Chapter 19: Bond Portfolio Management

Strategies - Immunization
Bond Portfolio Performance, Style and Strategy
 Bond Portfolio Performance
 Fixed-income portfolios generally produce both less return and
less volatility than found in other asset classes (e.g., domestic
equity, foreign equity)
 Exhibit shows the average returns and standard deviations for
several performance indexes over the 20-year period
 The low historical correlation between fixed-income and equity
securities— only 0.08 over this time period—has made bond
portfolios an excellent tool for diversifying risk
Exhibit

Source: Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, 10th edition Cengage Learning, 2015.
Bond Portfolio Performance, Style &Strategy
 Bond Portfolio Style
 The investment style of a bond portfolio can be
summarized by its two most important characteristics:
credit quality and interest rate sensitivity
 The average credit quality of the portfolio can be classified
as high, medium, and low grades
 The interest rate sensitivity of the bond portfolio can be
separated as short-term, intermediate-term, and long-
term in terms of duration
Exhibit

Source: Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, 10th edition Cengage Learning, 2015.
Bond Portfolio Performance Style and Strategy

 Bond Portfolio Strategies

 Passive Portfolio Strategies
 Active Management Strategies
 Core-plus Management Strategy
 Matched-funding Techniques- Immunization
 Contingent Procedure (Structured Active Management)
Source: Reilly Frank K and Keith C. Brown, Investment Analysis and Portfolio Management, 10th edition Cengage Learning, 2015.
Matched-Funding Techniques – Immunization Strategies
 Immunization Strategies
 The process is intended to eliminate interest rate risk that includes:
 Price Risk
 Coupon Reinvestment Risk
 A portfolio manager (after client consultation) may decide that the
optimal strategy is to immunize the portfolio from interest rate changes.
 The immunization techniques attempt to derive a specified rate of
return during a given investment horizon regardless of what happens to
market interest rates.
 Immunize a portfolio from interest rate risk by keeping the portfolio
duration equal to the investment horizon.
 Duration strategy superior to a strategy based only a maturity since
duration considers both sources of interest rate risk
Immunization strategies

 Components of Interest Rate Risk

 Price Risk
 Coupon Reinvestment Risk
 If Duration ˃ Investment horizon, investor faces net price risk
 If Duration ˂ Investment horizon, investor faces net reinvestment risk
 If Duration = Investment horizon, investor is immunized.
References
 Reilly Frank K and Keith C. Brown, Investment Analysis and
Portfolio Management, 10th edition Cengage Learning, 2016.
 Zvi Bodie, Alex Kane, Alan Marcus, Pitabas Mohanty,
“Investments”, 10th edition, McGraw Hill, 2015.