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Chapter Sixteen: Managing Bond Portfolios

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Chapter Sixteen: Managing Bond Portfolios

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8. Managing Bond Portfolio

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Chapter Sixteen: Managing Bond Portfolios

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Chapter Sixteen

Managing Bond Portfolios

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Passive Management
• Two passive bond portfolio strategies:
• Indexing
• Immunization
• Both see market prices as being correct
• Differ greatly in terms of risk

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-2
Passive Management: Indexing

Bond Index Funds

Contains Thousands of
Issues, many of which
are infrequently traded
They only hold a
representative
sample of the bonds
in the actual index
Turnover more than
stock indexes as the
bonds mature

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-3
Stratification of Bonds into Cells

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-4
Passive Management: Immunization
• Control interest rate risk
• Widely used by pension funds, insurance companies, and
banks
• The interest rate exposure of assets and liabilities are matched
in the portfolio
• Match the duration of the assets and liabilities
• Price risk and reinvestment rate risk exactly cancel out
• Value of assets match liabilities whether rates rise/fall

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-5
Terminal value of a
Bond Portfolio After 5 Years

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-6
Growth of Invested Funds

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-7
Market Value Balance Sheet

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-8
Immunization

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-9
Cash Flow Matching
• Cash Flow Matching and Dedication
• Cash flow matching = Automatic immunization
• Cash flow matching is a dedication strategy
• Not widely used because of constraints associated with bond choices

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-10
Exercise
• You are managing a portfolio of $1 million. Your target duration
is 10 years, and you can invest in two bonds, a zero-coupon
bond with maturity of five years and a perpetuity, each
currently yielding 5%.
• a. What weight of each bond will you hold to immunize your
portfolio?
• b. How will these weights change next year if target duration is
now nine years?

INVESTMENTS | BODIE, KANE, MARCUS


Check:
• The duration of the perpetuity is: 1.05/0.05 = 21 years
Call w the weight of the zero-coupon bond. Then
(w × 5) + [(1 – w) × 21] = 10  w = 11/16 = 0.6875
Therefore, the portfolio weights would be as follows: 11/16
invested in the zero and 5/16 in the perpetuity.

INVESTMENTS | BODIE, KANE, MARCUS


Check:
• Next year, the zero-coupon bond will have a duration of 4 years
and the perpetuity will still have a 21-year duration. To obtain
the target duration of nine years, which is now the duration of
the obligation, we again solve for w:
• (w × 4) + [(1 – w) × 21] = 9  w = 12/17 = 0.7059
So, the proportion of the portfolio invested in the zero increases
to 12/17 and the proportion invested in the perpetuity falls to
5/17.
 
INVESTMENTS | BODIE, KANE, MARCUS
Active Management
(1 of 3)

• Swapping Strategies
1. Substitution swap

2. Intermarket spread swap

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-14
Active Management
(2 of 3)

• Swapping Strategies
3. Rate anticipation swap

4. Pure yield pickup swap

5. Tax swap

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-15
Active Management
(3 of 3)

• Horizon Analysis
• Select a particular holding period and predict the yield curve at end
of period

• 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 the end-of-
period price can be calculated

INVESTMENTS | BODIE, KANE, MARCUS


©2018 McGraw-Hill Education 16-16

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