Managing Bond Portfolio

Objectives:

Analyze the features of a bond that affect the sensitivity

of its price to interest rates.

Compute the duration of bonds.

Formulate fixed-income immunization strategies for

various investment horizons.

Analyze the choices to be made in an actively managed

fixed-income portfolio.

16.1 INTEREST RATE RISK

Interest rate risk is uncertainty related to bond prices due to
uncertainty in interest rate

Interest rate sensitivity:

Time to maturity
Coupon rate

Inverse relationship between price and yield

Long-term bonds tend to be more price
sensitive than short-term bonds
Interest rate risk is inversely related to
bonds coupon rate

Change in price of 8% coupon bond < change in price of

0% coupon bond or 8% bond has higher interest rate risk
than 0% bond
We also know that long-term bond has higher interest rate
risk than short-term bond.
This implies that 0% bond is a longer term investment than
8% bond.
This implies that regular maturity is not good enough to tell
about the short term/long term nature (or interest rate
sensitivity) of the bonds.
We need a maturity that can tell 0% bond is really longer
term investment than 8% bond
Hence we have concept of effective maturity or duration
that takes into account both regular maturity and coupon
payments.

8% coupon bond
Time
0
cash flow
40
0% coupon bond
Time
0
cash flow
0

1
40

2
40

..... 20
40+1000

1
0

2
0

..... 20
0+1000

If we view a bond is a portfolio of all coupon

payments and principal payment, and each
payment has its own maturity, and the effective
maturity of the bond is the weighted average of
all maturity of all payments, then obviously, the
maturity of 0% coupon bond is different from
maturity of 8% coupon bond.

A measure of the effective maturity of a bond

The weighted average of the times until each
payment is received, with the weights
proportional to the present value of the
payment
Duration is shorter than maturity for all
bonds except zero coupon bonds
Duration is equal to maturity for zero coupon
bonds

Measures the effective maturity by

weighting the payments by their
proportion of the bond value.

tw

t 1

where t =1, 2, 3, ... T are the times to maturity of payments

t
PV CFt
CFt / 1 y
wt

Bond Price Bond Price

y is the bond's yield to maturity (current market rate)

A pension plan is obligated to make disbursements of $1

million, $2 million, and $1 million at the end of each of the
next three years, respectively. Find the duration of the
plans obligations if the interest rate is 10% annually .

Duration measure does three things:

It measures the effective average
maturity of a bond.
It measures interest rate sensitivity
correctly.
It provides the necessary information
for immunization.

Sensitivity of prices to interest rate changes:

y
P
D

P
1 y
where y is the yield to
maturity

P
*
D y
P

D
and D
1 y
*

D* is modified duration

Example: The duration for a bond (6% coupon rate, semiannual payment, 2 years to maturity), currently priced at
$929.08, with a yield-to-maturity (YTM) of 10% is 1.91061
years. If interest rates rise by 0.5 percentage points (50 basis
points), what will be the percentage change in the price of the
bond?
If interest rates rise by 0.1 percentage points (10 basis points),
what will be the percentage change in the price of the bond?

The relationship between bond prices

and yields is not linear
Duration rule is a good
approximation for only small changes
in bond yields

1
Convexity
2
P (1 y )

CFt
2

(1 y ) t (t t )
t 1

Correction for Convexity:

P
2
1
D y [Convexity (y ) ]
2
P

Determinants of a bonds price sensitivity

to interest rate changes:

the time to maturity

(Duration not always increasing in time to Maturity)

the coupon rate

(Duration always decrease with high Coupon)

the yield to maturity

(Duration always decrease if YTM increase)

Rule 1 The duration of a zero-coupon bond

equals its time to maturity
Rule 2 Holding maturity constant, a
bonds duration is higher when the
coupon rate is lower
Rule 3 Holding the coupon rate constant,
a bonds duration generally increases
with its time to maturity
Rule 4 Holding other factors constant, the
duration of a coupon bond is higher when
the bonds yield to maturity is lower
Rules 5 The duration of a level perpetuity
is equal to: (1+y) / y

Key concept in bond management

Simple summary measure of effective maturity of bond. It
is the effective maturity that tells the short-term/long-term
nature of bond, not regular maturity
Measure of interest sensitivity of a bond portfolio
Bond A: 8% semi-annual coupon, 2 years to maturity, D = 1.8852
Bond B: 0% coupon, 2 years to maturity, D = 2
Bond B has more interest rate risk than bond A
Bond A: 8% semi-annual coupon, 2 years to maturity, D = 1.8852
Bond B: 0% coupon, 1.8852 years to maturity, D = 1.8852
Bond B and Bond A has same interest rate risk

It provides the necessary information for immunization.

Longest-duration security provides the maximum

price variation
If you expect a decline in interest rates, increase the
average duration of your bond portfolio to experience
maximum price increase
If you expect an increase in interest rates, reduce the
average duration to minimize your price decline

FIN 8330 Lecture 4 9/6/2007

25

10.2 PASSIVE BOND MANAGEMENT

Takes prices as given and tries to control the risk

of the fixed-income portfolio.
Measures:

1. Net Worth Immunization (Present)

(e.g. Banks: Asset/Liability Management)

2. Target Date Immunization (Future)

(e.g. Pension Funds: meet future obligations)

Net Worth Immunization:

Match duration of asset and liabilities by adjusting
their maturity structure (Gap Management)

Target Date Immunization:

Set the duration of a portfolio equal to the target date.
This guarantees that at this date reinvestment risk and
price risk exactly cancel out.

Example. An insurance company issue a 5-years

Guaranteed investment contract (GIC) at 8%, nominal
value $10,000. The insurance company decides to meet
this obligation by investing $10,000 in 8% annual
coupon bonds with maturity in 6yrs.
Can the firm meets its obligation at time 5?
What if interest rate drops to 7% ?
What if interest rate increases to 9% ?

a.

b.

An insurance company must make payments to a customer of

$10 mil in 1 year and $4 mil in 5 years. The market interest
rate is 10%
If it wants to fully fund and immunize its obligation to this
customer with a single issue of a zero-coupon bond, what
maturity bond must it purchase?
What must be the face value and market value of that zerocoupon bond?

Given a liability currently worth L and with duration DL

Match it with an asset currently worth L and with
duration DL.
This guarantees that, for small changes in the interest
rate the net worth will always be approximately zero.

Current Value of
Asset and
Liabilities

Current of Coupon Bond (Asset)

(YTM=8%)

Present Value
of CIG (Liability)
(YTM=8%)

8%=YTM

Interest rate

Even if a position is immunized, there is still need

for rebalancing for duration because of
Change in interest rate in market
Passage of time

Cannot rebalance continuously because of

transaction cost involved
In practice, must establish a compromise
between the desire for perfect immunization
which requires continuous rebalancing and the
need to control for trading cost which dictates
less frequent rebalancing

36

10.3 ACTIVE BOND MANAGEMENT

Sources of potential profits:

Interest rate forecasts

Identification of mispriced bonds

Substitution swap
Intermarket swap
Rate anticipation swap
Pure yield pickup
Tax swap

Substitution swap

an exchange of bond for nearly identical substitute

(coupon, maturity, quality, call features, etc)
Toyota bond, 20 years to maturity, 8% coupon, YTM =
8.05%
Honda bond, 20 years to maturity, 8% coupon, YTM =
8.15%
Honda looks more attractive

Intermarket swap

the yield spread between 2 sectors of bond market is

temporarily out of line.
Example: currently, the yield spread between 10-year
T-bond and 10 year BBB corporate bond is 3%, the
historical spread is 2%, should consider selling T-bond
and buy BBB corporate bond

Rate anticipation swap

expected rate to fall, swap into bonds of longer
duration. Expected rate to rise, swap into shorter
duration

Pure yield pickup

the strategy depends on the shape of the yield
curve in the market
If yield curve is upward sloping, should move into
long-term bonds to get higher yield. However, at
the same time, your portfolio is exposed to higher
interest rate risk.

Tax swap:
Swap a capital gain bond to a capital loss bond to
avoid tax

A combination of active and passive

management
The strategy involves active
management with a floor rate of return
As long as the rate earned exceeds the
floor, the portfolio is actively managed
Once the floor rate or trigger rate is
reached, the portfolio is immunized