Managing Bond
Portfolios
Bodie, Kane, and Marcus
Essentials of Investments,
11
9th Edition
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
11.1 Interest Rate Risk
• Interest Rate Sensitivity
• Bond prices and yields are inversely related
• Increase in bond’s yield to maturity results in smaller
price change than yield decrease of equal magnitude
• Long-term bond prices more sensitive to interest rate
changes than short-term bonds
• As maturity increases, sensitivity of bond prices to
changes in yields increases at decreasing rate
11-2
11.1 Interest Rate Risk
• Interest Rate Sensitivity
• As maturity increases, sensitivity of bond prices to
changes in yields increases at decreasing rate
• Interest rate risk is inversely related to bond’s coupon
rate; low-coupon bonds are more sensitive to interest
rates
• Sensitivity of bond’s price-to-yield change is inversely
related to current yield to maturity
11-3
Figure 11.1 Change in Bond Prices as a Function of Change
in Yield to Maturity
11-4
Table 11.1 Annual Coupon Prices
Prices of 8% annual coupon bonds
*Equals value of bond at a 9% yield to maturity minus value of bond at (the
original) 8% yield, divided by the value at 8% yield.
11-5
Table 11.2 Zero-Coupon Bond Prices
Prices of zero-coupon bonds
*Equals value of bond at a 9% yield to maturity minus value of bond at (the
original) 8% yield, divided by the value at 8% yield.
11-6
11.1 Interest Rate Risk
•
11-7
Spreadsheet 11.1 Calculation of Duration of Two Bonds
11-8
11.1 Interest Rate Risk
•
11-9
Spreadsheet 11.2 Computing Duration
11-10
11.1 Interest Rate Risk
• What Determines Duration?
• Zero-coupon bond’s duration is time to maturity
• Time/yield to maturity constant, bond’s duration
and interest-rate sensitivity higher when coupon
price lower
• Coupon rate constant, bond’s duration and
interest-rate sensitivity generally increase with
time to maturity; duration always increases with
maturity for bonds at or above par
11-11
11.1 Interest Rate Risk
•
11-12
Figure 11.2 Duration as Function of Maturity
11-13
Table 11.3 Annual Coupon Bond Duration
Durations of annual coupon bonds
(initial bond yield = 6%)
Coupon Rates (% per year)
Years to
Maturity 4% 6% 8% 10%
1 1.000 1.000 1.000 1.000
5 4.611 4.465 4.342 4.237
10 8.281 7.802 7.445 7.169
20 13.216 12.158 11.495 11.041
Infinite
(perpetuity) 17.667 17.667 17.667 17.667
11-14
11.2 Passive Bond Management
• Immunization
• Strategy to shield net worth from interest rate
movements
• Rebalancing
• Realigning proportions of assets in portfolio as
needed
11-15
Table 11.4 Terminal Value of Bond Portfolio after Five
Years
11-16
Figure 11.3 Growth of Invested Funds
11-17
Table 11.5 Market Value Balance Sheets
11-18
Figure 11.4 Immunization
11-19
11.2 Passive Bond Management
• Cash Flow Matching and Deduction
• Cash flow matching
• Matching cash flows from fixed-income
portfolio with those of obligation
• Deduction strategy
• Multi-period cash flow matching
11-20
11.3 Convexity
•
11-21
Figure 11.5 Bond Price Convexity
11-22
11.3 Convexity
• Why Do Investors Like Convexity?
• More convexity = greater price increases,
smaller price decreases when interest rates
fluctuate by larger amounts
11-23
11.4 Active Bond Management
• Sources of Potential Profit
• Substitution swap
• Exchange of one bond for bond with similar
attributes and better price
• Intermarket swap
• Switching from one segment of bond market to
another
• Rate anticipation swap
• Switch made in response to forecasts of
interest rate changes
11-24
11.4 Active Bond Management
• Sources of Potential Profit
• Pure yield pickup swap
• Moving to higher yield bonds, usually with longer
maturities
• Tax swap
• Swapping two similar bonds to receive tax benefit
• Horizon analysis
• Forecast of bond returns based largely on
prediction of yield curve at end of investment
horizon
11-25
11.4 Active Bond Management
• Example of Fixed-Income Investment
Strategy
• Key features
• Firms respect market prices
• To have value, information cannot already be
reflected in prices
• Interest rate movements extremely hard to
predict
11-26
