Chapter

Managing Bond
11 Portfolios

Bodie, Kane, and Marcus

Essentials of Investments
12th Edition

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 11.1 Interest Rate Risk 1

• Interest Rate Sensitivity:

1. Bond prices and yields are inversely related.
2. Increase in bond’s yield to maturity  smaller
price change than yield decrease of equal
magnitude.
3. Long-term bond prices are more sensitive to
interest rate changes than short-term bonds.

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 11.1 Interest Rate Risk 2

• Interest Rate Sensitivity:

4. As maturity increases, sensitivity of bond
prices to changes in yields increases at
decreasing rate.
5. As maturity increases, sensitivity of bond
prices to changes in yields increases at
decreasing rate.

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 11.1 Interest Rate Risk 3

• Interest Rate Sensitivity:

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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 Table 11.1 Prices of 8% Annual Coupon Bonds

Bond’s Yield to Maturity T = 1 Year T = 10 Years T = 20 Years

8% 1,000.00 1,000.00 1,000.00
9% 990.83 935.82 908.71
Percent change in price* −0.92% −6.42% −9.13%

*Equals value of bond at a 9% yield to maturity minus value of bond at

(the original) 8% yield, divided by the value at 8% yield.

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 Table 11.2 Prices of Zero-Coupon Bonds

Bond’s Yield to Maturity T = 1 Year T = 10 Years T = 20 Years

8% 925.93 463.19 214.55
9% 917.43 422.41 178.43
Percent change in price* −0.92% −8.80% −16.84%

*Equals value of bond at a 9% yield to maturity minus value of bond at

(the original) 8% yield, divided by the value at 8% yield.

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 11.1 Interest Rate Risk 4

Macaulay’s Duration (D):

• Measures effective bond maturity.
• Weighted average of the times until each
payment, with weights proportional to the
present value of payment.
T
D   t  wt
t 1

where
CFt 1  y 
t

wt 
Bond Price
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 Spreadsheet 11.1 Calculation of Duration of Two
Bonds

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 11.1 Interest Rate Risk 5

• Change in Bond Price to Yield to Maturity:

P   1  y  
 D  
P  1 y 

• Modified Duration (D*):

D
D* 
1 y
P
  D * y
P
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 Spreadsheet 11.2 Computing Duration

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 11.1 Interest Rate Risk 6

• What Determines Duration?

1. Zero-coupon bond’s duration is time to
maturity.
2. Holding time and yield to maturity constant, a
bond’s duration and interest-rate sensitivity
are higher when the coupon rate lower.
3. 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 value.

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 11.1 Interest Rate Risk 7

• What Determines Duration?

4. Other factors constant, duration and interest
rate sensitivity of coupon bond higher when
bond’s yield to maturity lower.
1 y
5. Duration of a perpetuity  .
y

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 Figure 11.2 Duration as Function of Maturity

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 Table 11.3 Annual Coupon Bond Duration

Coupon Coupon Coupon Coupon

Maturity (years) Rate: 2% Rate: 4% Rate: 6% Rate: 8%
1 1.000 1.000 1.000 1.000
5 4.786 4.611 4.465 4.342
10 8.961 8.281 7.802 7.445
20 15.170 13.216 12.158 11.495
Infinite (perpetuity) 17.667 17.667 17.667 17.667

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 11.2 Passive Bond Management 1

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 1

Years Remaining Accumulated Value of

Payment Number until Obligation Invested Payment
A. Rates remain at 8%
800  1.08   1, 088.39
4
1 4
2 3 800  1.08   1, 007.77
3

800  1.08  
2
3 2 933.12
800  1.08  
1
4 1 864.00
800  1.08  
0
5 0 800.00

Sale of bond 0 10,800 1.08  10, 000.00

14, 693.28
B. Rates fall to 7%
800  1.07   1, 048.64
4
1 4
800  1.07  
3
2 3 980.03

3 2 800  1.07  
2
915.92
4 1 800  1.07  
1
856.00
5 0 800  1.07  
0
800.00
Sale of bond 0 10,800 1.07  10, 093.46
14, 694.05

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 Table 11.4 Terminal Value of Bond Portfolio after Five
Years 2

Years Remaining Accumulated Value of

Payment Number until Obligation Invested Payment
C. Rates increase to 9%
800  1.09   1,129.27
4
1 4
2 3 800  1.09   1, 036.02
3

800  1.09  
2
3 2 950.48
800  1.09  
1
4 1 872.00
800  1.09  
0
5 0 800.00
Sale of bond 0 10,800 1.09  9,908.26
14, 696.02

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 Figure 11.3 Growth of Invested Funds

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 Table 11.5 Market Value Balance Sheets

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 Figure 11.4 Immunization

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 11.2 Passive Bond Management 2

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.

P 1
  D * y   Convexity   y 
2

P 2

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
prediction of yield curve at end of
Horizon analysis investment horizon

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 11.4 Active Bond Management
Fixed-Income Investment Strategy:
• Key features:
1. Firms respect market prices.
2. To have value, information cannot already be reflected
in prices.
3. Interest rate movements extremely hard to predict.

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 End of Main Content

© 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill.