Bond Portfolio Management

Strategies
 Types of Strategies
Passive Bond Portfolio Management
Strategy
Semi-Active Management Strategy
Active Management Startegy
 Passive Strategy
Less role of expectation
Key inputs are known at the time of
investment analysis
Buy and hold strategy
Indexing Strategy
 Buy and Hold Strategy

A manager selects a portfolio of bonds

based on the objectives and constraints
of the client with the intent of holding
these bonds to maturity
Investors dont trade actively to
maximize the return
Hold the bond with a maturity or
duration close to their investment
horizon
 Buy and Hold Strategy Cont
Price risk elimination is the prime objective
Return on security is controlled by coupon
payments and reinvestment rate
Suitable for income maximizing investors
with low level of risk
Applicable for pensioners, endowment
funds, bond mutual funds, insurance
companies etc.
 Bond Ladder Strategy
It is another form of buy and hold strategy
It involves investing in bonds with several
maturity dates instead of a single time horizon
By staggering the maturities of the securities the
investor is assured that money will be available
for reinvestment at regular intervals
It helps offsetting the interest rate risk
It follows the philosophy of diversification
 Indexing Strategy
The objective is to construct a portfolio of
bonds that will equal the performance of a
specified bond index
Performance is measured in terms of total
return realized over the investment horizon
 Advantages of Indexing Strategy

Poor and inconsistent performance of

active bond portfolio mangers
Lower transaction cost
Degree of control exercised by the
investor
 Factors affecting the Selection of
the Index
Investors Risk tolerance
Objectives
Constraints imposed by the regulator
 Indexing Methodologies
To minimize the tracking error
Causes of Tracking Error
Transaction costs in construction of the index
Differences in the composition of the indexed
portfolio and the index itself
Discrepancies between prices used by the
organization constructing the index and the
transaction prices paid by the index manager
 Methods of Construction of
Portfolio to Replicate the Index
Stratified sampling or Cellular Approach
Optimization Approach
Variance Minimization Approach
 Semi-Active Management
Strategies
Immunization Strategies
A portfolio manager (after client consultation)
may decide that the optimal strategy is to
immunize the portfolio from interest rate
changes
The immunization techniques attempt to
derive a specified rate of return during a given
investment horizon regardless of what
happens to market interest rates
 Immunization Strategies
Components of Interest Rate Risk
Price Risk
Coupon Reinvestment Risk
 Classical Immunization

When a bonds duration is equal to the

liabilitys duration, the direct interest-on-
interest effect and the inverse price effect
exactly offset each other.

As a result, the total return rate from the

investment (TR) or the value of the
investment at the horizon or liability date
does not change because of an interest rate
change.

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 Classical Immunization: Example
Example
Suppose:
1. An investment trust has a single liability of $1,352
due in 3.5 years, DL = 3.5 years

2. A current investment to cover the liability of $968.30

Note: $968.30(1.10)3.5 = $1,352

3. The current relevant yield curve is flat at 10%

4. There is 4-year, 9% annual coupon trading at YTM of

10% for P0 = $968.30. This bond has a Macaulay
duration of 3.5.
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 Classical Immunization: Example
Example
Immunization Strategy: Buy bond with Macaulays
duration of 3.5 years to match the duration liability of 3.5
years

Buy 4-year, 9% annual coupon at YTM of 10% for P0

= $968.30.

This bond has both a duration of 3.5 years and is

worth $968.50, given a yield curve at 10%.

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 Classical Immunization: Example

If the trust buys this bond, then any parallel

shift in the yield curve in the very near future
would have price and interest-on-interest rate
effects that exactly offset each other.

As a result, the cash flow or ending wealth at

year 3.5, referred to as the accumulation
value or target value, would be exactly
$1,352.

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 Classical Immunization: Example
Duration-Matching
Ending Target Values at 3.5 Years Given Different Interest
Rates for 4-Year, 9% Annual Coupon Bond with Duration of 3.5

Duration = 3.5
Time (yr) 6% 10% 11%
1 $ 90(1.06)2.5 = $98.22 $ 90(1.10)2.5 = $114.21 $ 90(1.11)2.5 = $116.83
2 90(1.06)1.5 = $104.11 90(1.10)1.5 = $103.83 90(1.11)1.5 = $105.25
3 90(1.06).5 = $ 92.66 90(1.10).5 = $ 94.39 90(1.11).5 = $ 94.82
3.5 1090/(1.06).5 = $1058.70 1090/(1.10).5 = $1039.27 1090/(1.11).5 = $1034.58
Target Value $1,352 $1,352 $1,352

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 Classical Immunization
Note
In addition to matching duration, immunization also
requires that the initial investment or current market
value of the assets purchased to be equal to or
greater than the present value of the liability using the
current YTM as a discount factor.

In this example, the present value of the $1,352

liability is $968.50 (= $1,352/(1.10)3.5), which equals
the current value of the bond and implies a 10% total
return:

Total Return = [$1352/$968.50]1/3.5 1] = .10

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 Classical Immunization
Redingtons classical duration-matching strategy
works by having offsetting price and reinvestment
effects.

In contrast, a maturity-matching strategy where a

bond is selected with a maturity equal to the horizon
date has no price effect and therefore no way to
offset the reinvestment effect.

This can be seen in the next exhibit where unlike the

duration-matched bond, a 10% annual coupon bond
with a maturity of 3.5 years and initially priced at
$1,000 (not $968.50) has different ending values
given different interest rates.

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 Classical Immunization: Example
Maturity-Matching and Duration Matching
Duration = 3.5
Time (yr) 6% 10% 11%
1 $ 90(1.06)2.5 = $98.22 $ 90(1.10)2.5 = $114.21 $ 90(1.11)2.5 = $116.83
2 1.5
90(1.06) = $104.11 90(1.10)1.5 = $103.83 1.5
90(1.11) = $105.25
3 90(1.06).5 = $ 92.66 .5
90(1.10) = $ 94.39 90(1.11).5 = $ 94.82
3.5 1090/(1.06).5 = $1058.70 1090/(1.10).5 = $1039.27 1090/(1.11).5 = $1034.58
Target Value $1352 $1352 $1352
Total Return 10% 10% 10%
From $968.50
Maturity = 3.5 years
Time (yr) 6% 10% 11%
1 2.5 2.5
$ 100(1.06) = $109.13 $ 100(1.10) = $126.91 2.5
$ 100(1.11) = $129.81
2 1.5
100(1.06) = $115.68 1.5
100(1.10) = $115.37 100(1.11)1.5 = $116.95
3 100(1.06).5 = $102.96 100(1.10).5 = $ 104.88 100(1.11).5 = $ 105.36
3.5 1050 = $1050__ 1050 = $1050__ 1050 = $1050_
Target Value $1378 $1397 $1402
Total Return 9.59% 10% 10.135%
From $1,000
Note:
The 4-year, 9% bond with duration of 3.5 is initially priced at $968.50 and has a total return of 10% for
each scenario: Total Return = [$1352/$968.50]1/3.5 1]
The 3.5 year, 10% bond is priced at $1,000 and has a target value and total return that varies with each
scenario: Total Return = [Target Value/$1,000]1/3.5 1] 21
 Active Management
Strategies
Interest Rate Anticipation
Valuation Analysis
Credit Analysis
Yield Spread Analysis
Bond Swaps
 Interest Rate Anticipation
Reduce the portfolio duration when
interest arte rate is expected to increase
and vice versa.
Increase the investment in long duration
bonds when interest rates are expected to
decline
Move into shorter duration bonds if interest
rate is going to be declined
 Valuation Analysis
Select the bonds on the basis of their
intrinsic values
What are the factors which affect the
bonds intrinsic values?
Bonds Rating, call feature etc
Buy the under valued bonds and sell the
over valued bonds
 Credit Analysis
It involves detailed analysis of the bond
issuer to determine expected changes in
its default risk
What are the internal and external factors
which affect the credit rating of the
company?
Explanation of credit analysis model
 Yield Spread Analysis
What is Yield Spread?
What are the factors affecting yield
spread?
Business cycle
Volatility in the market interest rate
 Bond Swap
It involves liquidating a current position
and simultaneously buying a different
issue in its place with similar attributes but
having a chance for improved return.
The main purpose of the bond swap is
portfolio improvement.
 Different Types of Bond Swap
Pure Yield Pickup Swap
Substitution Swap
Tax Swap
 Pure Yield Pickup Swap
It involves swapping out of a low-coupon bond into a
comparable higher coupon bond to realize an automatic
and instantaneous increase in current yield and yield to
maturity.
Advantages:
No need for interest rate speculation
No need to analyze prices or overvaluation or under valuation
No specific work-out period needed because the investor is
assumed to hold new bond to maturity
Disadvantages:
Increased risk of call in the event interest rate decline
Reinvestment risk is greater with higher coupon bonds.
 Substitution Swap
It is generally short-term
It relies heavily on interest rate expectations
It is subject to more risky than pure yield pickup swaps
The procedure assumes a short-term imbalance in yield spreads
between issues that are perfect substitutes
The imbalance in yield spread is expected to be corrected in near
future
Advantage:
Realization of Capital Gain by switching out of your current position into
higher yielding obligation
Disadvantages:
Yield spread thought to be temporary in fact be permanent thus
reducing capital gains advantages.
The market rate may change adversely.
 Tax Swap
It does not involve any interest arte
projections.
The investor enters into tax swaps due to
tax laws and realized capital gains in their
portfolio.
 A Global Fixed-Income
Investment Strategy
Factors to consider
The local economy in each country
including the effects of domestic and
international demand
The impact of total demand and
domestic monetary policy on inflation
and interest rates
The effect of the economy, inflation, and
interest rates on the exchange rates
among countries