BOND EQUITY PORTFOLIO MANAGEMENT

STRATEGIES

By

Student Name : Siti Fazatulatiyah binti Fauzi

Course / Group : FIN552 / DBMF8A
Lecturer Name: Sir Wan Yusrol Rizal bin W. Yusof
Introduction Bond Portfolio

Portfolio focuses on investment on bond securities also gives advantage for project manager
to manage their analysis and strategies since portfolio has the same influencing factors, such
as market interest rate.

Two Approaches To Calculate Bond Portfolio’s Yield

Weighted average portfolio yield method (WAPY).

The method uses the weighted average of the yield for all the bonds based on market value.

BP = Σ k1 =1 w i y i

Where,

BP = Bond portfolio yield

w i = Market value of bond is relative to the total market value of the portfolio
y i = the yield on bond i

k = number of bond in the portfolio

Example of Weighted average portfolio yield method (WAPY)

Determine the portfolio yield for the bond portfolio:

COUPON YEARS TO PAR VALUE MARKET

BOND YTM
RATE % MATURITY (RM) VALUE (RM)
1 8 5 10 Mil 9.5 Mil 9%
2 11 8 20 Mil 20 Mil 11%
3 6 3 30 Mil 28.8 Mil 8%
Total 60 Mil 58.3 Mil

Step 1: Determine the weight for each bond in the portfolio.

Wi = Market value i / Total market value
Step 2: Determine the weighted yield for each bond.
Step 3: Determine the bond portfolio yield.

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 WEIGHTE Weighted of
MARKET D BOND YTM yield
BOND (Wi)
VALUE (RM) (Yi) (wi x yi )
(1) (1) X (2)
1 9.5 Mil 0.163 9% 1.47%
2 20 Mil 0.343 11% 3.77%
3 28.8 Mil 0.494 8% 3.95%
TOTAL 58.3 Mil 1.0000 9.19%

WAPY only relies on the market value of bond and bond yield to maturity. It does not consider the
investment horizon and the expected coupon received during the investment period.

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Internal Rate of Return Method (IRR)

Interest / discount rate that make the present value of the portfolio’s cash flows to be equal to the
portfolio’s initial investment at par value.

PV OF CASH FLOW = Σ C F n x PVI F irr , n

Assumptions:
Cash flows received are on the same date of payment and can be invested at the same rate of the
bond yield.
Portfolio to be held till the maturity date of the longest-maturity bond in the portfolio.

Example
Given the following portfolio which coupon is paid semi annually.

PAR
COUPON YEARS TO MARKET
BOND VALUE
RATE % MATURITY VALUE (RM)
(RM)
B1 6% 2 YEARS 12 Mil 10 Mil
B2 8% 2.5 YEARS 20 Mil 18 Mil
Total 32 Mil 28 Mil

Step 1: Determine the coupon payment for each bond

B1 6%/2 X RM12 m = 0.36 m
= RM360,000
B2 8%/2 x RM20 m = 0.80 m
= RM800,000

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Step 2: Determine total CFs at every period.
CASH B1 B2 PORTFOLIO CFs
FLOWS (RM 000') (RM 000') (RM 000')
1 360 800 1160
2 360 800 1160
3 360 800 1160
4 12,360 800 13160
5 - 20800 20800
TOTAL 13,440 24000

Step 3: PV of CF is equal to portfolio’s initial investment

PV of cash flow =  CFn x PVIF ⅈrr , n
28 m =  CFn x PVIF Irr , n

Step 4: Estimate the IRR of the equation. Use the Financial Calculator to determine IRR

CFO - 28,000.00
CO1 1,160.00 FO1=3
CO2 13,160.00 FO1=1
CO3 20,800.00 FO3=1
CO4 IRR CPT 6.9237%

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Interest Rate (i) & Bond Price (PB)

1. When i increases , PB in market will decrease : reducing the yield of older bonds.
2. When i decreases , PB in market will increase : raising the yield of older bonds.

3. Bond price and its yield (in terms of coupon or interest rate) is inversely related.

Risks of purchasing bonds

1. Interest rate risk

2. Default risk
3. Reinvestment rate of interest
4. Inflation risk
5. Maturity risk
6. Call risk

Bond Portfolio PerformanceStyle and Strategy

Bond Portfolio Performance

Fixed-income portfolios generally produce both less return and less volatility than found in other
asset classes such as domestic equity, foreign equity. Exhibit 19.1 shows this in the examination of
the investment performance of different long-term securities over the 21-year time horizon. The low
historical correlation between fixed income and equity has made bond portfolios an excellent tool for
diversifying risk.

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.

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Bond Portfolio Strategies had five broad groups:

1. Passive Portfolio Strategies

2. Active Management Strategies
3. Core-plus Management Strategy
4. Matched-funding Techniques
5. Contingent Procedure (Structured Active Management)

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1. 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 be 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.

2. Active Management Strategies

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 scalability,
sustainability, risk-adjusted performance and extreme values.

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Interest-rate anticipation is a risky strategies rely on uncertain predictions such as the surprise ladder
strategy of maturity and also the barbell strategy divides funds between short term and long-term
securities. Valuation analysis also the portfolio manager attempts to select bonds based on their
intrinsic value and credit analysis involves detailed analysis of the bond issuer to determine expected
changes in its default risk.

High-Yield Bond Research Several investment houses such as Merrill Lynch, First Boston, Lehman
Brothers, and other similar thing have developed specialized high-yield groups that examine high.
Yield bond issues and monitor high-yield bond spreads. Yield spread analysis Assumes normal
relationships exist between the yields for bonds in alternative sectors.

Bond swaps Involve liquidating a current position and simultaneously buying a different issue in its
place with similar attributes but having a chance for improved return. 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.

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.

3. Core-Plus Management 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.

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4. Matched-Funding Strategies

Dedicated Portfolios

Designing portfolios that will service liabilities and exact cash match conservative strategy, matching
portfolio cash flows to needs for cash also useful for sinking funds and maturing principal payments.

Dedication with reinvestment does not require an exact match of cash flows with liabilities flow is
also a great option, flexibility can help in generating higher return at a lower cost.

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.

Classical Immunization
Immunize the portfolio from interest rate risk with keeping the portfolio duration equal to investment
horizon. A time frame strategy is better than a strategy based only on a maturity since period
considering both sources interest rate risk as well as immunized portfolios require frequent
rebalancing due to modified periods the portfolio should always be equal to the balance time horizon.

Difficulties in Maintaining Immunization Strategy

Rebalancing is required as the duration decreases slowly from the maturity period and modified
duration changes with changes in market interest rates and yield curves shift.

Horizon matching

A combination of cash matching dedication and immunization. An important decision is the length of
the horizon period with various cash requirements within the specified time period, can match period
to period of time, while cash matching in each time period.

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5. Contingent and Structured Strategies

Contingency procedures for managing bond portfolios are a form of what already exists called
structured active management. Immunization contingent are the duration of the portfolio must be
maintained at the horizon value.

The cushion spread is the potential return below current market returns. The margin of safety is the
value of the above portfolio required value. The trigger point refers to the minimum return that will
stop active portfolio management.

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