Lecture Note Eight:

Bond Portfolio Management

FINA3323 Fixed Income Securities

HKU Business School
University of Hong Kong

Dr. Huiyan Qiu

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 Outline
Fixed income portfolio management: asset allocation
decision, passive strategies, active strategies
Fixed income portfolio management: hedging
Cash matching
Duration hedging
Minimum-variance approach

Reference: Fabozzi’s chapter 22, Tuckman’s chapter 4, 5

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 The Asset Allocation Decision
The first decision that an investor must make is the asset
allocation decision: how much to invest in the major
asset classes?
• According to a study in 2010, US public pension funds
have allocations of about 2/3 in equities (which includes
real estate and private equity) and about 1/3 in fixed
income.
Who should manage the fund allocated to each asset
class?
• Internal or external? Asset management firm?

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 The Asset Allocation Decision
The asset allocation decision must be made in light of
the investor’s investment objective.
• Pension funds: to generate sufficient cash flow from
investments to satisfy pension obligations.
• Life insurance companies: to satisfy obligations
stipulated in insurance policies and generate a profit.
• Banks: to earn a return on invested funds that exceeds the
cost of acquiring those funds.
Decision is usually made by a portfolio management
team.
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 Portfolio Management Team
The composition and risk exposure of a portfolio is the
result of recommendations and research provided by the
portfolio management team.
• At the top of the organization chart of the investment
group is the chief investment officer (CIO) who is
responsible for all of the portfolios.
• A chief compliance officer (CCO) monitors portfolios to
make sure that the holdings comply with the fund’s
investment guidelines and that there are no activities
conducted by the managers of the fund that are in violation
of federal and state securities laws or investment policies.
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 Portfolio Management Team
An asset management firm employs analysts and
traders who can support all of the portfolios managed
by the firm or just designated portfolios.
• The analysts are responsible for the different sectors and
industries.
• The traders are responsible for executing trades approved
by a portfolio manager.
A large firm may also employ an economist or an
economic staff that would support all portfolios
managed by the firm.
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 Portfolio Management Team
At the individual portfolio level there is either a lead or
senior portfolio manager or co-managers.

It is the lead manager or co-managers who will make the

decision regarding the portfolio’s interest rate exposure
and the allocation of the fund’s assets among the
countries, sectors and industries.

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Fixed Income Portfolio Management
Asset allocation can be an active process to varying
degrees or strictly passive in nature.

Portfolio managers pursuing a passive strategy act as if

the market is efficient.
• If the market is totally efficient, no active strategy should
be able to beat the market on a risk-adjusted basis.

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 Passive Strategies
Passive strategies do not seek to outperform the market
but simply do as well as the market, i.e., the objective of
passive strategies is to match the performance of the
benchmark.
Passive strategies: (1) Investing directly in bond index
funds
• Only 3% of all bond fund assets are in bond index funds –
these assets are held disproportionately by institutional
investors, who keep about 25% of their fund assets in
bond index funds.

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 Passive Strategies
Passive strategies: (2) Straightforward replication
• Duplicating the target index precisely. Holding all its
securities in their exact proportions.
• Once replication is achieved, trading is necessary only
when the make-up of the index changes.
This approach is not practical:
• There can be a large number of securities involved.
• Many securities are thinly traded.
• Index composition changes frequently.

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 Passive Strategies
Passive strategies: (3) stratified sampling
• Replicating an index using a few securities
• First, divide the index into cells, each cell representing a
different characteristic
• Then buy one or several bonds to match those
characteristics and represent the entire cell
Examples of identifying characteristics are
• Duration (< 5 years, > 5 years)
• Market sectors (Treasury, corporate, mortgage-backed)
• Credit rating (AAA, AA, A, and BBB)
• Number of cells in this example:

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Active Fixed Income Portfolio Management

Active investment strategies are taken by investors who

believe to possess some advantage relative to other
market participants:
• Superior information
• Superior analytical or judgment skills
• Ability or willingness to do what other investors are
unable to do
Two types of active strategies
• Market timing (interest rates predictions)
• Bond picking (market inefficiencies)
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 Market Timing
Portfolio managers are making bets on changes in the
Treasury yield curve /changes in interest rates
• Bets based on no changes in the yield curve (riding the
yield curve)
• Bets on changes in interest rate level (naïve or roll-over
strategies)
• Bets based on level, slope and curvature moves of the
yield curve (butterflies and others)

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Market Timing: Riding the Yield Curve
Riding the yield curve is a technique that fixed-income
portfolio managers traditionally use in order to enhance
returns
• When the yield curve is upward sloping
• And is supposed to remain unchanged

Riding the yield curve:

• Purchasing fixed-income securities with maturities longer
than the desired holding periods
• Selling them to profit from falling bond yields as
maturities decrease with the passing of time
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 Riding the Yield Curve: Example
Consider at date 0 the following spot rate curve / zero-
coupon yield curve and five bonds with the same $100
face value and 6% annual coupon rate
Maturity (years) Spot Rate Bond Prices at t = 0
1 3.90% $102.0212
2 4.50% $102.8422
3 4.90% $103.0981
4 5.25% $102.8479
5 5.60% $102.0775

assuming that the spot rate curve will remain unchanged.

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 Riding the Yield Curve: Example
A portfolio manager who has money to invest with a 1
year horizon considers the following investment
strategies
• Strategy 1: Invest in 1-year maturity bond
• Strategy 2: ride the yield curve
• 2.1: buy the 2-year bond and sell it back in 1 year
• 2.2: buy the 3-year bond and sell it back in 1 year
• 2.3: buy the 4-year bond and sell it back in 1 year
• 2.4: buy the 5-year bond and sell it back in 1 year

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 Riding the Yield Curve: Example
Yield of the strategies
Original
Maturity Zero-Coupon Bond Prices Bond Prices Rate of
Strategy (years) Rate at t = 0 at t = 1 Return
1 1 3.90% $102.021 $100 3.9000%
2.1 2 4.50% $102.842 $102.021 5.0359%
2.2 3 4.90% $103.098 $102.842 5.5715%
2.3 4 5.25% $102.848 $103.098 6.0771%
2.4 5 5.60% $102.077 $102.848 6.6326%

Riding the curve are better than holding bonds with the
maturity equal to your investment horizon.

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 Market Timing: Bets on Rates Level
Strategies based on changes in the level of interest rates
assume that
• Only one factor drives the yield curve
• And yield curve has parallel shift
Bet on interest rate decrease: buy bonds with longest
possible duration
Bet on interest rate increase: shorten the duration of
your portfolio by selling bonds
• Alternatively, you hold short-term instruments until
maturity and roll over at higher rates (roll-over strategy)
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Expect Decrease in Rates: Naive Strategy
Consider the following five bonds. If a portfolio
manager thinks that the YTM curve will decrease to
4.5%, which bond would he pick?
Maturity Coupon
Bond (Years) Rate YTM Price
1 2 5% 5% $100.00
2 10 5% 5% $100.00
3 30 5% 5% $100.00
4 30 7.5% 5% $138.43
5 30 10% 5% $176.86

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Expect Increase in Rates: Roll-Over Strategy

Consider a flat 5% yield to maturity curve

• Investment horizon: 5 years
• Expects an interest rate increase by 1% in one year
Option 1: Buy a 5-year par coupon bond and hold it
until maturity
Option 2: Buy a 1-year par coupon bond, hold it until
maturity, and buy in one year a 4-year par coupon bond
Suppose interest rates stay at 6% from then on

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 Roll-Over Example: Results
Cash flows for the two investment options:
Dates T=0 T=1 T=2 T=3 T=4 T=5
Option 1 – $100 $5 $5 $5 $5 $105
Option 2 – $100 $5 $6 $6 $6 $106

Annual rate of return for option 1

Annual rate of return for option 2

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Market Timing: Bets on Moves of Yield Curve

Yield curve is potentially affected by many other

movements than parallel shifts
• Pure slope and curvature movements
• Combinations of level, slope and curvature movements
It is in general fairly complex to know under what exact
market conditions a given strategy might generate a
positive or a negative pay-off when all these possible
movements are accounted for.

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 Bets on Moves of Yield Curve
Bullets: A bullet portfolio is constructed so that the
maturity of the securities in the portfolio are highly
concentrated at one point on the yield curve.
• Although all of the bonds held in a bullet strategy
portfolio mature at the same time, they are all purchased
at different times. Can minimize the impact of interest-
rate fluctuations.
• Example: a portfolio with 100% invested in bonds
maturing in 5 years

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 Bets on Moves of Yield Curve
Barbells: A barbell portfolio is constructed by
concentrating investments at the short-term and the
long-term ends of the yield curve instead of
intermediate-term.
• Investor is able to reinvest shorter-term portion when
bonds mature. Can put more weight to short or long
portions of barbell
• Example: a portfolio invested 40% in a 2-year Treasury
Note and 60% in a 30-year Treasury Bond

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 Bets on Moves of Yield Curve
Ladders: A ladder portfolio is constructed by investing
equal amounts in bonds with different maturity

Example: In 2017, an
investor’s ladder might
consist of 9 bonds of
$100K face value
spanning from two to ten
years, as in the graph to
the right.

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 Bets on Moves of Yield Curve
Barbells, bullets and ladders are building blocks used in
the construction of complex strategies
A butterfly is one of the most common fixed-income
active strategies used by practitioners
• It is the combination of a barbell (called the wings of the
butterfly) and a bullet (called the body of the butterfly)
There exist many different kinds of butterflies which are
structured so as to generate a positive payoff in case a
particular move of the yield curve occurs.

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Bets on Moves of Yield Curve: Butterflies
The purpose of the strategy is to adjust the weights of
these components so that the transaction is cash-neutral
and duration-neutral.
When only parallel shifts affect the yield curve, the
strategy is structured so as to have a positive convexity.
The investor is then certain to enjoy a positive payoff if
the yield curve is affected by a positive or a negative
parallel shift.

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 Butterflies: Example
Following table provides information on three on-the-
run par-yield Treasuries.
Issue Yield Duration Convexity
2-year 7.71% 1.78 0.041
5-year 8.35 3.96 0.195
10-year 8.84 6.54 0.568

We structure a butterfly by investing

• amount x in 2-year bond
• amount y in 5-year bond
• amount z in 10-year bond.
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 Butterflies: Example
Cash-neutral

Duration-neutral

Convexity positive

One solution is

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 Butterflies: Example
The butterfly can be created by selling $1M of the 5-
year bond (bullet portfolio) and buying $0.542M of the
2-year bond and $0.458M of the 10-year bond (barbell
portfolio).
• Net investment zero
• Duration zero
• Convexity = 0.0874 > 0
The butterfly strategy always generates a gain as long as
the yield curve shift is parallel.

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 Butterflies: Example
Seems too good to be true!
We know, however, that the yield curve is affected by
many other movements than parallel shifts.
• For example, if the yield curve steepens, the barbell
portfolio can substantially underperform the bullet
portfolio.
It is generally fairly complex to know under what
market conditions a given butterfly generates a positive
or a negative payoff.

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 Trading Market Inefficiencies
Bond relative value (bond picking) is a technique
which is used to detect underpriced and overpriced
bonds.

Two types of investment opportunities exist

• Pure arbitrage opportunities
• Speculative arbitrage opportunities

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 Pure Arbitrage Opportunities
Compare the price of two products with the same cash
flows
• Typically a bond and the sum of strips that reconstitute
exactly the bond
If a difference in prices exist, there is risk-free arbitrage
opportunity
• Such arbitrage opportunities appear to be rare
• When price differences occur, they are usually small and
too short-lived to be exploited

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 Speculative Arbitrage
Because pure arbitrage opportunities are extremely hard
to find, more speculative trades are often performed –
Rich and Cheap Analysis.
Bond rich and cheap analysis is a common market
practice.
• The idea is to obtain a relative value for bonds which is
based on a comparison to a homogeneous reference

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 Rich and Cheap Analysis
Rich-Cheap Analysis is a multi-step process

Step 1: Construct an adequate current zero-coupon yield

curve using data for assets with homogeneous
characteristics in terms of liquidity and risk
Step 2: Compute a theoretical price for each asset as the
sum of the discounted cash flows
Step 3: Compute the market YTM and compare it to the
theoretical YTM

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 Rich and Cheap Analysis
Step 4: The spread (market yield – theoretical yield)
allows for the identification of an expensive (spread < 0)
or a cheap asset (spread > 0)
Step 5: Use statistical analysis of historical spreads for
each asset in an attempt to distinguish actual
inefficiencies from abnormal yields related to specific
features of a given asset (liquidity effect, benchmark
effect, coupon effect, etc.)

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 Rich and Cheap Analysis
Step 6: Combine short and long positions to create a
portfolio that is quasi-insensitive to interest rate changes
Step 7: Revise short and long positions according to a
criterion which is defined a priori:
• At the first time when the position generates a profit net
of costs
• When the spread has come back to a more “normal” level

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Bond Portfolio Management: Hedging
An investor has money to invest today and must achieve
a specific investment goal at a future date
• Severe penalties incurred if the goal is not attained
• Excess beyond the desired goal brings no reward
Pension funds and life insurance companies face this
type of problem
Immunization is an investment strategy used to
eliminate (hedge) interest-rate risk on a bond portfolio

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 Hedging Interest Rate Risk
There are three approaches to hedge interest rate risk:
• Cash matching: construct the exact synthetic replication
of the underlying position.
• Duration hedging: use bond portfolio with an
appropriate duration.
• Minimum-variance approach: estimate the hedge ratio
numerically to minimize the variance of the hedged
returns.

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 Hedging: Cash Matching
Interest rate risk can be managed perfectly by
constructing the exact synthetic equivalent of the
underlying position.
• The closest available zero-coupon bonds are used to
construct the synthetic portfolio.
• The hedged position is independent of shifts in the yield
curve.
Cash matching is conceptually straightforward but
costly to implement. It may not always be feasible due
to liquidity / availability constraints.
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 Hedging: Duration Hedging
We can reduce the problem of hedging interest rate risk
to one dimension: duration.
Recall that duration measures how sensitive bond price
is with respect to the change in interest rate.

Moreover, percentage change in bond price can be

approximated by duration and convexity

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 Hedging: Duration Hedging
Example: A pension fund manager has the following
liabilities: $100m due in 4 years and $200m due in 8
years. The yield curve is flat at 5% (annual
compounding).
Question (1): what is the present value and modified
duration of liabilities?
Answer:

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 Example (cont’d)
Question (2): Assume the pension fund is “fully
funded”, that is, the manager has cash on hand equal to
the PV found in (1). If she wishes to only invest in a
single maturity zero-coupon bond, what maturity should
she choose so that her portfolio is immunized (duration
zero)?

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 Example (cont’d)
Question (3): If ‘overnight’ the yield curve shifts to 4%,
what is the actual change in the PV of investment and
liabilities? What would the duration approximation
predict for the change in value for the PV of investment
and liabilities?

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 Hedging: Duration Hedging
Duration hedging is very simple. It has several
limitations:
• The approximation works well only for small changes in
interest rate. Hedged portfolio should be re-adjusted
reasonably often.
• It implicitly assumes that movements in the entire term
structure can be described by one interest rate factor.
• It also assumes parallel shifts of all interest rates.

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 Multi-Factor Hedging
One solution to consider non-parallel shifts and changes
in the shape of the yield curve is to measure and hedge
the risks of a portfolio in terms of several hedging
securities, where each hedging security is most sensitive
to a different part of the term structure.
Multi-factor hedging approach strikes a sensible
balance between hedging effectiveness and cost or
practicality.
• Key rate method

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 Key-Rate Exposure
Key-rate exposure are used for measuring and hedging
the risk of bond portfolios in terms of a relatively small
number of the most liquid bonds available, usually the
most recently issued, near-par, government bonds.
• The idea was proposed in Thomas Ho, “Key Rate
Duration: A Measure of Interest Rate Risk”, Journal of
Fixed Income, September, 1992.
The following table shows a key-rate exposure report for
the U.S. Lehman Aggregate Bond Index (now run by
Barclays Capital).

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 Key-Rate Exposure Report
Key Rate Duration of the U.S. Lehman Aggregate Bond
Index as of December 31, 2004
Key Rate Duration
6-Month 0.145
2-Year 0.655
5-Year 1.151
10-Year 1.239
Source: The Lehman
20-Year 0.800 Brothers Global Risk
30-Year 0.349 Model: A Portfolio
Total 4.339 Manager’s Guide, April
2005
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 Key-Rate Exposure Report
4.339 is the duration of the portfolio and it quantifies
interest rate risk. The table also tells the distribution of
this risk across the curve. For example, more than half of
the portfolio’s duration risk is closely related to – and
could be hedged with – 5- and 10-year bonds.
Consider a portfolio with the same duration as the index
but is concentrated in 30-year bond.
• Same performance if parallel shift in yield curve
• Underperform if yield curve steepens
• Outperform if yield curve flattens
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 Key-Rate Approach
The crucial assumption of the key-rate approach is
that all rates can be determined as a function of a
relatively small number of key rates.
Decisions to be made for implementation:
• The number of key rates
• The type of the key rates (spot rates or par yields)
• The terms of the key rates (maturities)
• The rule for computing all other rates given the key rates.

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 Choosing Key Rates
One popular choice of key rates for the U.S. Treasury
and related markets are 2-, 5-, 10-, and 30-year par
yields.
The change in the term structure of par yields given a
one-basis point change in each of the key rates is
assumed to be as in the Figure on the next slide.
Each of the four shapes is called a key-rate shift:
• Each key rate affects par yields from the term of the
previous key rate (or zero) to the term of the next key rate
(or the last term).
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 Key-Rate Shifts

Source: Tuckman’s “Fixed Income Securities: Tools for Today’s Markets”

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 Key-Rate Shifts
For example, 5-year key rate shift affects the rates at
terms of 2 to 10 years.
The impact of each key rate is normalized to be one
basis point at its own maturity and then assumed to
decline linearly, reaching zero at the terms of the
adjacent key rates.
For the two-year shift, at terms of less than 2-years, and
for the 30-year shift, at terms greater than 30 years, the
assumed change is constant at one basis point.

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 Key-Rate Approach: Example
Key-rate securities: 2-, 5-, 10-, and 30-year par coupon
bond
Security chosen to hedge: 30-year nonprepayable
mortgage with $3,250 payment every 6 months
Par yield flat at 5% (just for simplicity, we do not need
to assume a flat yield curve)
• All spot rates are 5%.
• The initial value of the security before shifts in key rates
= $100,453.13 (by simple discounting)

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 Key-Rate 01s and Duration
For a one basis point change in key rate, the par yield
curve is changed, which leads to the change in spot
rates. (Refer to lecture note 4 on bootstrapping.)
Discounting the cash flows using the new spot rates to
get the new value.
Key rate 01 is simply the dollar change in value.
Key rate duration is the percentage change in value.

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 Key-Rate 01s and Duration
Key Rate Exposures of a 30-Year Nonprepayable Mortgage
Monthly payment: $3,250
Par yields flat at: 5%
Key Rate Key Rate Percentage
Initial Value $100,453.13 01($) Duration of Total
After 2-year shift $100,452.15 0.98 0.10 0.9%
After 5-year shift $100,449.36 3.77 0.38 3.3%
After 10-year shift $100,410.77 42.37 4.22 37.0%
After 30-year shift $100,385.88 67.26 6.70 58.8%
Total 114.38 11.39

The dollar change in security value for 1 bp change in each of the four
key rates is $114.38. For 1% change in each of the four key rates, there
is 11.39% change in security value.
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 Hedging Key Rate Exposure
Knowing the key rate exposure of the mortgage loan, we
can construct the hedging portfolio consisting of 2-, 5-,
10-, and 30-year par bonds to hedge.
Since the key rates are par yields, the par bonds have no
exposure to any key rate but that of the corresponding
maturity.
The bond key rate 01 with respect to that key rate would
equal its yield-based DV01 while its key rate 01 with
respect to all other key rates would be zero.

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 Key Rate Exposures of Hedging Securities

Par yield flat at: 5%

Key Rate 01s (100 Face)
Coupon Term 2-Year 5-Year 10-Year 30-Year
5% 2 0.01881 0 0 0
5% 5 0 0.04375 0 0
5% 10 0 0 0.07793 0
5% 30 0 0 0 0.15444
Nonprepayable
0.98129 3.77314 42.36832 67.25637
mortgage

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 Hedging Key Rate Exposure
For each key rate exposure, we want to make sure that
the key rate exposure of the nonprepayable mortgage is
the same as that of the hedging portfolio. Therefore,

• Where Ft is the $ face

amount of the t-year bond
in the hedging portfolio.

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 Hedging Key Rate Exposure
Solving for the four equations, we get

Go long on the nonprepayable mortgage and short on the

four hedging bonds will be approximately immune to
any combination of key rate changes.

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 Other Multi-Factor Hedging
Another multi-factor hedging approach widely used in
practice (especially useful for management of large swap
portfolios) is called forward-bucket analysis.
A bucket is a region of the term structure of interest
rates.
• Number of buckets is usually greater than number of key
rates.
• Each bucket shift is a parallel shift of forward rates in that
bucket by one basis point.
• Forward-bucket 01 is computed similarly.
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 Minimum-Variance Approach
The third approach to hedging interest rate risk is the
minimum-variance approach.
After selecting the hedging instruments, you estimate the
hedge ratio numerically from the problem of minimizing
the variance of the hedged returns.
• This approach can be applied empirically, by using
historical returns to construct the minimum-variance
hedge ratio, or analytically, by using the valuation model
to estimate the population values for the variance and
covariance of returns.

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 Minimum-Variance Approach
Given assumption of linear relationship between the
change in the value of the position and the change in the
value of hedging instrument, a constant hedge ratio can
be estimated and applied independently of the
magnitude of the position’s value.
Most investment firms do not choose to minimize their
variance. In general, institutions that want to hedge
interest rate risk tend to prefer some other possibility
between no-hedging and the minimum-variance hedge.

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End of the Notes!

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