Chap 016

CHAPTER 16
Managing Bond Portfolios
INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
16-2
Bond Pricing Relationships

1. Bond prices and yields are inversely
related.
inversely or directly

16-3

2. An decrease in a bond’s yield to maturity
results in a ……. price change than a
increase of equal magnitude.
Smaller or larger

14-4
Figure 14.3 The Inverse Relationship

Between Bond Prices and Yields

16-5

3. Short-term bonds tend to be …..price
sensitive than long-term bonds.
More or less

16-6
4. As maturity increases, price sensitivity

increases at a decreasing rate.
5. Interest rate risk is inversely related to
the bond’s coupon rate.
6. Price sensitivity is inversely related to
the yield to maturity at which the bond
is selling.

16-7
Figure 16.1 Change in Bond Price as a

Function of Change in Yield to Maturity

16-8
Question 3
You predict that interest rates are about to fall.
Which bond will give you the highest capital
gain?
a. Low coupon, long maturity.
b. High coupon, short maturity.
c. High coupon, long maturity.
d. Zero coupon, long maturity.

16-9
Question 4
Rank interest rate risks of the following pairs of
bonds:
a. Bond A is a 6% coupon bond, with a 20-year
time to maturity selling at par value. Bond B is a
6% coupon bond, with a 20-year time to maturity
selling below par value.
b. Bond A is a 20-year coupon bond with a
coupon rate of 6%, selling at par. Bond B is a 20-
year bond with a coupon rate of 7%, also selling
at par.

16-10
Question 4

16-11
Table 16.1 Prices of 8% Coupon Bond

(Coupons Paid Semiannually)

16-12
Table 16.2 Prices of Zero-Coupon Bond

(Semiannually Compounding)

16-13
Duration: Calculation
A measure of the effective maturity of a bond
D=
T
 t w
t =1
t 
w t = C F t (1 + y )
t
 P ric e
CFt: cash flow at time t
The weighted average of the times until each payment is
received, with the weights proportional to the present
value of the payment

16-14
Duration
• Duration is shorter than maturity for all
bonds except zero coupon bonds.
• Duration is equal to maturity for zero
coupon bonds.

16-15
Duration/Price Relationship
P   (1 + y ) 
= − Dx  
P  1 + y 
P
= − D * y
P
16-16
Example 16.1 Duration

• Two bonds have duration of 1.8852 years. One
is a 2-year, 8% coupon bond with YTM=10%.
The other bond is a zero coupon bond with
maturity of 1.8852 years. The 2-year coupon
bond make payments semiannually
• Duration of both bonds is 1.8852 x 2 = 3.7704
semiannual periods.
• Modified D = 3.7704/(1+0.05) = 3.591 periods

16-17

• Suppose the semiannual interest rate
increases by 0.01%. Bond prices fall by:
P = − D y
*
P
• =-3.591 x 0.01% = -0.03591%

• Bonds with equal D have the same
interest rate sensitivity.
16-18

Coupon Bond Zero
• The coupon bond, • The zero-coupon
which initially sells at bond initially sells for
$964.540, falls to $1,000/1.05 3.7704 =
$964.1942 when its $831.9704.
yield increases to • At the higher yield, it
5.01% sells for
• percentage decline of $1,000/1.05013.7704 =
0.0359%. $831.6717. This price
also falls by 0.0359%.
16-19
Rules for Duration

w t = C F t (1 + y )
t
 P ric e
T
D=  t w
t =1
t
Rule 1 The duration of a zero-coupon bond

equals its time to maturity

16-20
Rules for Duration

wt = CF t (1 + y )
t
 P r ic e
T
D =  t w
t =1
t
Rule 2 Holding maturity constant, a bond’s

duration is lower when the coupon rate is
higher
16-21
Rules for Duration

wt = CF t (1 + y )
t
 P r ic e
T
D =  t w
t =1
t
Rule 3 Holding the coupon rate constant,

a bond’s duration generally increases
with its time to maturity
16-22
Figure 16.2 Bond Duration versus

Bond Maturity

16-23
Rules for Duration

wt = CF t (1 + y )
t
 P r ic e
T
D =  t w
t =1
t
Rule 4 Holding other factors constant,

the duration of a coupon bond is higher
when the bond’s yield to maturity is
lower

16-24
Rules for Duration
Rules 5 The duration of a level perpetuity

is equal to: (1+y) / y

16-25
Table 16.3 Bond Durations (Yield to

Maturity = 8% APR; Semiannual Coupons)

16-26
Convexity
• The relationship between bond prices
and yields is not linear.
• Duration rule is a good approximation

for only small changes in bond yields.
• Bonds with greater convexity have

more curvature in the price-yield
relationship.
16-27
Figure 16.3 Bond Price Convexity: 30-Year

Maturity, 8% Coupon; Initial YTM = 8%
P
= − D * y
P

16-28
Convexity
1 n
 C Ft 
C onv ex ity =
P  (1 + y ) 2
  (1 + y ) t ( t + t ) 
t =1 
2
Correction for Convexity:
P
= − D   y + 1 [ C onvexity  (  y ) 2 ]
P 2

16-29
Figure 16.4 Convexity of Two Bonds
Which one
between
Bond A and
Bond B is
preferable?

16-30
Why do Investors Like Convexity?
• Bonds with greater curvature gain more in

price when yields fall than they lose when
yields rise.
• The more volatile interest rates, the more
attractive this asymmetry.
• Bonds with greater convexity tend to have
higher prices and/or lower yields, all else
equal.

16-31
Callable Bonds
At home from here on out

16-32
Figure 16.5 Price –Yield Curve for a

Callable Bond

16-33
Callable bonds
Callable bonds sell at ….. initial prices

(higher initial yields) than otherwise
comparable straight bonds
Higher or lower

16-34
Mortgage-Backed Securities
• The number of outstanding callable

corporate bonds has declined, but the
MBS market has grown rapidly.
• MBS are based on a portfolio of
callable amortizing loans.
– Homeowners have the right to repay
their loans at any time.
– MBS have negative convexity.
16-35
Mortgage-Backed Securities
• Often sell for more than their principal
balance.
• Homeowners do not refinance as soon as
rates drop, so implicit call price is not a
firm ceiling on MBS value.
• Tranches – the underlying mortgage pool
is divided into a set of derivative securities

16-36
Figure 16.6 Price-Yield Curve for a

Mortgage-Backed Security

16-37
Figure 16.7 Cash Flows to Whole Mortgage

Pool; Cash Flows to Three Tranches

16-38
Passive Management
• Two passive bond portfolio strategies:
1.Indexing
2.Immunization
• Both strategies see market prices as

being correct, but the strategies have
very different risks.

16-39
Bond Index Funds

• Bond indexes contain thousands of issues,
many of which are infrequently traded.
• Bond indexes turn over more than stock
indexes as the bonds mature.
• Therefore, bond index funds hold only a
representative sample of the bonds in the
actual index.

16-40
Figure 16.8 Stratification of

Bonds into Cells

16-41
Immunization
• Immunization is a way to control interest
rate risk.
• Widely used by pension funds, insurance

companies, and banks.

16-42
Immunization
• Immunize a portfolio by matching the
interest rate exposure of assets and
liabilities.
– This means: Match the duration of the assets
and liabilities.
– Price risk and reinvestment rate risk exactly
cancel out.
• Result: Value of assets will track the value
of liabilities whether rates rise or fall.
16-43
Table 16.4 Terminal value of a Bond

Portfolio After 5 Years

16-44
Table 16.5 Market Value Balance Sheet

16-45
Figure 16.9 Growth of Invested Funds

16-46
Figure 16.10 Immunization

16-47

16-48
Rules for Duration

wt = CF t (1 + y )
t
 P r ic e
T
D =  t w
t =1
t
Rule 3 Holding the coupon rate constant,

a bond’s duration generally increases
with its time to maturity
16-49

16-50

16-51
Cash Flow Matching and Dedication

• Cash flow matching = automatic
immunization.
• Cash flow matching is a dedication
strategy.
• Not widely used because of
constraints associated with bond
choices.

16-52
Active Management:
Swapping Strategies
• Substitution swap
• Intermarket swap
• Rate anticipation swap
• Pure yield pickup
• Tax swap

16-53
Horizon Analysis
• Select a particular holding period and
predict the yield curve at end of period.
• Given a bond’s time to maturity at the
end of the holding period,
– its yield can be read from the
predicted yield curve and the end-of-
period price can be calculated.

16-54
Question 1
A 9-year bond has a yield of 10% and a
duration of 7.194 years. If the market yield
changes by 50 basis points, what is the
percentage change in the bond’s price?

16-55
Question 1
A 9-year bond has a yield of 10% and a
duration of 7.194 years. If the market yield
changes by 50 basis points, what is the
percentage change in the bond’s price?
D 7.194
−  y = −  0.005 = −0.0327 = −3.27%, or a 3.27% decline
1+ y 1.10

16-56
Question 2
a. Find the duration of a 6% coupon bond
making annual coupon payments if it has three
years until maturity and has a yield to maturity
of 6%.
b. What is the duration if the yield to maturity is
10%?

16-57
Question 2
a. YTM = 6%
(1) (2) (3) (4) (5)
Time until PV of CF
Payment (Discount Column (1) 
(Years) Cash Flow Rate = 6%) Weight Column (4)
1 $ 60.00 $ 56.60 0.0566 0.0566
2 60.00 53.40 0.0534 0.1068
3 1,060.00 890.00 0.8900 2.6700
Column sums $1,000.00 1.0000 2.8334
Duration = 2.833 years

16-58
Question 2
b.
YTM = 10%
(1) (2) (3) (4) (5)
Time until PV of CF
Payment (Discount Column (1) 
(Years) Cash Flow Rate = 10%) Weight Column (4)
1 $ 60.00 $ 54.55 0.0606 0.0606
2 60.00 49.59 0.0551 0.1102
3 1,060.00 796.39 0.8844 2.6532
Column sums $900.53 1.0000 2.8240
Duration = 2.824 years, which is less than the duration at the YTM of 6%.

16-59
Question 3
You predict that interest rates are about to fall.
Which bond will give you the highest capital
gain?
a. Low coupon, long maturity.
b. High coupon, short maturity.
c. High coupon, long maturity.
d. Zero coupon, long maturity.

16-60
Question 4
Rank the durations of the following pairs of
bonds:
a. Bond A is a 6% coupon bond, with a 20-year
time to maturity selling at par value. Bond B is a
6% coupon bond, with a 20-year time to maturity
selling below par value.
b. Bond A is a 20-year coupon bond with a
coupon rate of 6%, selling at par. Bond B is a 20-
year bond with a coupon rate of 7%, also selling
at par.

16-61
Question 5
a. Calculate the convexity of a 5-year, 8%
coupon bond making annual payments at the
initial yield to maturity of 10%.
b. What is the convexity of a 5-year zero-coupon
bond? Assume YTM = 10%.

16-62
Question 5
a. Time Cash
(t) Flow PV(CF) t + t2 (t + t2) × PV(CF)
Coupon = $80 1 $ 80 $ 72.727 2 145.455
YTM = 0.10 2 80 66.116 6 396.694
Maturity = 5 3 80 60.105 12 721.262
Price = $924.184 4 80 54.641 20 1,092.822
5 1,080 670.595 30 20,117.851
Price: $924.184
Sum: 22,474.083
2
Convexity = Sum/[Price × (1+y) ] = 20.097

16-63
Question 5
b. Time Cash
(t) Flow PV(CF) t2 + t (t2 + t) × PV(CF)
Coupon = $0 1 $ 0 $ 0.000 2 0.000
YTM = 0.10 2 0 0.000 6 0.000
Maturity = 5 3 0 0.000 12 0.000
Price = $620.921 4 0 0.000 20 0.000
5 1,000 620.921 30 18,627.640
Price: $620.921
Sum: 18,627.640
2
Convexity = Sum/[Price × (1+y) ] = 24.793

16-64
Question 6
Currently, the term structure is as follows: 1-year
zero-coupon bonds yield 7%; 2-year zero-coupon
bonds yield 8%; 3-year and longer-maturity zero-
coupon bonds all yield 9%. You are choosing
between 1-, 2-, and 3-year maturity bonds all
paying annual coupons of 8%.
a. What is the price of each bond today?
b. What will be the price of each bond in one year
if the yield curve is flat at 9% at that time?
c. What will be the rate of return on each bond?
16-65
Question 6
Maturity 1 Year 2 Years 3 Years

YTM at beginning of year 7.00% 8.00% 9.00%
a. Beginning of year prices $1,009.35 $1,000. $974.69
b. Prices at year-end (at 9% YTM) $1,000.00 $990.83
00 $982.41
Capital gain –$9.35 –$9.17 $7.72
Coupon $80.00 $80.00 $80.00
1-year total $ return $70.65 $70.83 $87.72
c. 1-year total rate of return 7.00% 7.08% 9.00%

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Chap 016

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CHAPTER 16

Managing Bond Portfolios

INVESTMENTS | BODIE, KANE, MARCUS

Bond Pricing Relationships

INVESTMENTS | BODIE, KANE, MARCUS

Bond Pricing Relationships

INVESTMENTS | BODIE, KANE, MARCUS

Figure 14.3 The Inverse Relationship

INVESTMENTS | BODIE, KANE, MARCUS

Bond Pricing Relationships

INVESTMENTS | BODIE, KANE, MARCUS

Bond Pricing Relationships

4. As maturity increases, price sensitivity

INVESTMENTS | BODIE, KANE, MARCUS

Figure 16.1 Change in Bond Price as a

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Table 16.1 Prices of 8% Coupon Bond

INVESTMENTS | BODIE, KANE, MARCUS

Table 16.2 Prices of Zero-Coupon Bond

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Example 16.1 Duration

INVESTMENTS | BODIE, KANE, MARCUS

Example 16.1 Duration

• =-3.591 x 0.01% = -0.03591%

Example 16.1 Duration

Rules for Duration

Rule 1 The duration of a zero-coupon bond

INVESTMENTS | BODIE, KANE, MARCUS

Rules for Duration

Rule 2 Holding maturity constant, a bond’s

Rules for Duration

Rule 3 Holding the coupon rate constant,

Figure 16.2 Bond Duration versus

INVESTMENTS | BODIE, KANE, MARCUS

Rules for Duration

Rule 4 Holding other factors constant,

INVESTMENTS | BODIE, KANE, MARCUS

Rules for Duration

Rules 5 The duration of a level perpetuity

INVESTMENTS | BODIE, KANE, MARCUS

Table 16.3 Bond Durations (Yield to

INVESTMENTS | BODIE, KANE, MARCUS

• Duration rule is a good approximation

• Bonds with greater convexity have

Figure 16.3 Bond Price Convexity: 30-Year

INVESTMENTS | BODIE, KANE, MARCUS

Correction for Convexity:

INVESTMENTS | BODIE, KANE, MARCUS

Figure 16.4 Convexity of Two Bonds

INVESTMENTS | BODIE, KANE, MARCUS

Why do Investors Like Convexity?

• Bonds with greater curvature gain more in

INVESTMENTS | BODIE, KANE, MARCUS

INVESTMENTS | BODIE, KANE, MARCUS

Figure 16.5 Price –Yield Curve for a

INVESTMENTS | BODIE, KANE, MARCUS

Callable bonds sell at ….. initial prices

INVESTMENTS | BODIE, KANE, MARCUS