Overview
Chapter 19 considers how to use the
Chapter 19
Bond Portfolio
Management Strategies
Overview
The second category includes active
management strategies that can involve one of
five alternatives: interest rate anticipation,
valuation analysis, credit analysis, yield spread
analysis, or bond swaps.
The third category includes matched funding
strategies, which include constructing
dedicated portfolios, constructing classical or
contingent immunization portfolios, or horizon
matching .
background provided in Chapter 17 and
Chapter 18 to create and manage a bond
portfolio.
We consider three major categories of
portfolio strategies in detail.
The first is passive portfolio management
strategies, which include either a simple buy-
and-hold strategy or indexing to one of the
major benchmarks.
Overview
In this chapter, we shift attention from bond
valuation and analysis to an examination of the
most widely used bond portfolio management
strategies.
After a brief discussion of how bonds have
performed as an asset class in recent years and
how fixed-income investment styles are
typically classified, we will see that these
strategies can be classified into one of five
broad approaches:
 Learning Objectives
Overview
passive management After you read this chapter, you should be able to
active management,
What are the five major classes of bond portfolio
core-plus management,
matched-funding management, and
How is the investment style box defined for fixed-
contingent and structured active management.
What are the two main types of passive bond
In the following sections, we describe these
approaches in more detail and give examples of how What are the main active bond portfolio
each is used in practice.

Learning Objectives Learning Objectives

How do active bond portfolio strategies differ from How does bond immunization work and how
one another in terms of scope, scalability, and does that strategy differ from a cash-matching
risk-adjusted return potential?
What is meant by core-plus bond portfolio What other dedicated management strategies

What are the primary "plus" strategies in a core- What is meant by a contingent immunization
plus approach to management? approach to bond portfolio management?
How does a matched-funding approach to bond
portfolio management differ from an active or
passive approach?
Bond portfolio management strategies
can be classified into one of five broad 19.1 BOND PORTFOLIO
approaches: PERFORMANCE, STYLE
passive management, AND STRATEGY
active management,
core-plus management,
matched-funding management, and
contingent and structured active
management.
10

19.1 Bond Portfolio Performance

Style and Strategy Exhibit 19.1
Bond Portfolio Performance
Fixed-income portfolios generally produce both less
return and less volatility than found in other asset
classes (e.g., domestic equity, foreign equity)
Exhibit 19.1 shows the average returns and
standard deviations for several performance
indexes over the 20-year period ending in 2010
The low historical correlation between fixed-income
and equity securities only 0.08 over this time
period has made bond portfolios an excellent tool
for diversifying risk
 Bond Portfolio Performance
Style and Strategy Exhibit 19.2
Bond Portfolio Style
The investment style of a bond portfolio can be
summarized by its two most important
characteristics: credit quality and interest rate
sensitivity
The average credit quality of the portfolio can be
classified as high, medium, and low grades
The interest rate sensitivity of the bond portfolio can
be separated as short-term, intermediate-term, and
long-term in terms of duration
See Exhibit 19.2

Bond Portfolio Performance

Style and Strategy Exhibit 19.3
Bond Portfolio Strategies
Passive Portfolio Strategies
Active Management Strategies
Core-plus Management Strategy
Matched-funding Techniques
Contingent Procedure (Structured Active
Management)
See Exhibit 19.3
 19.2 Passive Portfolio
Strategies
Buy and hold
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
Can by modified by trading into more desirable
positions
Indexing
The objective is to construct a portfolio of bonds that
will track the performance of a bond index
Performance analysis involves examining tracking
error for differences between portfolio performance
and index performance

Active Management Strategies Exhibit 19.5

Active management strategies attempt
to beat the market
Mostly the success or failure is going to
come from the ability to accurately
forecast future interest rates
Active Strategy Attributes (Exhibit 19.5)
Scalability
Sustainability
Risk-adjusted performance
Extreme values
Active Management Strategies

Interest-rate anticipation
Risky strategy relying on uncertain forecasts
Ladder strategy staggers maturities
Barbell strategy splits funds between short duration
and long duration securities
Valuation analysis
The portfolio manager attempts to select bonds
based on their intrinsic value
Credit analysis
Involves detailed analysis of the bond issuer to
determine expected changes in its default risk
See Exhibit 19.7

Exhibit 19.7

Zeta = a0 + a1X1 + a2X2 +a3X3 nXn

Where:
Zeta = the overall credit score
X1 n = the explanatory variables (ratios and
market measures)
a0 n = the weightings or coefficients
 X1= profitability: earnings before interest and taxes
(EBIT)/total assets (TA)
X2=stability of profitability measure: the standard error
of estimate of EBIT/TA (normalized for 10 years)
X3=debt service capabilities (interest coverage);
EBIT/interest charges
X4=cumulative profitability : retained earnings/total
assets
X5=liquidity: current assets/current liabilities
X6=capitalization levels: market value of equity/total
capital (five-year average)
X7=size: total tangible assets (normalized)

: liquidation (are there any claims against
1.
of cost and pricing? This can be critical to a
small firm.
2. What
requirements for interest, research, growth, and
periods of economic decline? Also, what is the
safety net and provide flexibility?
3.
assets? Are these assets available for
them)? In many cases, asset sales are a
critical part of the strategy for a leveraged
buyout.
4. How good is the total management team? Is
the management team committed to and
capable of operating in the high-risk
environment of this firm?
absolute basis and on a market-adjusted
basis (using market value of equity and
debt)?
Active Management Strategies (Bond Swaps)

Yield spread analysis

Assumes normal relationships exist between the
yields for bonds in alternative sectors
When abnormal relationship occurs, a bond
(Pure Yield Pickup Swaps)
manager could execute various sector swaps
The spread widens during economic recession
Interest rate volatility also affects the spread
(Substitution Swaps)
Bond swaps
Involve liquidating a current position and
simultaneously buying a different issue in its place (Tax Swaps)
with similar attributes but having a chance for
improved return

Active Management Strategies

Bond Swaps Types
Pure yield pickup swap
Swapping low-coupon bonds into higher coupon
bonds
Substitution swap
Swapping a seemingly identical bond for one that
is currently thought to be undervalued
Tax swap
Swap in order to manage tax liability (taxable &
munis)
Swap strategies and market-efficiency
Bond swaps by their nature suggest market
inefficiency
 19.4 Core-Plus Management
Active Global Bond Investing
An active approach to global fixed-income
management must consider the following
three interrelated factors
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
Strategies
A combination of passive and active styles ( a
form of enhanced indexing)
A large, significant part of the portfolio is
passively managed in one of two sectors:
The U.S. aggregate sector, which includes
mortgage-backed and asset-backed securities
The U.S. Government/Corporate sector alone
The rest of the portfolio is actively managed
Often focused on high yield bonds, foreign bonds,
emerging market debt
Diversification effects help to manage risks

Core-Plus Management
Strategies
Relative to a passive index strategy, a core-plus
approach to managing a bond portfolio offers three
potential advantages:
(1)Higher returns that occur from exploiting market
inefficiencies outside the traditional core sectors
(2)Increased opportunities for exploiting the

(3)The ability to alter the composition of the fixed-

income asset class in a manner consistent with the
insights and views of the manager
Matched-funding strategies are a form of asset-
liability management whereby those of the
liabilities the investor is obligate to pay

An important assumption underlying all of the

matched-funding techniques is that the

degree of precision.

Such an exact cash match portfolio is

The goal is to build a portfolio that will
generate sufficient funds in advance of
each schedules payment to ensure that
the payment will be met.
One alternative is to find a number of zero-
coupon Treasury securities that will
exactly cash match each liability.
referred to as a total passive portfolio
because it is designed so that any prior
receipts would not be reinvested.
It assumes a zero reinvestment rate
Useful for sinking funds and maturing
principal payment
Matched-Funding Strategies
Dedicated Portfolios
Designing portfolios that will service liabilities
Exact cash match
Conservative strategy, matching portfolio cash
flows to needs for cash
Useful for sinking funds and maturing principal
payments
Dedication with reinvestment
Does not require exact cash flow match with liability
stream
Great choices, flexibility can aid in generating
higher returns with lower costs
In addition, the assumption of
reinvestment within each period and
between periods also will generate a
higher return for the asset portfolio.
As a result, the net cost of the portfolio will
be lower, with almost equal safety,
assuming the reinvestment rate
assumption is conservative.
It is similar to the pure cash-matched
technique except it is assumed that the
bonds and other cash flows do not have to
exactly match the liability stream.
Any inflows that precede liability claims can
be reinvested at some reasonably
conservative rate.
This assumption allows the portfolio manager
to consider a substantially wider set of bonds
that may have higher return characteristics.
Matched-Funding Techniques
Immunization Strategies
The process is intended to eliminate interest
rate risk that includes:
Price Risk
Coupon Reinvestment Risk
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
Matched-Funding Techniques
Classical Immunization
Immunize a portfolio from interest rate risk by An investor has a liability that she needs to
keeping the portfolio duration equal to the pay off in exactly three years, so her
investment horizon desired investment horizon is three years.
Duration strategy superior to a strategy
based only a maturity since duration
The promised yield for each of these
considers both sources of interest rate risk
prospective investments is 10 percent at
An immunized portfolio requires frequent
rebalancing because the modified duration of
the time she makes her initial decision.
the portfolio always should be equal to the
remaining time horizon

The initial investment (per $1000 of face value) is:

A: Purchase a 10-years bond paying a 9

percent annual coupon and sell it in three
years
B: Purchase three consecutive one-year
C: Purchase a three-year, pure discount
bond
D: Purchase a four-year bond paying a
34.85 percent annual coupon and sell it in
three years
Since this position will not have matured by Year
3, it will have to be sold at the prevailing market
rate (assumed to then be 8 percent). Also, she will
be able to reinvest the coupons she receives prior
to her planning horizon. Thus, the ending-wealth in
this position is the combination of :
(i)Sale of bond:
(ii)Reinvested Coupon Payments:
1052.06+292.18=1344.24
 Assume for simplicity that the bondholder
Bond A would be : invests $1000 initially at 10% and then reinvests
the total annual proceeds for two more years at
8%:

The initial of Bond C (per $1000 face

strategy would be: value) is:

So, the realized yield would be:

Bond D is similar to Bond A in that it must be The ending level in Year 3 combines:
sold prior to maturity and its coupons must be (i) Sale of Bond:
reinvested. The initial price for this security is:
(ii)Coupon Payments:

1248.61+1131.37=2379.98

Thus the realized yield would be: Realized yield

--Bond A: 12.72%>10% --Bond B: 8.66%<10%
--Bond C: 10%=10% --Bond D: 10%=10%
Duration
--Bond A: 6.89 years>3 years (net price risk)
--Bond B: 1 year<3 years (net reinvestment risk)
--Bond C: 3 years=3 years (Immunization)
--Bond D: 3 years=3 years (Immunization)
 Duration & Investment Horizon
-- An immunized portfolio would be to
-- examine the specific growth path that
Risk converts the beginning-wealth
-- position into the ending-wealth
Setting the duration of an asset equal to the position and then consider what
duration of the liability (investment horizon) will happens when interest rates change.
immunize an investment against the next interest
rate movement.

A. compound growth path

Initial wealth position : $1,000,000

Investment horizon : 10 years
Coupon and Current YTM : 8 percent
Ending-wealth position (assuming
semiannual compounding) : $2,191,123
 B. the end of The interest rate change will impact the
Year2, interest portfolio in two ways
rates increase (1) the market value will decline to reflect the
from 8 percent higher interest rates
to 10 percent.
(2) the reinvestment potential, which is the
future growth rate of the portfolio, will
increase.
The important question therefore is
what will be the new ending-wealth position of
the portfolio?
With no prior rate changes, at the end of Year 2 the
value of the portfolio would have grown at an 8 percent The answer depends on the duration of the
compound rate to $1,169,859 (=$1 million X (1.04)^4). 61
position then rates change.

Thus, the price decline is exactly offset by

If this new portfolio the higher reinvestment rate, assuming that
value grows at 10 the duration of the portfolio at the time of the
percent a year for 8 yield movement was equal to the remaining
years, the projected investment horizon.
ending-wealth value
will be:
$1,003,779 X
(1.05)^16 = What happens if the duration of the portfolio
$2,191,123 is not properly matched to the desired
investment horizon?
The actual Year 2 value of the portfolio after the rate
increase will be $1,003,779.
63
 C. Effect of
When duration is greater than eight years, if interest rate
interest rates increase, the value of the increase with
portfolio after the rate change will be less duration greater
than $1,003,779. than investment
horizon.
In this case, even if the new value of the
portfolio grew at the higher growth rate of 10
percent a year, it would not reach the original
expected ending-wealth value.

The value of the portfolio with a duration greater than

eight years declined to $950,000.
66

Supposing this
New portfolio value amount to be
then grew at the $1,450,000, the
higher growth rate for revised ending-
the rest of the wealth position
investment horizon, would be:
its ending value would $1,450,000 X
be, (1.03)^16
$950,000 X (1.05)^16 = $2,326,824
= $2,073,731

The shortfall of $117,392 between the original expected

ending-wealth level and the realized position is due to the
fact that the portfolio was not properly duration matched If duration exceeds eight years, the Year2 portfolio value
when the interest rate change occurred. would be greater than the required value of $1,365,435.
67 68
 D. Effect of
interest rate
decline with The important point here is that when
duration greater you are not duration matched, you are
than investment
effectively speculating on interest rate
horizon.
If the rate grows at 6
changes and the result can be either
percent for 8 years, very good or very bad.
its ending value will
be:
$1,365,435 X The purpose of immunization is to avoid
(1.06)^16 = this uncertainty and to lock in the
$2,191,123
expected ending-wealth regardless of
Assuming that the portfolio is properly duration matched,
its Year 2 value will increase to $1,365,435.
interest rate changes.
69

Matched-Funding Techniques

Difficulties in Maintaining Immunization We can see the example first.

Strategy
Rebalancing required as duration declines compensation insurance benefits to the employees
more slowly than term to maturity of his parent firm.
Modified duration changes with a change in
The parent firm conservatively plans for payments
market interest rates
to continue an average of 3.50 to 4.50 years.
Yield curves shift Thus, they consider this to be the duration range of
the potential liabilities (i.e., planning horizon) they
face.
The uncertainty of both the size and length of Details of the specific securities the held are
the benefit claims that Stonewall is liable for shown in Exhibit 19.17.
makes the implementation of a cash-matched The portfolio has been assembled to have a
portfolio solution impractical. modified duration of 3.96 years, which closely
matches the target horizon period implied by
their projected liabilities.
insurance firms have less predictable
liabilities than life insurance companies.
The position
is effectively
asset-liability management problem is to immunized
assemble a bond portfolio that has a duration
statistic of around 4 years. 73 74

This example highlight some challenges when

investors designing an immunization strategy.

First of all, except for the special case of a zero-

coupon bond, an immunized portfolio will
require frequent rebalancing. Such
rebalancing will be necessary with every
significant shift in the yield curve, but it will also
be required by the passing time.

After a year has passed, the modified duration

of the bond portfolio will be substantially lower
than 3.96 years. Because duration declines
more slowly than maturity as time passes.
Of course, since the target investment horizon
would still be 4.00 years, this decay in the
duration of the portfolio would leave the firm in
a position of net reinvestment risk and
therefore adversely exposed to a subsequent
downward movement in the yield curve.
Thus, the bond manager for Stonewall will
periodically need to rebalance the portfolio to
maintain the original duration target.
Consequently, the manager of an immunized
bond portfolio should also pay attention to the
convexity statistic of the position. And they
should attempt to construct a bond portfolio
liabilities.
Kritzman (1992) demonstrates that for two
portfolios with the same duration the one with
cash flows that are more spread out will
have greater convexity.
Second, that duration changes inversely
with changes in interest rates. It is this
property that makes the relationship
curved (i.e., convex) function.
Finally, because certain segments of the
fixed-income market can be illiquid, there
sometimes is a problem acquiring the bonds
you have identified as optimal positions for
your portfolio.
In summary, it is important to recognize that
classical immunization is generally not a
passive strategy because it is subject to all of
these practical issues that demand the
attention of the manager.
Matched-Funding Techniques Exhibit 19.18

Horizon matching
Combination of cash-matching dedication
and immunization
Important decision is the length of the
horizon period
With multiple cash needs over specified
time periods, can duration-match for the
time periods, while cash-matching within
each time period
See Exhibit 19.18

Matched-Funding Techniques The combination technique also helps

In the first segment, the portfolio is contrasted
to provide a cash match for the liabilities
during this horizon period.
The second segment is the remaining liability
stream following the end of the horizon
period. During this second time period, the
liabilities are covered by a duration matched
strategy based on immunization principles.
the client receives the certainty of cash
matching during the early years and the cost
saving and flexibility of duration matched
flows thereafter.
alleviate one of the problems with classical
immunization: the potential for nonparallel
shifts in the yield curve.
Most of the problems related to non-parallel
shifts are concentrated in the short end of the
yield curve because this is where the most
severe curve reshaping typically occurs.
Because the near-term horizon is cash-
matched, however, these irregular rate
changes are not of concern. Further, we
know that the long end of the yield curve
tends toward parallel shifts.

An important decision when using horizon
matching is the length of the horizon period.
The trade-off when making this decision is
between the safety and certainty of cash
matching and the lower cost and flexibility of
duration-based immunization .
It also is possible to consider rolling out the
cash-matched segment over time. The ability
and cost of rolling out depends on
movements in interest rates.
The specific contingent procedure is contingent
immunization, which is a strategy that slows the
bond manager flexibility to actively manage the
portfolio subject to an overriding constraint that
the portfolio remains immunized at some
predetermined yield level.
19.6 Contingent and Structured
Strategies
Contingent procedures for managing bond
portfolios are a form of what has come to be called
structured active management
Contingent Immunization (Exhibit 19.21)
Duration of portfolio must be maintained at the
horizon value
Cushion spread is potential return below the
current market return
Safety margin is a portfolio value above the
required value
Trigger point refers to the minimum return that
will stop active portfolio management
Subsequent to the developments of classical
immunization, the portfolio strategy that allows a
bond portfolio manager to pursue the highest
returns available through active strategies while
relying on classical bond immunization
techniques to ensure a given minimal return over
the investment horizon.
That is, their new procedure allows active
portfolio management with a safety net provided
by classical immunization.
An important decision when using horizon
matching is the length of the horizon period.
The trade-off when making this decision is
between the safety and certainty of cash
matching and the lower cost and flexibility of
duration-based immunization .
As part of their discussion on horizon
matching, it also is possible to consider
rolling out the cash-matched segment over
time. The ability and cost of rolling out
depends on movements in interest rates.
Consider the following example of this
process.
Assume that your desired ending-wealth
value is $206.3 million, a five-year horizon
and a 15 percent return. The present value
factor of 0.48473 times the $206.3 million
ending value equals $100 million this is the
required initial investment under these
assumptions to attain the desired ending
value.
91
When the portfolio duration is equal to the
investment horizon a change in interest rates
will cause a change in the dollar value of the
portfolio such that when the new asset value
is compounded at the new market interest
rate, it will equal the expected (desired)
ending wealth value.
This required change in value occurs only
when the modified duration of the portfolio is
equal to the remaining time horizon, which is
why the modified duration of the portfolio
must be maintained at the horizon value.
Assuming the five-year horizon, we can do it
for other interest rates as follows:
Exhibit 19.19 reflects these calculations-that
is, the dark line indicates the required initial
amount that must be invested at every yield
level to attain $206.3 million in five years.
92
 At lower yields
you need a
larger initial
investment, and
it declines with
higher yields.

That the price sensitivity of a portfolio with a modified

duration of five years will have almost exactly the
price sensitivity required. 94

Contingent immunization requires that the

client be willing to accept a potential return
below the current market return.

This is referred to as a cushion spread, or

the difference between the current market
return and some floor rate.

This cushion spread in required yield

provides flexibility for the portfolio manager
to engage in active portfolio strategies.

95

Required return: 15%
Beginning-wealth value: 95.56mn
Ending-wealth value: $196.72 mn.
Required return: 14%
Beginning-wealth value:
100mn Ending-wealth value:
$196.72 mn.
97
Management strategies to increase the ending-
wealth value of the portfolio above that required
at 14 percent.
If rates decline as expected, the value of the
long-duration portfolio will experience a rapid
increase above the initial value. In contrast, if
rates increase, the value of the portfolio will
decline rapidly.
In this case, depending on how high rates go,
the value of the portfolio could decline to a value
below that needed to each the desired ending-
wealth value of $196.72 million.
99
of $100 million and the required assets of
$95.56 million is the dollar cushion available
to the portfolio manager.
This dollar cushion arises because the client
has agreed to a lower investment rate.
Therefore, the manager effectively now has a
$4.44 million (=100-95.56) with
which to pursue active management
strategies in an attempt to add alpha to the
overall portfolio.
98
Exhibit 19.21 shows what happens to value
of this portfolio if we assume an
instantaneous change in interest rates
when the fund is established.
Specifically, if rates decline from 15 percent,
the portfolio of long-duration, 30-years bonds
would experience a large increase in value
and develop a safety margin portfolio value
above the required value. In contrast, if rates
increase, the value of the portfolio will
decline until it reaches the asset value
required at 14 percent.
100
 Exhibit 19.21 When the value of the portfolio
reaches this point of minimum
return (trigger point), it is
necessary to stop active
portfolio management and use
classical immunization with the
remaining assets to ensure that
you attain the desired ending-
wealth value .

102

(See Exhibit 19.21 ) If this $147 million

portfolio were immunized at the market rate
of 10 percent over the remaining five-year
period, the portfolio would grow to a total
The concept of potential return is helpful in
value of 239.5 million ($147 million X
understanding the objective of contingent
1.6289, which is the compound growth factor
immunization.
for 5 percent and 10 periods).

This is the return the portfolio would achieve

This ending value of $239.45 million
over the entire investment horizon if, at any
represents an 18.25 percent realized
point, the assets on hand were immunize at
(horizon) rate of return on the original $100
the prevailing market rate.
million portfolio.
103 104
If market rates rise to 17 percent, the asset
value of the 30-year bond portfolio will
decline to $88 million (see Exhibit 19.21).
If this portfolio of $88 million were immunized
for the remaining five years at the prevailing
market rate of 17 percent, the ending value
would be $199 million.
This ending value implies a potential return of
14.32 percent for the total period.
105
The potential return for the portfolio would be
exactly 14 percent as show in Exhibit 19.21.
Regardless of what happens to subsequent
market rates, the portfolio has been
immunized at the floor rate of 14 percent.
That is a major characteristic of the
contingent immunized portfolio; if there is
proper monitoring you will always know the
trigger point where you must immunize to be
assured of receiving a return no less than
the minimum rate of return specified.
106
When the value of the portfolio
reaches this point of minimum
return (trigger point), it is
necessary to stop active
portfolio management and use
classical immunization with the
remaining assets to ensure that
you attain the desired ending-
wealth value .
108
 Monitoring the contingent immunized
portfolio is crucial to ensure that, if the
asset value falls to the trigger point, the
appropriate action is taken to ensure that
the portfolio is immunized at the floor-level
rate.

109

To demonstrate how this floor portfolio would
be constructed, consider again our ending-
wealth value in five years of $196.72 million
based on an initial investment of $100
million and an acceptable floor rate of 14
percent.
If one year after the initiation of the portfolio,
market rates were 10 percent, you would
need a minimum portfolio value of
approximately $133.14 million to get to
$196.72 million in four years.
112
If the active manager had originally predicted
correctly that market rates would decline and
had structured a long-duration portfolio under
these conditions, the actual value of the
portfolio would be much higher than this
minimum required value, and there would be
a safety margin.
A year later (after Year 2), you would
determine the assets needed at the rate
prevailing at that point in time.
113
You would expect the actual value of the
portfolio to be greater than this required floor
portfolio, so you still have a safety margin.
If you ever reached the point where the
actual value of the portfolio was equal to
the required floor value, you would stop the
active management and immunize what was
left at the current market rate to ensure that
the ending value of the portfolio would be
$196.72 million.
114
Summary
During the past decade, there has been a
significant increase in the number and range of
bond portfolio management strategies available.
Bond portfolio management strategies include
the relatively straightforward buy-and-hold and
bond indexing strategies, several alternative
active portfolio strategies, dedicated cash
matching, classical immunization, horizon
matching, and contingent immunization.
In summary, the contingent immunization
strategy encompasses the opportunity for a
bond portfolio manager to engage in various
active portfolio strategies if the client is
willing to accept a floor return that is below
what is currently available.
Specifically, by allowing for a slightly lower
minimum target rate, the client is making it
possible to experience a much higher
potential return from active management by
the portfolio manager.
115
Summary
Although you should understand the alternatives
available and how to implement them, you also
should recognize that the choice of a specific
strategy is based on the needs and desires of
the client.
In turn, the success of any strategy will depend
on the background and talents of the portfolio
manager.
 The Internet Investments
Online
http://www.ryanalm.com
http://www.finpipe.com
http://www.finpipe.com

ETF

(Buy and Hold)

 ( )

Vanguard

ETF

(Rate Anticipation)

(Credit Analysis)

(Yield Spread Analysis)

(Yield Spread)

;
(Yield Spread)
 16-1

2009 1 5

5
10 5 10
10 20
 (Bond Swaps)

(Pure Yield Pickup Swaps)

50 (Substitution Swaps)

100
(Tax Swaps)

(Bond Swaps) (Substitution Swap)

( ) (
)
(
(Pure Yield Pickup Swap) YTM )

A B A
(Tax Swap) $1,000 (YTM 10% ) B $996.83 (YTM
10.1% ) A B
 (Intermarket Swap)
YTM

(Rate Anticipation Swap)

OR

(Pure Cash-flow Matching)

(Rebalancing)
 (Classical
Immunization)

(Parallel Shift)

twist

(Rebalancing)
 (Contingent (Contingent
Immunization) Immunization)
 Immunization Strategies
( )

The process intended to eliminate interest

rate risk is referred to as interest rate
risk
Components of Interest Rate Risk
Price Risk
Coupon Reinvestment Risk

Duration

(1)
Duration is a measure of the sensitivity of the
price of a bond to a change in interest rates

(2)
1 horizontal yield curve
2 parallel shift
(8.8)
149
 -Dmac

(1/3)

( )
 (2/3) (3/3)
(duration)
Duration( )
( ) ( )
( ) Macaulay (1993)
Duration
(effective)

( )

Duration

A measure of the effective maturity of a bond

The weighted average of the times until each
payment is received, with the weights
proportional to the present value of the
payment
Duration is shorter than maturity for all bonds Macaulay (duration)
except zero coupon bonds
Duration is equal to maturity for zero coupon
bonds
 (Duration) Duration: Calculation

Duration: A Measure of
Interest Rate Sensitivity
The weighted-average time to maturity on an
investment
N N

CFt t PVt t
t=1 (1 + R)t t=1

D = N = N

CFt PVt
t=1 (1 + R)t t=1
161
 Economic Meaning of Duration
(duration) ( )
( ) ( ) Measure of the average life of a
bond

Measure of a bond s interest rate

sensitivity (elasticity)

(term to
maturity)
 Macaulay Duration
The Characteristics
Duration of a bond with coupons is always less than
its term to maturity
A zero-
Duration and coupon is inversely related
1.
There is a positive relationship between term to
maturity and duration, but duration increases at a 2.
decreasing rate with maturity (Exhibit 18.16)
YTM and duration is inversely related
Sinking funds and call provisions can have a 3.
167

9-
311

5 2.862
6% 2.8382

2.862
2.8259
169
 YTM
YTM
170

(1 y) /y
 Rules for Duration
Rule 1 The duration of a zero-coupon bond
equals its time to maturity
1,000 3
Rule 2
duration is higher when the coupon rate is 4% ?
lower
Rule 3 Holding the coupon rate constant, a
time to maturity
Rule 4 Holding other factors constant, the
duration of a coupon bond is higher when the
Rules 5 The duration of a level perpetuity is
equal to: (1+y) / y
0 175

Properties of duration

Duration
Duration
bond duration a sequence
of pure discount bond duration
(Dmac)
 Duration/Price Relationship
Price change is proportional to duration and not
to maturity

D* = modified duration

1/3 2/3

( )
(modified duration)
 Modified Duration and Bond Price Volatility
3/3
As A Measure of Bond Price Volatility
(modified duration) Bond price movements will vary proportionally
with modified duration for small changes in
yields

where:
P = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
(modified duration)
i = yield change in basis points divided by 100

An adjusted measure of duration can be used to

approximate the price volatility of an option-free
(straight) bond

Where:
m = number of payments a year
YTM = nominal YTM 185
 ( )

186 187

Modified Duration and Bond Price Volatility

Trading Strategies Using Modified Duration
Longest-duration security provides the maximum
price variation
If you expect a decline in interest rates, increase the
average modified duration of your bond portfolio to
experience maximum price volatility
If you expect an increase in interest rates, reduce the
average modified duration to minimize your price
decline
Note that the modified duration of your portfolio is
the market-value-weighted average of the modified
durations of the individual bonds in the portfolio
 Convexity

The relationship between bond prices and

yields is not linear

Duration rule is a good approximation for only

small changes in bond yields

Limitations of Macaulay & Modified Duration

Percentage change estimates using modified
duration only are good for small-yield changes
Difficult to determine the interest-rate
sensitivity of a portfolio of bonds when there is
a change in interest rates and the yield curve
experiences a nonparallel shift
Initial assumption that cash flows from the bond
are not affected by yield changes
Practitioners have developed the effective
duration of a bond or any security due to these
limitations
Limitations of Macaulay & Modified Duration
Effective Duration
Measure of the interest rate sensitivity of an asset
Use a pricing model to estimate the market prices
surrounding a change in interest rates
The Formulas
Effective Duration (DEff) = [(P-) (P+)] / 2PS
Effective Convexity (CEff) = [(P-) (P+)-2P] / PS2
Where:
P- = the estimated price after a downward shift in interest rates
P+ = the estimated price after a upward shift in interest rates
P = the current price
S = the assumed shift in the term structure
Limitations of Macaulay & Modified Duration
Effective duration greater than maturity
Negative effective duration
Empirical duration
Needed when it is not possible to generate well-
specified market price estimates in response to
yield changes
Empirical duration is computed as the actual
percent change for an asset in response to a
change in yield during a specified time period

Bond Convexity Exhibit 18.20

Modified duration is a linear approximation of
bond price change for small changes in market
yields

However, price changes are not linear, but a

curvilinear (convex) function of bond yields
Different bonds have different convex price-
yield curve (Exhibit 18.20)

Determinants of Convexity
Price-Yield Relationship for Bonds
The convexity is the measure of the curvature and
is the second derivative of price with resect to yield
(d2P/di2) divided by price
Convexity is the percentage change in dP/di for a
given change in yield
Modified Duration
For small changes this will give a good
estimate, but this is a linear estimate on the
tangent line
Bond Convexity
The graph of prices relative to yields is not a straight
line, but a curvilinear relationship
This can be applied to a single bond, a portfolio of
bonds, or any stream of future cash flows
The convex price-yield relationship will differ among
bonds or other cash flow streams depending on the
coupon and maturity
The convexity of the price-yield relationship declines
slower as the yield increases
Modified duration is the percentage change in price
for a nominal change in yield
 Bond Convexity Exhibit 18.21
The Desirability of Convexity
As yield increases, the rate at which the price of the
bond declines becomes slower
Similarly, when yields decline, the rate at which the
price of the bond increases becomes faster
For bonds with equal durations, bond with greater
convexity would have better price performance
The estimate using only modified duration will
underestimate the actual price increase caused by a
yield decline and overestimate the actual price
decline caused by an increase in yields
See Exhibit 18.21

Bond Convexity Exhibit 18.22

The Determinants of Convexity
The Formula

Important Relationships
Inverse relationship between coupon and convexity
Direct relationship between maturity and convexity
Inverse relationship between yield and convexity
Computation of Convexity
See Exhibit 18.22
 Correction for Convexity

Correction for Convexity: