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Chapter 9 CHAPTER OVERVIEW

Bonds: Analysis and Strategy

Valuation, prices and yields are covered in Chapter 8, and analysis and strategy in Chapter 9. The purpose of this chapter is to cover issues involving the analysis of bonds from an investors perspective, and some strategies that could be employed in managing a portfolio of bonds. Chapter 9 starts with a discussion of why investors buy bonds, both domestic and foreign. Included in this discussion is a discussion of the total returns on bonds over long periods of time. Instructors should emphasi e how different types of investors are interested in bonds!!some for the income return and some for the chance to earn capital gains as a result of interest rate changes. The discussion of foreign bonds is a good place to once again tal" about currency ris"s. This discussion concludes with the case for not buying bonds outlined by #eter $ernstein. % "ey part of this chapter is the discussion on important considerations in managing a bond portfolio. This includes the term structure of interest rates, and the ris" structure of interest rates &yield spreads'. The author feels strongly that the essential elements of this material are covered while tedious details are avoided. (tudents in a beginning Investments course do not need to get bogged down in the details of the term structure, and the various theories to e)plain term structure. The remainder of Chapter 9 is devoted to a discussion of bond strategies and management. This chapter sets the foundation for the comparable chapter on stoc"s &Chapter **' by dividing the discussion of strategies into passive and active. This is consistent with modern investing approaches and also allows instructors to incorporate any discussion of +fficient ,ar"ets they may choose as well as touch on such issues as direct versus indirect investing. This chapter concludes with a discussion of building a bond portfolio. The discussion is divided into how conservative investors approach this issue as opposed to aggressive 120

investors. It concludes with a consideration of the international perspective. It is here that instructors will want to mention the use of mutual funds and closed!end funds when investing internationally. CHAPTER OBJECTIVES

To analy e the reasons why investors buy bonds. To recogni e important considerations in managing a bond portfolio, including the term structure of interest rates and yield spreads. To differentiate between the passive and active strategies for managing a bond portfolio. To consider how both conservative investors and aggressive investors go about building a fi)ed!income portfolio.

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AJOR CHAPTER HEA!I"#S $Contents% Why B&y Bonds' -reasons why investors buy bonds. bond returns over long periods of time. large annual gains in bonds do occur/

$uying 0oreign $onds1 -international considerations, primarily problems in transacting. discussion of the +uro/ anaging A Bond Port)olio

I(portant Considerations In

2nderstanding the $ond ,ar"et -the importance of e)pected inflation on the bond mar"et. currency effects/ The Term (tructure of Interest 3ates -definition. yield curves. forward rates. term structure theories4 e)pectations theory, li5uidity preference theory, mar"et preferred habitat theory, segmentation theory/ The 3is" (tructure of Interest 3ates!!6ield (preads -definition. factors leading to yield spreads. 7un" bonds. yield spreads over time/

Bond Strategies

#assive ,anagement (trategies -definition. case for doing this. buy and hold. inde)ing/ Immuni ation!!% (tructured #ortfolio (trategy -definition. e)tended e)ample/ %ctive ,anagement (trategies -forecasting changes in interest rates. identifying mispricings among securities. interest rate swaps/

B&ilding A *i+ed,In-o(e Port)olio

Conservative Investors -factors that must be considered/

%ggressive Investors -how they might behave/ The International #erspective -returns and ris"s. procedures/

POI"TS TO "OTE ABO.T CHAPTER 9 Ta/les and *ig&res +)hibit 9!* is new to the 8th edition. It e)plains as a flow diagram, in words, what immuni ation is all about. This will ma"e the discussion in Table 9!* easier to follow. Table 9!* is a detailed e)ample of the immuni ation principle. It is probably worth some significant class discussion in order to help students better understand duration and reinvestment rate ris" &which were covered in Chapter 8'. 0igure 9!* illustrates the relationship between real 89# growth rates, C#I growth rates, and yields on *:!year Treasuries. The C#I growth rate behaves in a manner similar to bond yields. 0igure 9!; shows yield curves for various periods, illustrating the different shapes that yield curves can ta"e. 0igure 9!< illustrates yield spreads for a recent period by showing differences between $aa corporates and %aa corporates. Bo+ Inserts $o) 9!* is an interesting analysis of the unusual rates on municipal bonds. The stated rates for munis e)ceeded those for Treasuries, and this is before the ad7ustment for ta)es. That is, putting the muni bond yields on a ta)able e5uivalent basis made the muni yields significantly higher. This illustrates how these relationships can fluctuate widely over time.

A"SWERS TO E"! O* CHAPTER 0.ESTIO"S 9,12 (ome investors are interested in bonds because they offer a steady stream of interest income over the life of the obligation and a return of principal at maturity. =n the other hand, other investors are interested in bonds e)actly because bond prices will change as interest rates change. $ecause bonds can be purchased on margin, large potential gains are possible from speculating on interest rates. In buying and selling foreign bonds, individual investors may find it difficult to invest directly in foreign bonds both in a dollar sense and in a time sense. (econdary mar"ets in some foreign countries are not comparable to the 2. (. Treasury mar"et. Transaction costs are an issue. Currency ris" is always a potential problem. The "ey factor in analy ing bonds is the behavior of interest rates. ,ar"et yields and prices for all bonds are directly related to interest rate behavior. Two passive bond management strategies are4 &a' &b' $uy and hold Immuni ation!!protecting a portfolio against interest rate ris". >ote, however, that immuni ation re5uires activity to succeed. It is not a true passive strategy.

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I((&ni7ation is the strategy of immuni ing &protecting' a portfolio against interest rate ris". It involves offsetting the two components of interest rate ris"!!the price ris" and the reinvestment rate ris"!!which move in opposite directions. Duration is the basis for immunization theory. % portfolio is immuni ed if its duration is made e5ual to a preselected investment hori on for the portfolio.

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%ctive bond management strategies include forecasting interest rates and bond swaps. The two are related in that at least some bond swaps involve some type of

forecast of interest rates &e.g., the rate anticipation swap'. 9,92 % sharp decline in interest rates is, of course, the ideal environment for the bond investor see"ing capital gains. (uch an investor should concentrate on low coupon, long maturity bonds, or bonds with the longest duration. %ll bonds will perform well in such an environment, but investors may prefer certain types depending on the circumstances. 0or e)ample, yield spreads should be considered. 8overnments can be purchased on 8!*?@ margin. The after!ta) return of municipals may be superior. Aero coupons offer ma)imum volatility. %nd so forth. Bong maturities have greater price fluctuations. therefore, if a rise in mar"et rates is e)pected, these bonds will be unattractive for speculative purposes. The lower the coupon, the higher the price volatility. $onds selling at large discounts presumably have lower coupons. %gain, these would not be preferable if rates are e)pected to rise. $ond swaps!!the term usually refers to the purchase and sale of bonds in an attempt to improve the rate of return on the bond portfolio by identifying temporary mispricings in the bond mar"et. Thus, managers of bond portfolios attempt to ad7ust to changing conditions by identifying mispricings among securities. Hori7on analysis is one form of interest rate forecasting. It involves the pro7ection of bond performance over a planned investment hori on. The investor evaluates bonds being considered for purchase over a selected holding period in order to determine which will perform the best. To do this, the investor must ma"e assumptions about reinvestment rates and future mar"et rates and calculate the reali ed compound yields for the bonds being considered. If you thin" the $ritish economy will slow down, interest rates are li"ely to drop because of slac" loan demand, and bond prices are li"ely to rise.

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If you are bullish on the pound, you could ta"e an unhedged position. % bearish investor might choose to hedge the position. C*A 9,132 C*A 9,142 C*A 9,152 C*A 9,162 a a c &a' The three issues that 3obert and >eil should address are the following4 &*' The starting yield level relative to the U.S. If the spread is positive, this provides a cushion against unfavorable moves in either interest rates in the foreign mar"et or in the value of the foreign currency. If the spread is negative, the foreign mar"et must ma"e up the difference by outperforming in local currency terms or by e)periencing an appreciation in its currency &or both'. The prospects for internal price movements relative to the U.S. bond market. In other words, what is the li"ely trend in yield spreads between the foreign mar"et and the 2.(.1 2nli"e in the 2.(., where yields in different sectors will generally move in the same direction, albeit at different rates, yields in foreign mar"ets may move in opposite directions to the 2.(., due to differences in economic, social and political factors in those foreign mar"ets. The prospects for currency gain or loss versus the dollar. The factors 3obert and >eil should loo" at to assess prospects for the 9eutschemar" and the %ustralian dollar include4 &a' &b' trends in the balance of payments. inflation and interest rate differentials.

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the social and political atmosphere, particularly as it relates to foreign investment. the e)tent of central ban" intervention in the currency mar"ets.

The two reasons for investing in a mi)ture of international bonds are &*' the opportunity for superior rates of return and &;' diversification. Cith respect to return, economic and interest rate cycles tend not to move in parallel worldwide. %s a result, being able to invest in a host of different mar"ets presents opportunities for above! average return in comparison to having access to only one individual and relatively homogeneous mar"et. (imilarly, as regards diversification, foreign bond mar"ets are not perfectly correlated with the 2.(. bond mar"et. This means that the volatility of return for a portfolio of global bonds will be less than for a portfolio comprised only of 2.(. bonds. The +3I(% account does have a *:@ position in Canadian bonds, but the close interrelationship of the Canadian economy and its capital mar"ets ma"es Canada highly correlated with the 2.(. In that sense, the Canadian position does not afford the return and diversification opportunities that other foreign bond mar"ets would offer.

A"SWERS TO E"! O* CHAPTER PROB<E S C*A 9,12

There are three components of return for international &8erman' bonds4 coupon income, capital appreciation &or loss' and resulting from interest rate movements, and profits &or loss' from changes in currency e)change rates. in contrast, only the first two components of return &coupon income and capital appreciation, or loss' apply to domestic &2.(. government' bonds. (ince both bonds were selling at par on *D*D9* in both cases, the mar"et yields on the bonds e5ualled their coupons', the contribution from coupon income is simply the coupon rate indicated in the table. 8iven weEre dealing with holding period return here, itEs appropriate to use the beginning price of the issue to measure the current yield &coupon' component of return. #rice change resulting from interest rate movements can be calculated using the change in yield times the modified duration, with the sign changed4 #ercent price change F ! modified duration ) yield change ) *:: 8erman government bond4 2.(. 8overnment $ond4 !:.?: ) !G.: F H<.?:@ !*.;? ) !I.? F H8.*<@

The percentage change from currency movements can be appro)imated by ta"ing the reciprocal of the 9,D2.(. e)change rate &to e)press the e)change rate in dollar terms' and finding the percentage change4 &*D*.?:'D&*D*.??' F .IIIGD.IJ?; F *.:<< F H<.<@ change Thus, the contribution to total return for the two bonds can be summari ed as follows4

9omestic 9omestic Coupon H Capital Currency Total Income 8ain H ,ovements F 3eturn 8erman 8ovt. $ond or appro)imated as 2.(. 8ovt. $ond 8.?@ 8.?@ 8.:@ H H H <.?@ <.?@ 8.*@ H H H <.G@K <.<@ :.:@ F F F *?.G@ *?.<@ *I.*@

%s indicated in the table above, the 2.(. government bond offered the superior return relative to the 8erman government $ond. K% more accurate formula to reflect currency movements is4 -&*::@ H coupon income H capital change' ) &currency change'/ F&*::@ H 8.?@ H <.?@' ) &.:<<'/ F <.G@ C*A 9,32 %. >ote that the concepts discussed below are applied specifically to non!callable bonds. The notions of duration and conve)ity do pertain to callable securities, but their behavior does not necessarily follow the pattern described in this guideline answer. 9uration is a gauge of a bondEs basic price volatility. ,acaulay duration is the weighted term to maturity e)pressed in years where the weights are the present values of the cash flows occurring in those years. ,odified duration is the ,acaulay duration divided by &* H semi!annual yield' for bonds with semi! annual payments. +5uivalently the first derivative of the bond price!yield e5uation with respect to yield divided by the price &present value' of the bond produces the same modified duration. ,odified duration measures bond price volatility and provides an estimate of the rate of change in bond price due to a change in yield. %s such, modified duration

measures a bondEs sensitivity to interest rate changes and its e)posure to interest rate ris". Conve)ity indicates the e)tent to which duration is affected by the curvature of the priceDyield relationship. That is, in con7unction with duration, conve)ity shows how much more bond price will rise with a drop in yield and how much less price will fall with an increase in bond yield. %s such, conve)ity acts to ad7ust duration so that when used together they provide a more complete measure of bond price volatility. #rice!yield relationship is fundamental to bond price behavior and is based on the principle that bond prices and yields move in opposite directions. This principle is derived from the fact that the price of a bond is e5ual to the present value of its future cash! flows. That is, a change in yield mathematically must produce an off!setting change in price in the opposite direction. $ecause present value is an e)ponential function, the price!yield relationship is conve), meaning that bond prices rise at an increasing rate when yields fall and decline at a decreasing rate when yields rise. $ecause the relationship is non linear, both duration and conve)ity are needed to accurately represent bond price behavior. >ow, because duration is the first derivative of bond price with respect to yield, it is represented by a straight line tangent to the price!yield relationship at a given bond yield. %s such, the rate of change in bond price estimated by duration remains the same for all changes in bond yields. 9uration alone underestimates price appreciation &when rates fall' and overestimates price depreciation &when rates rise'. Chile this is not much of a problem for small changes in yield, the differences can become substantial for large differences. $ecause conve)ity is the second derivative &of

price with respect to yield', it results in a curved price!yield relationship which much more accurately reflects bond price behavior. +ssentially, conve)ity is used with duration to correct errors in estimated price behavior, especially with large swings in yields. That is4 #rice Change +stimated by Duration %d7ustment in #rice Change 9ue to Conve ity ,ore %ccurate ,easure of #rice Change

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%s can be derived from the discussion above, the best way to monitor bond price volatility, whether individually or in a portfolio, is to use !"T# duration and conve)ity. 9uration is fine for small moves in yield, but as the change in yield increases &to more than *:: basis points or so', the combination of both duration and conve)ity provides the superior measure of estimated bond price behavior. $. % barbell portfolio combines two bonds such that the portfolio has the desired &bullet' modified duration. The term barbell comes from the usual practice of combining bonds at opposite ends of the term structure. The motivation for a barbell position is to manage the conve)ity of the investment. The barbell position is a combination of the two bonds, such that the weighted modified duration is eight years4 <.9G w* H 9.G< &* ! w*' F 8.: w* w; F F .<: &bond *' .G: &bond ;'

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$ond * ;

Ceights .<: .G: *.:: K K

9uration <.9G yrs. 9.G< yrs. F F

9uration *.*9 yrs. I.8* yrs. 8.:: yrs. LLLLLLLLL

%t the same time, this barbell portfolio will also have its own weighted average conve)ity4 $ond * ; Ceights .<: .G: *.:: Conve)ity *9.?8 *IG.?I CtEd. %vg. Conve)ity ?.8G **G.;9 *;<.*I LLLLLL

Thus, the two positions stac" up as follows4 ,od. 9uration *?!year T!$ond Currently Meld #roposed $arbell #ortfolio 8.: years 8.: years Conve)ity 9J.<I *;<.*I

Clearly, while the two positions result in the same duration, the conve)ity of the barbell is considerably higher than the bond currently held. The net result is that the price behavior of these two positions will not be the same over different yield environments. ,ore specifically, the two positions will undergo about the same price volatility if rates drop by only ?: basis points, since the durations are the same and conve)ity doesnEt have much of an impact with small swings in yields. In sharp contrast, if rates drop by ;?: basis points, the barbell will e)perience much better price appreciation, as the larger conve)ity will lead to more price volatility. %ll of this, of course, assumes an e5ual shift in the term structure !!i.e., that both ?!year and <:!year issues e)perience the same change in yield. If they donEt, the price behavior could differ !! not because of variations in

conve)ity, but because of variations in yield behavior. C*A 9,42 The three reasons for these discrepancies that could be cited from the information provided are4 *. ,odified duration, when used to estimate the e)pected price behavior of a bond, is only accurate for small changes in yield. The relatively large *:: basis point change assumed in the 5uestion accentuates this fact. The inaccuracy of modified duration as an estimator of percentage price change is referred to as conve)ity. Therefore, conve)ity is a measure of the degree to which modified duration &a linear estimate of price sensitivity' fails to capture the true dynamics of the curvilinear priceDyield function. The percentage volatility indicated by the modified duration number applies to the full price of the bond including accrued interest, and not the 5uoted &flat' price. Mere, only mar"et 5uoted prices have been used &e)cludes accrued interest'. The effect of a call price is shown by e)amining $ond A. (ince $ond A only rose in price by ;.J@ &to *:*', it is obvious that the price rise has been constrained by the greater li"elihood of it being called at par &*::' in one year on Nune *, *99:. %lthough no specific information is provided in the 5uestion, two other possible sources of discrepancy are4 J. % change in ta) rate could impact mar"et prices, so that their change would vary from the amount predicted by the modified duration number. 9ifferences in mar"et li5uidity could impact the changes in mar"et price of the three

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bonds. (upply and demand considerations could affect one type of bond more significantly than another.