Chapter

Managing Bond
11 Portfolios

Makoto Suzuki
Rikkyo Univ.
 11.1 Interest Rate Risk
• Interest Rate Sensitivity
1. Bond prices and yields are inversely related

2. Increase in bond’s yield to maturity results in smaller

price change than yield decrease of equal magnitude
3. Long-term bond prices more sensitive to interest rate
changes than short-term bonds
4. As maturity increases, sensitivity of bond prices to
changes in yields increases at decreasing rate

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 11.1 Interest Rate Risk
• Interest Rate Sensitivity
5. As maturity increases, sensitivity of bond prices to
changes in yields increases at decreasing rate
6. Interest rate risk is inversely related to bond’s coupon
rate; low-coupon bonds are more sensitive to interest
rates
7. Sensitivity of bond’s price-to-yield change is inversely
related to current yield to maturity

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 Figure 11.1 Change in Bond Prices as a Function of Change in
Yield to Maturity

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 11.1 Interest Rate Risk: Coupons Rate and Sensitivity
Prices of 8% annual coupon bonds

Prices of zero-coupon bonds

P −P
*==YTM 9%
= YTM 8%

PYTM =8%
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 11.1 Interest Rate Risk
• Macaulay’s Duration
• Measures effective bond maturity
• Weighted average of the times until each
payment, with weights proportional to the present
value of payment
𝐶𝐶𝐶𝐶𝑡𝑡 /(1+𝑦𝑦)𝑡𝑡
• 𝑤𝑤𝑡𝑡 =
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

• 𝐷𝐷 = ∑𝑇𝑇
𝑡𝑡=1 𝑡𝑡 × 𝑤𝑤𝑡𝑡

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 Spreadsheet 11.1 Calculation of Duration of Two Bonds

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 Concept of the Macaulay’s Duration

Dmac T=1 T=2 T=3

950.263 80 80 1080
Sum of the PV

72.727 66.116 811.420

Present Value
950.263 × Dmac = 1× 72.727 + 2 × 66.116 + 3 × 811.420
72.727 66.116 811.420
Dmac = 1× + 2× + 3×
950.263 950.263 950.263
= 1× 0.0765 + 2 × 0.0696 + 3 × 0.8539
= 2.774
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 11.1 Interest Rate Risk
• Change in Bond Price to Yield to Maturity
Δ𝑃𝑃 Δ 1+𝑦𝑦
• = 𝐷𝐷 ×
𝑃𝑃 1+𝑦𝑦

• Modified Duration
∗ 𝐷𝐷
• 𝐷𝐷 =
1+𝑦𝑦
Δ𝑃𝑃
• = −𝐷𝐷 ∗ Δ𝑦𝑦
𝑃𝑃

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 11.1 Interest Rate Risk
• What Determines Duration?
• Zero-coupon bond’s duration is time to maturity
• Time/yield to maturity constant, bond’s duration
and interest-rate sensitivity higher when coupon
price lower
• Coupon rate constant, bond’s duration and
interest-rate sensitivity generally increase with
time to maturity; duration always increases with
maturity for bonds at or above par

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 11.1 Interest Rate Risk

• What Determines Duration?

• Other factors constant, duration and interest rate
sensitivity of coupon bond higher when bond’s
yield to maturity lower
1+𝑦𝑦
• Duration of a perpetuity =
𝑦𝑦

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 Figure 11.2 Duration as Function of Maturity

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 Table 11.3 Annual Coupon Bond Duration

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 11.2 Passive Bond Management

• Immunization
• Strategy to shield net worth from interest rate
movements
• Rebalancing
• Realigning proportions of assets in portfolio as
needed

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Table 11.4 Terminal Value of Bond Portfolio after Five Years

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 Figure 11.3 Growth of Invested Funds

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 Figure 11.4 Immunization

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 11.2 Passive Bond Management

• Cash Flow Matching and Deduction

• Cash flow matching
• Matching cash flows from fixed-income
portfolio with those of obligation
• Deduction strategy
• Multi-period cash flow matching

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 11.3 Convexity
• Convexity
• Curvature of price-yield relationship of bond
Δ𝑃𝑃
• = −𝐷𝐷 ∗ Δ𝑦𝑦 + 1⁄2 × 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 × (Δ𝑦𝑦)2
𝑃𝑃

• Why Do Investors Like Convexity?

• More convexity = greater price increases,
smaller price decreases when interest rates
fluctuate by larger amounts

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 Figure 11.5 Bond Price Convexity

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 11.4 Active Bond Management: Strategies
Sources of Potential Profit Strategy
Exchange of one bond for bond with similar
Substitution swap attributes and better price

Switching from one segment of bond

Intermarket swap
market to another
Switch made in response to forecasts of
Rate anticipation swap
interest rate changes
Moving to higher yield bonds, usually with
Pure yield pickup swap
longer maturities
Swapping two similar bonds to receive tax
Tax swap
benefit
Forecast of bond returns based largely on
Horizon analysis prediction of yield curve at end of
investment horizon

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 11.4 Active Bond Management

• Fixed-Income Investment Strategy

• Key features
• Firms respect market prices
• To have value, information cannot already be
reflected in prices
• Interest rate movements extremely hard to predict

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