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By; CPA Innocent Kimaro 1

 Portfolio Management, implies tactfully managing an investment

portfolio, by selecting the best investment mix in the right proportion
and continuously shifting them in the portfolio, to increase the return
on investment and maximize the wealth of the investor.
 Portfolio management involves deciding about the optimal portfolio,
matching investment with the objectives, allocation of assets and
balancing risk.

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 Portfolio manager (PM) is a professional responsible for making

investment decisions and carrying out investment activities on behalf
of vested individuals or institutions.
 Portfolio Perspective

 The portfolio perspective is the key fundamental principle of

portfolio management.
 According to this perspective, portfolio managers, analysts, and
investors need to analyze the risk-return trade-off of the whole
portfolio and not of the individual assets in the portfolio

 The individual investments carry an unsystematic risk, which is

diversified away by bundling the investments into one single
portfolio.
 The whole portfolio carries only the systematic risk caused by the
influence of economic fundamentals on the returns of a stock. GDP
growth, consumer confidence, unexpected inflation etc..

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 The portfolio managers, analysts, and investors should only be

concerned with the systematic risk of the whole portfolio. In fact, all
the equity pricing models are based on the fact that only systematic
risk is factored

 Active Portfolio Management: When the portfolio managers actively

participate in the trading of securities with a view to earning a
maximum return to the investor.
 Passive Portfolio Management: When the portfolio managers are
concerned with a fixed portfolio, which is created in alignment with
the present market trends.
 Discretionary Portfolio Management: The Portfolio Management in
which the investor places the fund with the manager, and authorizes
him to invest them as per his discretion, on the investor’s behalf.

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 Non-Discretionary Portfolio Management: Non-discretionary

portfolio management is one in which the portfolio managers gives
advice to the investor or client, who can accept or reject it.

 The outcome, i.e. profit received or loss sustained belongs to the

investor himself, whereas the service provider receives an adequate
consideration in the form of fee for rendering services.

 1) Selection of securities in which the amount is to be invested.

 2) Creation of appropriate portfolio, with the securities chosen for
investment.
 3) Making decision regarding the proportion of various securities in
the portfolio, to make it an ideal portfolio for the concerned investor.
 These activities aim at constructing an optimal portfolio of
investment, that is compatible with the risk involved in it.

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 1) Security Analysis: It is the first stage of portfolio creation process,

which involves assessing the risk and return factors of individual
securities, along with their correlation.
 2) Portfolio Analysis: After determining the securities for investment
and the risk involved, a number of portfolios can be created out of
them, which are called as feasible portfolios.
 3) Portfolio Selection: Out of all the feasible portfolios, the optimal
portfolio, that matches the risk appetite, is selected.

 4) Portfolio Revision: Once the optimal portfolio is selected, the

portfolio manager, keeps a close watch on the portfolio, to make sure
that it remains optimal in the coming time, in order to earn good
returns.
 5) Portfolio Evaluation: In this phase, the performance of the portfolio
is assessed over the stipulated period, concerning the quantitative
measurement of the return obtained and risk involved in the
portfolio, for the whole term of the investment.

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 * The portfolio management services are provided by the financial

companies, banks, hedge funds and money managers *

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 Traditionally, debt has been identified as a long-term source of fund

for a corporate enterprise.
 Bonds, usually, are expected to offer a fixed rate of interest and
bondholders have a claim on the issuer of the security for the
payment of the principal amount at the time of repayment of the debt.
 Though debt has been viewed over a period of time as long-term
debt, there are many instruments that have been designed to meet
the short-term requirements of the market participants.

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 In our previous sessions we discussed risk and return

relationships, and how to choose securities for the
maximization of return and reduction of risk.
 We turn now to specific analyses of particular security
markets. We examine valuation principles, determinants
of risk and return, and portfolio strategies commonly
used within and across the various markets.

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 We begin by analyzing debt securities.

 A debt security is a claim on a specified periodic stream of
income.
 Debt securities are often called fixed-income securities
because they promise either a fixed stream of income or a
stream of income that is determined according to a
specified formula.

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 Bonds are long-term debt securities that are issued by government

agencies or corporations. The issuer of a bond is obligated to pay
interest (or coupon) payments periodically (such as annually or
semiannually) and the par value (principal) at maturity.
 Bonds are often classified according to the type of issuer.
 Treasury bonds are issued by the URT Treasury, municipal bonds are
issued by state and local governments, and corporate bonds are
issued by corporations.

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 A bond is a security that is issued in connection with a borrowing

arrangement.
 The arrangement obligates the issuer to make specified payments to
the bondholder on specified dates.
 A typical coupon bond obligates the issuer to make semiannual
payments of interest to the bondholder for the life of the bond.
 When the bond matures, the issuer repays the debt by paying the
bondholder the bond’s par value (equivalently, its face value).

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 The coupon rate of the bond serves to determine the interest

payment.
 The annual payment is the coupon rate times the bond’s par value.
 The coupon rate, maturity date, and par value of the bond are part of
the bond indenture, which is the contract between the issuer and the
bondholder.

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 A wide range of participants are involved in the bond markets. We

can group them broadly into borrowers and investors, plus the
institutions and individuals who are part of the business of bond
trading

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 The price of bond will equal to the present value of the expected
cash flows from the financial instrument. Therefore, determining the
price requires:
 An estimate of the expected cash flows.
 An estimate of the appropriate required yield.

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 The interest rate that is used to discount a bond’s cash flows

(therefore called the discount rate) is the rate required by the
bondholder. It is therefore known as the bond’s yield.
 The yield on the bond will be determined by the market, and is the
price demanded by investors for buying it, which is why it is
sometimes called the bond’s return.
 The required yield for any bond will depend on a number of political
and economic factors, including what yield is being earned by other
bonds of the same class.

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 The first step in determining the price of a bond is to estimate its

cash flows.
 The cash flows for a bond that the issuer cannot retire prior to its
stated maturity date (that is, an option-free bond) consists of:
 Periodic coupon interest payments to the maturity date.
 The par value at maturity.
 The maturity value is the lump-sum payment that represents the
repayment of the loaned amount, which we also refer to as the par
value or the face value of the bond.

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 To value a security, we discount its expected cash flows by the

appropriate discount rate.
 The cash flows from a bond consist of coupon payments until the
maturity date plus the final payment of par value. Therefore,
 Bond value = Present value of coupons + Present value of par value
 If we call the maturity date T and call the interest rate r, the bond
value can be written as

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 Yield is always quoted as an annualized interest rate, so that for a

semi-annually coupon paying bond exactly half of the annual rate is
used to discount the cash flows.
 The fair price of a bond is the present value of all its cash flows.
Therefore when pricing a bond we need to calculate the present
value of all the coupon interest payments and the present value of the
redemption payment, and sum these.

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 Illustration 1, Consider a 20-year bond with a 10% coupon rate and a

par, or maturity, value of TZS 1,000,000 has the following cash flows
from coupon interest:
 Annual coupon interest = TZS1,000,000 × 0.10 = 100,000
 Semiannual coupon interest = TZS 100 ÷ 2 = 50,000
 Therefore, there are 40 semiannual cash flows of Tzs 50,000 and there
is a Tzs 1,000,000 cash flow 40 six-month periods from now.

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 The price of a conventional bond that pays annual coupons can

therefore be given by

𝑝 = + + +⋯ +
𝑵
𝑪 𝑴
+
 P= (𝟏 + 𝒓)𝒏 (𝟏 + 𝒓)𝑵
𝒏=𝟏

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 Or the price of bond can be calculated as follows

𝟏 𝟏 𝟏
 Price = 𝐂𝐨𝐮𝐩𝐨𝐧 𝐱 𝟏− + 𝑷𝒂𝒓 𝑽𝒂𝒍𝒖𝒆 𝒙
𝒓 𝟏 𝒓 𝑵 𝟏 𝒓 𝑵

 Let’s suppose calculation to compute the price for this bond are as
follows: That the required yield on this bond is 11%. The inputs for a
financial

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𝟏 𝟏 𝟏
 Price = 𝟓𝟎, 𝟎𝟎𝟎 𝐱 𝟏− + 𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎𝟎 𝒙
𝟎.𝟎𝟓𝟓 𝟏 𝟎.𝟎𝟓𝟓 𝟒𝟎 𝟏 𝟎.𝟎𝟓𝟓 𝟒𝟎
 Price = 802,310

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 where
 P is the price
 C is the annual coupon payment (for semi-annual coupons, will be
C/2)
 r is the discount rate (therefore, the required yield)
 N is the number of years to maturity (therefore, the number of interest
periods in an annually-paying bond; for a semi-annual bond the
number of interest periods is N x 2).
 M is the maturity payment or par value (usually 100% of currency)

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 With zero-coupon bonds, issuers do not make any periodic coupon

payments. Instead, the investor realizes interest as the difference
between the maturity value and the purchase price. The price of a
zero-coupon bond is calculated by substituting zero for C in equation
1.
𝑃=
( )

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 A fundamental property of a bond is that its price changes in the

opposite direction from the change in the required yield.
 At a higher interest rate, the present value of the payments to be
received by the bondholder is lower.
 Therefore, the bond price will fall as market interest rates rise. This
illustrates a crucial general rule in bond valuation.
 When interest rates rise, bond prices must fall because the present
value of the bond’s payments are obtained by discounting at a higher
interest rate.

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 The inverse relationship between price and yield is a central feature

of fixed-income securities.
 Interest rate fluctuations represent the main source of risk in the
fixed-income market, and we devote considerable attention in
assessing the sensitivity of bond prices to market yields.
 A general rule in evaluating bond price risk is that, keeping all other
factors the same, the longer the maturity of the bond, the greater the
sensitivity of price to fluctuations in the interest rate.

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 We have noted that the current yield of a bond measures only the
cash income provided by the bond as a percentage of bond price
and ignores any prospective capital gains or losses.
 We would like a measure of rate of return that accounts for both
current income and the price increase or decrease over the bond’s
life.
 The yield to maturity is the standard measure of the total rate of
return of the bond over its life.

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 In practice, an investor considering the purchase of a bond is not

quoted a promised rate of return.
 Instead, the investor must use the bond price, maturity date, and
coupon payments to infer the return offered by the bond over its life.
 The yield to maturity (YTM) is defined as the interest rate that
makes the present value of a bond’s payments equal to its price.
 This interest rate is often viewed as a measure of the average rate of
return that will be earned on a bond if it is bought now and held until
maturity.

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 To calculate the yield to maturity, we solve the bond price equation

for the interest rate given the bond’s price. We solve for r using:
 𝑵
𝑪 𝑴
P= +
(𝟏 + 𝒓)𝒏 (𝟏 + 𝒓)𝑵
𝒏=𝟏

𝟏 𝟏 𝟏
P=𝐂𝐱 𝟏− +𝑴𝒙
𝒓 𝟏 𝒓 𝑵 𝟏 𝒓 𝑵

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 The computation of YTM requires a trial and error procedure. To

illustrate this, consider a TZs. 1,000,000 par value bond, carrying a
coupon rate of 9%, and maturing after 8 years. The bond is currently
selling for Tzs. 800,000. What is the YTM on this bond? The YTM is the
value of r in the following equation:

8
90,000 1,000,000
800,000 = +
(1 + 𝑟 ) 𝑡 (1 + 𝑟 ) 8
𝑡=1

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 800,000 = 90,000 (PVIFAr,8yrs) + 1,000,000 (PVIFr,8yrs)

 To answer this question, we find the interest rate at which
the present value of the remaining bond payments equals
the bond price. This is the rate that is consistent with the
observed price of the bond.
 These equations have only one unknown variable, the
interest rate, r.
 There is not direct solution for r, so we need to resort to an
iterative procedure.
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 Let us begin with a discount rate of 14%. Putting a value of 14 %

for r we find that the right-hand side of the above expression is:
 90,000 (PVIFA14%,8yrs) + 1,000,000 (PVIF14%,8yrs)
 = 90,000 (4.639) + 1,000,000 (0.351) = 768,100
 Since this value is less than 800, 000 we try a lower value for r.
Let us try r = 13%. This makes the right-hand side equal to:
 90,000 (PVIFA13%,8yrs) + 1,000,000 (PVIF13%,8yrs)
 = 90,000 (4.800) + 1,000,000 (0.376) = 808,000

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 Thus r lies between 13 percent and 14 percent. Using a

linear interpolation1 in the range 13% to 14 %.

, ,
 13% + 14% − 13% = 13.2%
, ,

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 The issuer may be entitled to call a bond prior to the stated maturity
date. When the bond may be called and at what price is specified in
the indenture. The price at which the issuer may call the bond is
referred to as is the call price.
 For some issues, the call price is the same regardless of when the
issue is called. For other callable issues, the call price depends on
when the issue is called. That is, there is a call schedule that specifies
a call price for each call date.

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 The procedure for calculating the yield to any assumed call date is
the same as for any yield calculation: Determine the interest rate that
will make the present value of the expected cash flows equal to the
price plus accrued interest.
 Mathematically, we can express the yield to call as:

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 Where M* is the call price and n* is the number of periods to the call
date. If the coupon is paid semiannually, we first calculate r and then
multiply this rate by 2 to arrive at the yield to call, YTC
 Investors typically compute both the yield to call and the yield to
maturity for a callable bond selling at a premium. They then select
the lower of the two as the yield measure. The lowest yield based on
every possible call date and the yield to maturity is referred to as the
yield to worst.

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 An investor who purchases a bond can expect to receive a

dollar return from one or more of these sources:
 1. The periodic coupon interest payments made by the
issuer.
 2. Income from reinvestment of the periodic interest
payments (the interest on-interest component).
 3. Any capital gain (or capital loss—negative dollar return)
when the bond matures, is called, or is sold.

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 Like any other investment, bonds should be viewed in terms of their

risk and return.
 Interest Rate Risk: Interest rates tend to vary over time, causing
fluctuations in bond prices.
 A rise in interest rates will depress the market prices of outstanding
bonds whereas a fall in interest rates will push the market prices up.
Interest rate risk, also referred to as market risk, is measured by the
percentage change in the value of a bond in response to a given
interest rate change.

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 Inflation Risk: Interest rates are defined in nominal terms. This

means that they express the rate of exchange between current and
future Shilling.
 According to the Fisher effect, the following relationship holds
between the nominal rate r, the real rate a, and the expected inflation
rate, .
 (1 + r) = (1 + a) (1 + inf)

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 Real Interest Rate Risk; Even if there is no inflation risk, borrowers

and lenders are still exposed to the risk of change in the real interest
rate. Shifts in supply and/or demand for funds will change the real
rate of interest.
 Default Risk: Default risk is the risk that a borrower may not pay
interest and/or principal on time. Other things being equal, bonds
which carry a higher default risk (lower credit rating) trade at a
higher yield to maturity. Put differently, they sell at a lower price
compared to government securities which are considered free from
default risk

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 Liquidity Risk: Except for some of the popular Government of

Tanzania securities which are traded actively, most debt instruments
do not seem to have a very liquid market. The market for debt is
mainly an over-the-counter market and much of the activity seems to
occur in the primary (new issues) market.
 Foreign Exchange: Risk If a bond has payments that are
denominated in a foreign currency its Shilling cash flows are
uncertain. The risk that the foreign currency will depreciate in
relation to the Indian rupee is referred to as the foreign exchange
risk (or currency risk).

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 Junk bonds, also known as high-yield bonds, are bonds that are rated
below investment grade by the bond rating agencies.
 Junk bonds carry a higher risk of default than other bonds, but they
pay higher returns to make them attractive to investors.
 The main issuers of such bonds are capital-intensive companies with
high debt ratios, or young companies that have yet to establish a
strong credit rating.

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 When you buy a bond, you are lending to the issuer in exchange for
periodic interest payments.
 Once the bond matures, the issuer is required to repay the principal
amount in full to investors.
 But if the issuer has a high risk of default, the interest payments may
not be disbursed as scheduled. Thus, such bonds offer higher yields
to compensate investors for the additional risk.

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