# Investment Management and Capital Markets

Lecture 5: Bond Management
Characteristics of Bonds Volatility, Duration and Convexity Bond Management Characteristics of bonds: (i) Price -Yield relationships for Bonds When we look at the redemption yield formula for a bond it becomes clear that prices and yields are inversely related ie a rise in yields lowers the price of a bond and vice versa. Bond price P = Σ Ct/ (1+y)t

ytm `y’ P= Market price of Bond Ct= cash Flow in time `t,’ (For this lecture, the last payment, R, redemption value, is counted within Ct.) For a given yield change, the rise in price is more than the fall; ie for a 1% fall in yield the % increase in price of the bond is higher than the % fall in the price of a bond for a 1% increase in yield. Hence the price-yield graph is convex to the origin. If a bond is selling at par : If a bond is selling at a discount If a bond is selling at a premium YTM = coupon rate YTM > coupon rate YTM < coupon rate

(ii) As the life of a bond reduces, the size of the discount/premium gets smaller. Bond Price

par value
discount

Maturity

`t’

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Duration, Convexity and Dispersion

Duration is the average time to maturity of the bond ie the average time after which the cash flows on the bond will be received.

Mathematically duration is: Σ C t t / ( 1 +y ) t -------------------------------Σ Ct / (1+y)t Σ t . (PV) C t = ---------------------------Σ (PV) C t (= P)

D =

Illustration: A bond with a ytm of 8% and a 10% coupon to be redeemed at par after 3 years. 100 Present Value 10 10 10

0

1

2

3

Present value: = 10/ (1.08) + 105.13 = 9.26 + 10/ (1.08) 2 + 8.57 + 110/ (1.08) 3 87.3

Duration:

9.26 x 1 + 105.13 = 2.74

8.57 x 2

+

87.3 x 3

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Duration of a bond increases with its term to maturity. The duration of a zero coupon bond is its time to maturity. The duration of a level perpetuity is = 1/current yield (y) Duration increases as coupon and yield decrease.

Zero coupon bond

Arrows show the effect on duration

Duration `t’ Ytm decreases

coupon decreases

term to maturity

`t’ Maturity

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Convexity and Dispersion As the Price (Present Value) - Yield profile of a bond is convex to the origin, we stated earlier that a fall in yield will result in a relatively higher increase in the price of a bond than a corresponding rise on yield will lower the price of the bond

By mathematical definition
2

P

or ∆P / P = -- D. dy / ( 1+ y) +. C. (dy)

y

Convexity allows for a correction in the bond price due to the curved profile of the PY graph. Note that the effect of convexity is always positive. Finally, Dispersion, noted as M2 , is a measure of the variance of the cashflows on a bond around its Duration (average time of receipt of cash flows on the bond) and is approximated by .

M 2 ≈ 2C - D(D+1)
Dispersion is higher when the cashflows on a bond are distributed across several years. What is the Dispersion of a zero?

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Illustration Q. For a 10% coupon bond with 3 years to redemption, and current ytm of 8% : Calculate the following(i) price volatility, duration, convexity and dispersion of the bond. (ii) If yields change by 2% estimate the change in fall in the price the bond using (a) duration only and (b) both duration and convexity. Answer (i) Duration has already been worked out as 2.74 yrs. Price Volatility = - D . dy/ (1+y) = - 2.74 x (.01) / (1.08) = 2.53%. Convexity is = ½ ( Σ t.(t+1) . (PV) C t ) / P

= ½. ( 1.2.( 9.26) + 2.3.(8.57) + 3.4 (87.32) ) 105.13 = ½ ( 1117.78 / 105.13 ) = 5.315

Dispersion = 2C – D(D+1) = 2 x 5.315 – 2.74 x 3.74= 0.3824.

(ii) Using duration only, estimated change in price of bond for 2% rise in yield = - 2.74 x 0.02 / 1.08 = - 0.0507 ( - 5.07%); or for a 2% rise in yield a decrease in price of 5.07%.

Using also convexity, if yields increase by 2%, the fall in price is = - 0.0507 + 5.315 x. (0.0004) = - 0.0507 + 0.0021 = - 0.0486 ( -4.86% ) and if yields fall by 2% the rise in price is = 0.0507 + 5.315 (0.0004) = 0.0507 + 0.0021 = 0.0528 ( + 5.28% ) Notice the effect of convexity is always positive.

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Bond Management strategies (i) Passive ( eliminating interest rate risk): - Immunisation (ii) Active (speculative, based on predicting yield curve changes) - Horizon analysis - Bond swaps - Riding the Yield curve Passive Strategies: Immunisation: is a strategy to protect against interest rate risk. The concept of duration matching is central to immunisation. Immunisation may be single period or multiperiod liability depending on whether a single liability is to be met or whether liabilities in several periods have to be immunised. The duration of a portfolio is the weighted average of the duration of the components; ie Portfolio Duration Dport = Σ Wi. Di ; Σ Wi = 1 Duration of Portfolio Dport = DaWa + Db Wb Wa+Wb=1 (100%) When immunisation is achieved through a range of bonds themselves of different duration than the duration of the asset required to be matched, the interest rate risk is higher than when a single bond matching the duration of the liability is chosen for immunisation. Note that the underlying assumption for immunisation is that the yield curve is flat. Formally stated the conditions to be met if immunisation is to be achieved are: (i) present value of assets > present value of liabilities (ii) duration of assets = duration of liabilities ( More rigorously, the convexity of assets also needs to be > convexity of liabilities, though this involves computer programmes and is beyond the scope of this course. ) As time passes, with interest rate changes, immunisation is affected and it is necessary to rebalance the portfolio. Cash matching is an alternative method by which immunisation can be achieved. In this method immunisation is achieved by matching liabilities with bonds (`a dedicated strategy’) which offer the cash flow to meet the liabilities. Do nonparallel shifts in a yield curve which is not horizontal affect such a strategy of immunisation?
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What period is immunisation achieved for? What are the practical difficulties?

Active Strategies: are based on predicting yield curve changes. Horizon analysis: focuses on the yields/ bond prices at the end of a holding period. and examines alternative scenarios at the end of the period starting from the existing yield structure. It follows through the `time effect’ and `change in yield’ effect to evaluate the total cash flow from the bond at the end of the holding period. Bond swaps: - Substitution swaps are based on substituting higher priced bonds (lower ytm) for lower priced bonds (higher ytm). Bonds which lie significantly above the ytm curve (are lower in price) while bonds which lie significantly below the yield curve are higher in price. - Intermarket spread swaps are based on exchange of bonds from different sectors of the market on the basis of expectations of narrowing yield spreads. Eg treasury bond for Baa of same maturity but higher yield, if business conditions stabilise. - Rate anticipation swaps are based on the following principles: If the yield curve is expected to rise in the future at the long end: long yields increase, implying longer duration bonds will fall in price. Here the strategy is to sell longs and shift into shorts. Alternatively, if short term interest rates are expected to rise: short term bonds will fall in price. Here the strategy is to sell shorts and shift into longs. If a fall in all interest rates or a rise in all interest rates is expected: price changes are larger in longer term bonds than those with shorter duration.

Riding the Yield curve In an environment where the yield curve is expected to be upward sloping for some time there are profit opportunities in buying and selling longer dated bills/bonds over a particular holding period compared to a `simple buy and hold strategy’ of a bond maturing at the end of the holding period. This technique is called `riding the yield curve.’

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