Bond

Portfolio Management
Strategies
Alternative Bond Portfolio Strategies
1. Passive portfolio strategies
2. Active management strategies
3. Core-plus management strategy
3. Matched-funding techniques
4. Contingent procedure (structured active
management)
Passive Portfolio Strategies
Buy and hold
A manager selects a portfolio of bonds based on
the objectives and constraints of the client with
the intent of holding these bonds to maturity
Indexing
The objective is to construct a portfolio of bonds
that will equal the performance of a specified
bond index (Match performance of a selected
bond index)
Performance analysis involves examining tracking
error

Passive Portfolio Strategies
Advantages to using indexing strategy
Historical performance of active managers
Reduced fees
Indexing methodologies
Full participation
Stratified sampling (cellular approach)
Optimization approach
Variance minimization
Determinants of Price Volatility
Determinants of Price Volatility
1. Bond prices move inversely to bond yields (interest rates)

2. For a given change in yields, longer maturity bonds post larger
price changes, thus bond price volatility is directly related to
maturity.

3. Price volatility increases at a diminishing rate as term to
maturity increases

4. Price movements resulting from equal absolute increases or
decreases in yield are not symmetrical

5. Higher coupon issues show smaller percentage price fluctuation
for a given change in yield, thus bond price volatility is inversely
related to coupon
Determinants of Price Volatility
DURATION
It is a measurement of how long, in
years, it takes for the price of a bond to
be repaid by its internal cash flows.
ZERO COUPON BOND
VANILLA COUPON BOND
Duration
It is an important measure for investors to
consider, as bonds with higher durations carry
more risk and have higher price volatility than
bonds with lower durations.
It includes : present value, yield, coupon, final
maturity and call features.
Duration
Developed by Frederick R. Macaulay, 1938
Where:
n = number of cash flows
t = time to maturity
C = cash flow
i = required yield
M = maturity (par) value
P = bond price
Betty holds a five-year bond with a par value of $1,000 and
coupon rate of 5%. For simplicity, let's assume that the
coupon is paid annually and that interest rates are 5%.
What is the Macaulay duration of the bond?
= 4.55 years
Duration and Price Volatility
An adjusted measure of duration can be used to
approximate the price volatility of a bond
m
YTM
1
duration Macaulay
duration modified

Where:
m = number of payments a year
YTM = nominal YTM
Duration and Price Volatility
Bond price movements will vary proportionally with modified
duration for small changes in yields
An estimate of the percentage change in bond prices equals
the change in yield time modified duration

i D
P
P

mod
100
Where:
P = change in price for the bond
P = beginning price for the bond
D
mod
= the modified duration of the bond
i = yield change in basis points divided by 100
Characteristics of Duration
Duration of a bond with coupons is always less than its term
to maturity because duration gives weight to these interim
payments
A zero-coupon bonds duration equals its maturity
An inverse relation between duration and coupon
A positive relation between term to maturity and duration,
but duration increases at a decreasing rate with maturity
An inverse relation between YTM and duration
Sinking funds and call provisions can have a dramatic effect on
a bonds duration
Duration in Years for Bonds Yielding 6%
with Different Terms
COUPON RATES
Years to
Maturity 0.02 0.04 0.06 0.08
1 0.995 0.990 0.985 0.981
5 4.756 4.558 4.393 4.254
10 8.891 8.169 7.662 7.286
20 14.981 12.980 11.904 11.232
50 19.452 17.129 16.273 15.829
Source: L. Fisher and R. L. Weil, "Coping with the Risk of Interest Rate Fluctuations:
Returns to Bondholders from Nave and Optimal Strategies," Journal of Business 44, no. 4
(October 1971): 418. Copyright 1971, University of Chicago Press.
Duration and Price Volatility
Longest duration security gives maximum price
variation
Active manager wants to adjust portfolio duration to
take advantage of anticipated yield changes
Expect rate declines (parallel shift in YC), increase average
modified duration to experience maximum price volatility
Expect rate increases (parallel shift in YC), decrease
average modified duration to minimize price decline
Convexity
Convexity
Modified duration approximates price change for
small changes in yield
Accuracy of approximation gets worse as size of yield
change increases
WHY?
Modified duration assumes price-yield relationship of
bond is linear when in actuality it is convex.
Result MD overestimates price declines and
underestimates price increases
So convexity adjustment should be made to estimate of %
price change using MD
Convexity
Convexity of bonds also affects rate at which prices
change when yields change
Not symmetrical change
As yields increase, the rate at which prices fall becomes
slower
As yields decrease, the rate at which prices increase is
faster
Result convexity is an attractive feature of a bond in
some cases
Convexity
The measure of the curvature of the price-
yield relationship
Second derivative of the price function with
respect to yield
Tells us how much the price-yield curve
deviates from the linear approximation we get
using MD
Convexity Calculation
Convexity adjustment to the percentage price change =
C x change in yield squared x 100

To find the C in the equation, use this equation that has the same notation
as duration:

C = V3 +V2 - 2(V1) / 2V1(change in yield) squared
Total Price Change

Total Price change =
(-duration x change in yield x 100)
+
(C x change in yield squared x 100)
Using the Stone & Co. bonds that had duration of 5.5, let's add a
convexity of 93 and an increase of 150 bps in yield.
Active Management Strategies
Active Management Strategies
Potential sources of return from fixed income port:
1. Coupon income
2. Capital gain
3. Reinvestment income
Factors affecting these sources:
1. Changes in level of interest rates
2. Changes in shape of yield curve
3. Changes in spreads among sectors
4. Changes in risk premium for one type of bond
Active Management Strategies
Interest-rate anticipation
Risky strategy relying on uncertain forecasts
Ladder strategy staggers maturities
Barbell strategy splits funds between short duration and
long duration securities
Bullet strategies
Riding the YC.
Valuation analysis
The portfolio manager attempts to select bonds based on
their intrinsic value

Bonds rating, call feature, interest rate etc.
Buy the undervalued bond & sell the overvalued bonds
If bond rating is higher then interest is low and as result income is low
Credit analysis
Involves detailed analysis of the bond issuer to
determine expected changes in its default risk.
Internal & external Factors affect the credit rating of
the company such as financial ratios, inflation, etc.
Higher the risk higher the return.
Active Management Strategies
Active Management Strategies
High-Yield Bond Research
Several investment houses such as Merrill Lynch, First
Boston, Lehman Brothers, etc., have developed specialized
high-yield groups that examine high-yield bond issues and
monitor high-yield bond spreads
Ave. Cumul. Default Rates Corp Bonds
Years Since Issue
Ratings 5 10
AAA 0.08% 0.08%
AA 1.20% 1.30%
A 0.53% 0.98%
BBB 2.39% 3.66%
BB 10.79% 15.21%
B 23.71% 35.91%
CCC 45.63% 57.39%
Active Management Strategies
Yield spread analysis
Assumes normal relationships exist between the yields for
bonds in alternative sectors
Factor affecting yield spread:-
Business cycle
Volatility in the market interest rate
Bond swaps

Bond Swaps
Involve liquidating a current position and
simultaneously buying a different issue in its place with
similar attributes but having a chance for improved
return.
Pure Yield Pickup Swap
Swapping low-coupon bonds into higher coupon
bonds
Substitution Swap
Swapping a seemingly identical bond for one that is
currently thought to be undervalued

Bond Swaps (Cont.)
Tax Swap

Swap in order to manage tax liability (taxable & munis)

Swap strategies and market-efficiency

Bond swaps by their nature suggest market inefficiency
A Global Fixed-Income
Investment Strategy
Factors to consider
The local economy in each country including the
effects of domestic and international demand
The impact of total demand and domestic monetary
policy on inflation and interest rates
The effect of the economy, inflation, and interest
rates on the exchange rates among countries
Core-Plus Bond Portfolio
Management
This involves having a significant (core) part of the
portfolio managed passively in a widely
recognized sector such as the U.S. Aggregate
Sector or the U.S. Government/Corporate sector.
The rest of the portfolio would be managed
actively in one or several additional plus
sectors, where it is felt that there is a higher
probability of achieving positive abnormal rates of
return because of potential inefficiencies
Matched-Funding Techniques
Dedicated Portfolios
Dedication refers to bond portfolio
management techniques that are used to
service a prescribed set of liabilities
Pure Cash-Matched Dedicated Portfolios
Most conservative strategy
Dedication With Reinvestment
Cash flows do not have to exactly match
the liability stream
Matched-Funding Techniques
Immunization Strategies
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
Immunization Strategies
The process intended to eliminate interest rate
risk is referred to as immunization
Components of Interest Rate Risk
Price Risk
Coupon Reinvestment Risk
Classical Immunization
Immunization is neither a simple nor a
passive strategy
An immunized portfolio requires
frequent rebalancing because the
modified duration of the portfolio
always should be equal to the
remaining time horizon (except in the
case of the zero-coupon bond)
Classical Immunization
Duration characteristics
Duration declines more slowly than term to
maturity, assuming no change in market
interest rates
Duration changes with a change in market
interest rates
There is not always a parallel shift of the yield
curve
Bonds with a specific duration may not be
available at an acceptable price
Matched-Funding Techniques
Horizon matching
Combination of cash-matching dedication and
immunization
Important decision is the length of the horizon
period
Contingent Procedures
A form of structured active management
Constrains the manager if unsuccessful
Contingent immunization
duration of portfolio must be maintained at the
horizon value
cushion spread is potential return below
current market
safety margin
trigger point
Implications of Capital Market Theory and the
EMH on Bond Portfolio Management
Bonds and Total Portfolio Theory
Bonds and Capital Market Theory
Bond Price Behavior in a CAPM Framework
Bond-Market Efficiency