Chapter 16: Managing Bond Portfolios

Examine various fixed-income portfolio strategies

1- Passive Approach – You follow an index. Not risk-free due to market risk.
2- Active Approach – Analysis

Discuss sensitivity of bond prices to interest rates fluctuations

Sensitivity is measured by duration

Consider refinements in the way interest rate sensitivity is measured, focusing on

bond convexity

How is coupon rate determined?

1- Interest rate set by the central bank
2- Risk of the company (Includes maturity, rating, etc)
3- Expectations of increase in inflation
Once interest rate increases, the coupon rate will not be enough for the investor.
Therefore, the yield will increase to satisfy the investors so it will decrease the
current price of the bond due to pressure on prices.
Therefore, the yield will affect the prices.

YTM: Yield you will receive when you hold bond to maturity.

Interest Rate Sensitivity

The most important factor that affects bond and its components.

1. Bond prices and yields are inversely related.

2. An increase in a bond’s yield to maturity results in a smaller price change
than a decrease in yield of equal magnitude. (The decrease in price is lower
than the increase in yield. This will lead to a lower loss which is good for the
investor)
3. Prices of long-term bonds tend to be more sensitive to interest rate
changes than prices of short-term bonds. (More exposed to changes in
interest rate)
4. Interest rate risk is less than proportional to bond maturity (Increase in risk
increased but at a decreasing rate)
 5. Interest rate risk is inversely related to the bond’s coupon rate
6. The sensitivity of a bond’s price to a change in its yield is inversely related
to the YTM at which the bond is currently selling

Change in Bond Price as a Function of Change in Yield to Maturity

A and B: B is riskier because of the higher maturity. (Curve of B is steeper than A)
B and C: C is riskier because it has a lower coupon rate and is steeper.
C and D: D is riskier because it has a lower YTM and more sensitive to interest rate
changes.

Prices of 8% Coupon Bond (Coupons Paid Semiannually)

If interest rates don’t change, the YTM and the coupon rate will be equal to each
other.
If interest rates increase, YTM will increase, and the price will decrease.
The higher the maturity, the higher the interest rate sensitivity and the lower the
prices will be.
Prices of Zero-Coupon Bond (Semiannual Compounding)

The same thing happens to zero-coupon rates. However, because the coupon rate
is lower, the fall in prices will be higher.
(Look for how to calculate 9%)

Duration

Duration: Measures sensitivity of my bond to the interest rates. It measures how

long it will take for me to cover my initial investment in the bond. (Assumes
reinvestment of the coupon payments)

The lower the duration the better because it means it’s less sensitive to interest
rates.

A measure of the average maturity of a bond’s promised cash flows

Macaulay’s Duration: equals the weighted average of the times to each coupon or
principal payment
Weight applied to each payment time is proportion of total value of bond
accounted for by that payment (i.e., the PV of the payment divided by the bond
price)

Duration = Maturity for zero coupon bonds

Duration < Maturity for coupon bonds
Higher coupon = lower duration
Duration Calculation

Duration:

The higher the YTM, the numerator will be reduced, then W will be reduced, then
the duration will be lower.

Interest Rate Risk

Duration as a measure of interest rate sensitivity

Price change is proportional to duration

D* = Modified duration

This means that if the interest rates increase by 1%, the yield will increase by 1%,
and if the duration is 5 years it means that the price will decrease by 5%. Which is
why the lower duration is better. If duration is 7, the price will decrease by 7%.

Duration Rules

Duration Rules
1- Rule 1: The duration of a zero-coupon bond equals its time to maturity.
Why?
Duration depends on coupon payments to recover initial investments. And this
has no coupons, so it won’t recover it earlier than maturity.
 2- Rule 2: Holding maturity constant, a bond’s duration is lower when the
coupon rate is higher
Why?
Because there’s a negative relationship, the higher the payments the lower
the duration because reinvesting money will recover the investment earlier
and it will reduce duration and interest rate exposure.

3- Rule 3: Holding the coupon rate constant, a bond’s duration generally

increases with its time to maturity

4- Rule 4: Holding other factors constant, the duration of a coupon bond is

higher when the bond’s yield to maturity is lower
Similar to the coupon rule

5- Rule 5: The duration of a level perpetuity is equal to:

Example: At a 10% yield, the duration of a perpetuity that pays 100$ once a year
forever is 1.10/0.10= 11 years.
But at an 8% yield, 1.08/0.08= 13.5 years.

Bond Duration versus Bond Maturity

Relationship between duration and maturity in the zero-coupon rate is linear.
(Rule One)
Continuous blue curve and dotted blue curve: The higher coupon rate will have
lower duration holding maturity constant. (Rule Two)
Continuous blue curve and black curve: The lower yield to maturity the higher the
duration so it’s more sensitive to interest rates. (Rule Four)
Bond Durations (Yield to Maturity = 8% APR; Semiannual Coupons)

Convexity

Relationship between bond prices and yields is not linear.

This means that their changes are not equal to each other.

Duration rule is a good approximation for only small changes in bond yields. If
yield keeps changing you need to consider the convexity.

Bonds with higher convexity exhibit higher curvature in the price-yield

relationship. It says when yields increase bond prices will decrease but at a
decreasing rate.
Is convexity good for investor?
Yes, because it minimizes the loss of prices when yields increase and will
maximize gains when yields decrease

Convexity is measured as the rate of change of the slope of the price-yield curve,
expressed as a fraction of the bond price.
Bond Price Convexity (30-Year Maturity; 8% Coupon; Initial YTM = 8%)

The first term on the right-hand side of the second equation is the same as the
duration rule. The second term is the modification for convexity.
So, we add convexity to the duration.
Convexity of Two Bonds
Blue line is curving more at the end and it means that the price is decreasing but
at a decreasing rate and increase at the top at an increasing rate.

Why Do Investors Like Convexity?

Bonds with greater curvature gain more in price when yields fall than they lose
when yields rise
The more volatile interest rates, the more attractive this asymmetry

Investors must pay higher prices and accept lower yields to maturity on bonds
with greater convexity. Why? Because they’re attractive to investors.

Duration and Convexity of Callable Bonds

Issuers might call bond before maturity because interest rates in the market drop
because new similar bonds will be issued at a lower coupon payment.
For the bond holder they’re compensated with face value + more money.

As rates fall, there is a ceiling on the bond’s market price, which cannot rise above
the call price.
As rates fall, the bond is subject to price compression
Use effective duration (Change in price/change in interest rates):

If a bond’s price-yield curve lies below its tangency line, the curve is said to have
negative convexity.

Price–Yield Curve for a Callable Bond

At a specific rate, the issuer will call the bond at a specific price and price will stop
increasing.

Duration and Convexity: MBS

Mortgage-Backed Securities (MBS)

Though the number of outstanding callable corporate bonds has declined, the
MBS market has grown rapidly

MBS: are a portfolio of callable amortizing loans

Homeowners may repay their loans at any time
MBS have negative convexity
Often sell for more than their principal balance
Homeowners do not refinance as soon as rates drop, so implicit call price is not a
firm ceiling on MBS value

Why will the prices stop increasing at a specific level?

Because when interest rates decrease, bond prices will increase to a specific level
because issuer will repay back MBS loans and get another loan for a lower rate.

However, unlike callable bonds, there’s a gap between interest rates level and
when bonds are returned. For callable bonds you see it immediately.

Duration and Convexity: CMO

Collateralized Mortgage Obligation (CMO)
Further redirects the cash flow stream of the MBS to several classes of derivative
securities called “tranches”

Tranches may be designed to allocate interest rate risk to investors most willing
to bear that risk
Different tranches may receive different coupon rates
Some may be given preferential treatment in terms of uncertainty over mortgage
prepayment speeds
Price-Yield Curve for a Mortgage-Backed Security
They will repay loan to get another one when interest rates drop to get a new
loan with a lower rate, and this is why prices stop rising at a specific level.

Passive Bond Management

Passive managers take bond prices as fairly set and seek to control only the risk of
their fixed-income portfolio
Two classes of passive management:
1- Indexing strategy
2- Immunization techniques
Both classes accept market prices as being correct, but differ greatly in terms of
risk exposure

Bond-Index Funds

Similar to stock market indexing

Idea is to create a portfolio that mirrors the composition of an index that
measures the broad market

Challenges in construction:
1- Very difficult to purchase each security in the index in proportion to its
market value
2- Many bonds are very thinly traded
3- Difficult rebalancing problems
Therefore, replicating an index exactly is difficult.

Due to challenges, a cellular approach is pursued

Stratification of Bonds into Cells

In a cellular approach you define characteristics desired of the bonds. You only
buy bonds that fit your desired requirements. It’s easier than replicating whole
index.

Passive Management: Immunization

Immunization: techniques that are used to shield overall financial status from
interest rate risk
Widely used by pension funds, insurers, and banks.

Duration-matched assets and liabilities let the asset portfolio meet the firm’s
obligations despite interest rate movement.
Basically, when you have obligations, you construct a bond portfolio that matches
your future obligations.
1- Construct portfolio with equal future cash flows as your obligations.
2- The duration should be equal to the life of the obligation, so you can sell
your portfolio at the end because maturity is not over, but the duration is.

When interest rates rise, bond prices will fall, but your reinvestments will increase
which will balance out decrease in bond prices.
It balances reinvestment rate risk and price risk
Rebalancing is required to realign the portfolio’s duration with the duration of the
obligation

Terminal Value of a 6-year Maturity Bond Portfolio After 5 Years

A. I will sell the bond at the end of my duration for its par value because rates
didn’t change. Sum of selling price + cash flows is equal to my obligation.

B. When rates fall, cash flows are reinvested at a lower level. Last year you will
sell bond for higher than par value. So, reduction of investment is covered
by increase in bond price, and the sum of both covers my obligation.

C. When rates rise, cash flows are reinvested at a higher level. Last year you
will sell bond for lower than par value. So, reduction of price is covered by
increase in reinvestment, and the sum of both covers my obligation.
Growth of Invested Funds
When interest rates increase prices will decrease but it will be offset by increase
in reinvestments.

Market Value Balance Sheet

Immunization

When interest rates are around 8%, my coupon payments will cover my
obligation. When there are fluctuations my coupon will not cover my obligation as
we can see from the deviation at the end, and this is when immunization works.

Cash Flow Matching and Dedication

Cash flow matching: a form of immunization that requires matching cash flows
from a bond portfolio with those of an obligation.
Imposes many constraints on bond selection process
Cash flow matching in a multiperiod basis is referred to as a dedication strategy
Manager selects zero-coupon or coupon bonds with total cash flows in each
period that match a series of obligations.
Once-and-for-all approach to eliminating interest rate risk because zero-coupon
bonds are not subject to interest rate risk.

Sometimes, cash flow matching is simply not possible. An example is the inability
to cash flow match for a pension fund that is obligated to pay out a perpetual
flow of income to current and future retirees. In theory, the pension fund would
need to buy fixed-income securities with maturities ranging up to hundreds of
years, and these securities simply do not exist.

Active Bond Management: Sources of Potential Profit

1. Substitution swap – exchange of one bond for another more attractively

priced bond with similar attributes.
You sell your current bond, buy undervalued bond until it rises in price,
then sell it and buy your previous bond and gain from price difference.

2. Intermarket spread swap – switching from one segment of the bond

market to another (e.g., from Treasuries to corporates)
Sell treasury for corporate because when yield spread increases because of
higher risk their prices will decrease. So, you buy corporate bonds until
their prices rise then sell it then go back to treasury.

3. Rate anticipation swap – switch made between bonds of different

durations in response to forecasts of interest rates
When you expect interest rates to increase, you’ll switch from high to low
duration bonds.

4. Pure yield pickup swap – moving to higher-yield, longer-term bonds to

capture the liquidity premium.

5. Tax swap – swapping two similar bonds to capture a tax benefit. You do
this to avoid taxes. You sell bond with low price and buy a higher price to
avoid paying taxes because there’s no gain. Then, they go back to their
initial investment.
Active Bond Management: Horizon Analysis

Horizon analysis: involves forecasting the realized compound yield over various
holding periods of investment horizons.

Analyst selects a particular holding periods and predicts the yield curve at the end
of the period. Based on that you decide which bond you’d like to hold.

Given a bond’s time to maturity at the end of the holding period, its yield can be
read from the predicted yield curve and its end-of-period price calculated.