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    Chapter Sixteen: Managing Bond Portfolios

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    Oona Niall

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    © All Rights Reserved
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    Chapter Sixteen: Managing Bond Portfolios

    Uploaded by

    Oona Niall
    130 views16 pages

    Original Title

    8. Managing Bond Portfolio

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    © © All Rights Reserved

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    130 views16 pages

    Chapter Sixteen: Managing Bond Portfolios

    Uploaded by

    Oona Niall

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 16
    At a glance
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    The key takeaways are that there are two main passive bond portfolio strategies, indexing and immunization. Indexing involves holding a representative sample of bonds in an index, while immunization aims to match the duration of assets and liabilities to control interest rate risk.

    The two main passive bond portfolio strategies discussed are indexing and immunization.

    Indexing sees market prices as correct but differs from immunization in terms of risk. Immunization aims to exactly cancel out price and reinvestment rate risk by matching the duration of assets and liabilities.

    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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