullets may not always be
employed for flattenings, or ladders will not always be employed for shifts. The choice among the
three strategies will depend on a thorough analysis of duration and convexity of each asset and the
anticipated changes in the yield curve at every point. A robust attribution system should provide
the duration and convexity for each bond under such an analysis.

fi xe d i nco m e at t ribu t ion | 13

a practical example cont.

From the yield curve risk factors, the discussion shifts to non-yield curve risk factors, which could
include optionality, volatility and pre-payments. Again, this requires a thorough analysis of each
bond. For example, when assessing callable bonds in light of rising rates, a manager would typically
examine the convexity figures of each bond and assess the impact the negative convexity inherent in
callable bonds. Callable bonds are also affected by interest rate volatility (vega). Both changes in
rates and in volatility can make up a sizable portion of the outperformance between callable and
non-callable bonds. Rising rates also pose issues for mortgage pools as changes in rates can have
simultaneous increases and decreases in prepayments, although not to the same degree. An
attribution system with full pricing functions should be able to provide a manager with convexity
numbers, vega contribution, and the impact of rising rates on the price of a mortgage pool.
Issuer-specific risk factors generally centre on the credit quality of an issuer, which can be affected
by sector, capital structure and company-specific operational concerns. The RBC Economics analysis
included does not break down anticipated credit spread movements by sector, but it generally
implies that there will be a tightening of credit spreads across the board. From the exposure graphs,
the portfolio stands to make gains in an environment of credit spread tightening, more so in North
America than in any other region.
It is important to note that the impact of all risk factors (yield curve, non-yield curve, and issuer) is
simultaneous. While a manager may want to move bonds from higher duration US bonds in light of
rising rates, this decision must be tempered with the realisation that US bonds stand to gain the most
in a credit spread narrowing environment. An analysis of each bond and its corresponding risk
numbers from the attribution system would be helpful in this exercise.

Source: RBC Investor Services Investment Analytics Interactive

1 4 | rb c invest o r servic es & s tatpr o

summary

Fixed income investing is complex

and requires a combination of
ongoing assessment, monitoring
as well as critical decision-making
in response to macroeconomic and
dynamic market conditions.

Allocations to fixed income instruments are continuing upwards,

suggesting that it is now more important than ever before to have
a clear line of sight to where returns have been generated and
where they are expected to be generated. Moreover, investment
professionals and investors today are demanding greater
transparency and targeted solutions.
While conventional Brinson-based attribution models have
advantages, they are limited in their ability to provide useful and
relevant fixed income oversight. Traditionally, these models do
not incorporate the more targeted attributes that are unique to
fixed income portfolios. Encompassing attributes such as interest
rate sensitivity, convexity and optionality facilitates a more
precise examination of fixed income portfolio returns. Combining
that approach with a sophisticated attribution tool that aligns
with the fixed income investment process also contributes to
more informed and strategic investment decisions.
Fixed income investing is complex and requires a combination of
ongoing assessment, monitoring as well as critical decisionmaking in response to macroeconomic and dynamic market
conditions. Complementing your fixed income management with
an analytical model that captures the distinct qualities associated
with that strategy can play an essential role in adding quantitative
and qualitative value that benefits all stakeholders.

fi xe d i nco m e at t ribu t ion | 15

appendix

1 6 | rb c invest o r servic es & s tatpr o

Source: RBC Economics Research, Economic and Financial Market Outlook

fi xe d i nco m e at t ribu t ion | 17

about

rb c i nves t o r s ervice s
RBC Investor Services is a specialist provider of investor services to asset managers, financial
institutions and other institutional investors worldwide. Our unique approach to domestic and
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helps our clients achieve their ambitions.
RBC Investor Services ranks among the worlds top 10 global custodians with USD 3.0 trillion
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Bank of Canada, one of the largest and most financially sound banks in the world.
statpr o
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1 8 | rb c invest o r servic es & s tatpr o

contact

For more information on fixed

income attribution or to discuss
other risk and investment analytics
services and solutions, please
contact us:

rbc investor services

statpro

americas

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Group Chief Operating Officer, Boston
[email protected]

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Head, Investor Services, Canada
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Marketing Manager, Boston
[email protected]
@Swati_StatPro

rbcis.com

stratpro.com