Bond Portfolio Management

Strategies
Active, Passive, and
Immunization Strategies
Alternative Bond Portfolio
Strategies
1. Passive portfolio strategies
2. Active management strategies
3. Matched-funding techniques
4. Contingent procedure (structured active
management)
Passive Portfolio Strategies
Buy and hold
Can be modified by trading into more
desirable positions
Indexing
Match performance of a selected bond
index
Performance analysis involves
examining tracking error
Passive Portfolio Strategies
Advantages to using indexing strategy
Historical performance of active managers
Reduced fees
Indexing methodologies
Full participation
Stratified sampling (cellular approach)
Optimization approach
Variance minimization
Determinants of Price Volatility
1. Bond prices move inversely to bond yields (interest
rates)
2. For a given change in yields, longer maturity bonds post
larger price changes, thus bond price volatility is directly
related to maturity
3. Price volatility increases at a diminishing rate as term to
maturity increases
4. Price movements resulting from equal absolute
increases or decreases in yield are not symmetrical
5. Higher coupon issues show smaller percentage price
fluctuation for a given change in yield, thus bond price
volatility is inversely related to coupon
Duration
Since price volatility of a bond varies
inversely with its coupon and directly with
its term to maturity, it is necessary to
determine the best combination of these
two variables to achieve your objective
A composite measure considering both
coupon and maturity would be beneficial
Duration
price
) (
) 1 (
) 1 (
) (
1
1
1

n
t
t
n
t
t
t
n
t
t
t
C PV t
i
C
i
t C
D
Developed by Frederick R. Macaulay, 1938
Where:
t = time period in which the coupon or principal payment occurs
C
t
= interest or principal payment that occurs in period t
i = yield to maturity on the bond
Characteristics of Duration
Duration of a bond with coupons is always less than its
term to maturity because duration gives weight to these
interim payments
A zero-coupon bonds duration equals its maturity
An inverse relation between duration and coupon
A positive relation between term to maturity and
duration, but duration increases at a decreasing rate with
maturity
An inverse relation between YTM and duration
Sinking funds and call provisions can have a dramatic
effect on a bonds duration
Duration and Price Volatility
An adjusted measure of duration can be
used to approximate the price volatility of
a bond
m
YTM
1
duration Macaulay
duration modified

Where:
m = number of payments a year
YTM = nominal YTM
Duration and Price Volatility
Bond price movements will vary proportionally with
modified duration for small changes in yields
An estimate of the percentage change in bond prices
equals the change in yield time modified duration

i D
P
P

mod
100
Where:
P = change in price for the bond
P = beginning price for the bond
D
mod
= the modified duration of the bond
i = yield change in basis points divided by 100
Duration in Years for Bonds
Yielding 6% with Different Terms
COUPON RATES
Years to
Maturity 0.02 0.04 0.06 0.08
1 0.995 0.990 0.985 0.981
5 4.756 4.558 4.393 4.254
10 8.891 8.169 7.662 7.286
20 14.981 12.980 11.904 11.232
50 19.452 17.129 16.273 15.829
Source: L. Fisher and R. L. Weil, "Coping with the Risk of Interest Rate Fluctuations:
Returns to Bondholders from Nave and Optimal Strategies," Journal of Business 44, no. 4
(October 1971): 418. Copyright 1971, University of Chicago Press.
Duration and Price Volatility
Longest duration security gives maximum price
variation
Active manager wants to adjust portfolio
duration to take advantage of anticipated yield
changes
Expect rate declines (parallel shift in YC), increase
average modified duration to experience maximum
price volatility
Expect rate increases (parallel shift in YC), decrease
average modified duration to minimize price decline
Convexity
Modified duration approximates price change for
small changes in yield
Accuracy of approximation gets worse as size of
yield change increases
WHY?
Modified duration assumes price-yield relationship of
bond is linear when in actuality it is convex.
Result MD overestimates price declines and
underestimates price increases
So convexity adjustment should be made to estimate
of % price change using MD
Convexity
Convexity of bonds also affects rate at which
prices change when yields change
Not symmetrical change
As yields increase, the rate at which prices fall
becomes slower
As yields decrease, the rate at which prices increase
is faster
Result convexity is an attractive feature of a bond in
some cases
Positive convexity
Negative convexity
Convexity
The measure of the curvature of the price-
yield relationship
Second derivative of the price function
with respect to yield
Tells us how much the price-yield curve
deviates from the linear approximation we
get using MD
Active Management Strategies
Potential sources of return from fixed income
port:
1. Coupon income
2. Capital gain
3. Reinvestment income
Factors affecting these sources:
1. Changes in level of interest rates
2. Changes in shape of yield curve
3. Changes in spreads among sectors
4. Changes in risk premium for one type of bond
Active Management Strategies
Interest rate expectations strategy
Need to be able to accurately forecast future level
of interest rates
Use duration to change sensitivity of portfolio to
future rate changes
Alter portfolio duration by:
1. Swapping or exchanging bonds in portfolio for new bonds
to achieve target duration (rate anticipation swaps)
2. Interest rate futures buying futures increases duration
and selling futures decreases duration
Active Management Strategies
Yield Curve strategies
Positioning portfolio to capitalize on
expected changes in shape of Treasury YC
Parallel shift
Nonparallel shift
1. Bullet strategies
2. Barbell strategies

Active Management Strategies
3. Ladder strategies
4. Riding the YC
Strategies result in different performance
depending on size and type of shift hard to
generalize which gives optimal strategy
Valuation analysis
Identification of misvalued securities
Credit analysis
High-Yield Bonds
Spread in yield between safe and junk
changes over time
Ave. Cumul. Default Rates Corp Bonds
Years Since Issue
Ratings 5 10
AAA 0.08% 0.08%
AA 1.20% 1.30%
A 0.53% 0.98%
BBB 2.39% 3.66%
BB 10.79% 15.21%
B 23.71% 35.91%
CCC 45.63% 57.39%
Active Management Strategies
Bond swaps
Pure yield pickup swap
Substitution swap
Intermarket spread swap
Tax swap
Matched Funding Strategies
Classical immunization
Interest rate risk

Investment horizon
Maturity strategy
Duration strategy
Price risk
Reinvestment risk
Maturity Strategy vs. Duration
Strategy
Year CF Reinv. end val CF end val
1 80 .08 80.00 80 80.00
2 80 .08 166.40 80 166.40
3 80 .08 259.71 80 259.71
4 80 .08 360.49 80 360.49
5 80 .06 462.12 80 462.12
6 80 .06 596.85 80 596.85
7 80 .06 684.04 80 684.04
8 1080 .06 1805.08 1120.64 1845.72
Immunization
Parallel shift in YC
Net worth immunization
Banks, thrifts
Gap management
ARMs
Immunization
Target date immunization
Pension funds, insurance companies
Immunize future value of fund at some target
date to protect against rate changes
Immunization Strategies
Difficulties in maintaining good protection
Rebalancing is necessary as duration
declines more slowly than term to maturity
MD changes when market interest rates
change
YC shifts
Matched-Funding Techniques
Dedicated portfolio
Exact cash match
Optimal match with reinvestment
Horizon matching
Combination of immunization strategy and
dedicated portfolio
Contingent Immunization
Structured Active Management
Manager follows active strategy to point
where trigger point is reached
Switch made to passive strategy to meet
minimum acceptable return
Cushion spread
Safety margin