Chapter 12

BOND PORTFOLIO MANAGEMENT

The Passive and Active Stances
 OUTLINE

• Interest Rate Sensitivity

• Duration

• Convexity

• Passive Strategies

• Immunisation : A Hybrid Strategy

• Active Strategies

• Interest Rate Swaps

 PASSIVE VERSUS ACTIVE STRATEGY

• A PASSIVE STRATEGY SEEKS TO MAINTAIN AN

APPROPRIATE BALANCE BETWEEN RISK AND
RETURN.

• AN ACTIVE STRATEGY STRIVES TO ACHIEVE

RETURNS THAT ARE MORE THAN
COMMENSURATE WITH THE RISK EXPOSURE
 INTEREST RATE SENSITIVITY
1. THERE IS AN INVERSE RELATIONSHIP BETWEEN BOND
PRICES AND YIELDS.
2. AN INCREASE IN YIELD CAUSES A PROPORTIONATELY
SMALLER PRICE CHANGE THAN A DECREASE IN YIELD OF
THE SAME MAGNITUDE.
3. PRICES OF LONG-TERM BONDS ARE MORE SENSITIVE TO
INTEREST RATE CHANGES THAN PRICES OF SHORT-TERM
BONDS.
4. AS MATURITY INCREASES, INTEREST RATE RISK INCREASES
BUT AT A DECREASING RATE.
5. PRICES OF LOW-COUPON BONDS ARE MORE SENSITIVE TO
INTEREST RATE CHANGES THAN PRICES OF HIGH-COUPON
BONDS.
6. BOND PRICES ARE MORE SENSITIVE TO YIELD CHANGES
WHEN THE BOND IS INITIALLY SELLING AT A LOWER YIELD.
RELATIONSHIP BETWEEN CHANGE IN YIELD TO
MATURITY AND CHANGE IN BOND PRICE

200
Percentage change in bond price

Initial
150 Bond Coupon Maturity YTM
A 12% 5 years 10%
100 B 12% 30 years 10%
C 3% 30 years 10%
D 3% 30 years 6%
50

0
-5 -4 -3 -2 -1 0 1 2 3 4 5A
-50
B
Change in yield to maturity (%) C
D
 DURATION - 1
DURATION IS A MEASURE OF THE AVERAGE LIFE OF A DEBT
INSTRUMENT. IT IS DEFINED AS THE WEIGHTED AVERAGE TIME
TO FULL RECOVERY OF PRINCIPAL AND INTEREST PAYMENTS.

USING ANNUAL COMPOUNDING WE CAN DEFINE DURATION (D) AS:

Duration = [PV (ci) *1 + PV (c2) *2 +…PV (Cn)
*n/ Vo
where: PV (ct) is the present value of the cash flow
receivable at the end of year t (t =1,2,..n) and Vo is the
current value of the Bond.
The duration of a Bond, in effect, represents the length
of time that elapses before the average rupee of present
value from the bond is received.
 DURATION - 2
TO ILLUSTRATE HOW DURATION IS CALCULATED CONSIDER BOND A.
BOND A
FACE VALUE RS 100
COUPON (INTEREST RATE) 15 PERCNET PAYABLE ANNUALLY
YEARS TO MATURITY 6
REDEMPTION VALUE RS 100
CURRENT MARKET PRICE RS 89.50
YIELD TO MATURITY 18 PERCENT

CALCULATION OF DURATION
Year Cash Flow Present Value at 18% Proportionate of Proportionate of

Bond Value Time

Bond Value
 DURATION - 2
TO ILLUSTRATE HOW DURATION IS CALCULATED CONSIDER BOND A.
BOND A
FACE VALUE RS 100
COUPON (INTEREST RATE) 15 PERCNET PAYABLE ANNUALLY
YEARS TO MATURITY 6
REDEMPTION VALUE RS 100
CURRENT MARKET PRICE RS 89.50
YIELD TO MATURITY 18 PERCENT

CALCULATION OF DURATION
BOND A : 15 PERCENT COUPON

YEAR CASH FLOW PRESENT VALUE PROPORTION OF PROPORTION OF THE

AT 18 PER CENT THE BOND'S VALUE BOND'S VALUE TIME

1 15 12.71 0.142 0.142

2 15 10.77 0.120 0.241
3 15 9.13 0.102 0.306
4 15 7.74 0.086 0.346
5 15 6.56 0.073 0.366
6 115 42.60 0.476 2.856

DURATION 4.257
YEARS
YEAR CASH PV Cumulated
FLOW PV
1 15 12.71 12.71
2 15 10.77 21.54
3 15 9.13 27.39
4 15 7.74 30.96
5 15 6.56 32.8
6 115 42.60 255.6
7 89.51 381.00

381/89.51 = 4.25 years

 DURATION AND PRICE CHANGE

Duration reflects coupon, maturity and yield, the three

key variables that determine the response of price to
interest rate changes. Hence, duration can be used to
measure interest rate exposure.

In particular a variant of duration called Modified

Duration is used for this purpose.
 DURATION AND VOLATILITY – 1
D* = D/(1+y)
D* = modified duration
D = duration
y = the bond’s yield to maturity
D* = 4.257/(1+0.18) = 3.608 years
P/P  – D*y
— X
Percentage price  Modified Change in yield
change duration in decimal form

Example
D* = 3.608
y = 0.2 percent
P/P  – 3.608 x 0.2 = – 0.722 percent
100-(100*-0.00722) = 100 – 0.72 = 99.28 – Bond Value
 CONVEXITY

• IF THE DURATION RULE WERE AN EXACT RULE,

THE PERCENTAGE CHANGE IN PRICE WOULD BE
LINEARLY RELATED TO THE CHANGE IN YIELD.
YET WE KNOW FROM THE BOND-PRICING
RELATIONSHIPS DISCUSSED EARLIER THAT THE
ACTUAL RELATIONSHIP IS CURVILINEAR.

• THE DURATION RULE PROVIDES AN

APPROXIMATION WHICH IS FAIRLY CLOSE, FOR
SMALL CHANGES IN YIELD. HOWEVER, AS THE
YIELD CHANGE BECOMES LARGER, THE
APPROXIMATION BECOMES POORER.
 CONVEXITY
20-YEAR MATURITY, 9 PERCENT COUPON BOND, SELLING AT AN INITIAL YTM OF 9
PERCENT. MODIFIED DURATION IS 9.95 YEARS. THE FOLLOWING EXHIBIT SHOWS THE
STRAIGHT LINE PLOT OF -D*y = - 9.95 x y AS WELL AS THE CURVED LINE REFLECTING
THE ACTUAL RELATIONSHIP BETWEEN YIELD CHANGE AND PRICE CHANGE

Percentage
80
change in
bond price
60

40

20

0 •
-5 - 4 -3 -2 -1 0 1 2 3 4 5
- 20 Change in YTM
(percentage points)

- 40
 CONVEXITY

• THE TRUE PRICE-YIELD RELATIONSHIP IS

CONVEX, MEANING THAT IT OPENS UPWARD.

• CLEARLY, CONVEXITY IS A DESIRABLE

FEATURE IN BONDS. PRICES OF BONDS WITH
GREATER CONVEXITY (CURVATURE) INCREASE
MORE WHEN YIELDS FALL AND DECLINE LESS
WHEN YIELDS RISE.

• SINCE CONVEXITY IS A DESIRABLE FEATURE, IT

DOES NOT COME FREE. INVESTORS HAVE TO
PAY FOR IT IN SOME WAY OR THE OTHER.
 PASSIVE STRATEGIES

TWO COMMONLY FOLLOWED STRATEGIES BY

PASSIVE BOND INVESTORS ARE: BUY AND HOLD
STRATEGY AND INDEXING STRATEGY.

A BUY AND HOLD STRATEGY SELECTS A BOND

PORTFOLIO AND STAYS WITH IT –must have knowledge

of yield of various bonds, call risk, marketability of bond, any
current income requirement, taxes etc

AN INDEXING STRATEGY CALLS FOR BUILDING A

PORTFOLIO THAT MIRRORS A WELL-KNOWN BOND
INDEX
 QUASI- PASSIVE STRATEGIES

LADDERS :Portfolio of individual bonds with various

maturity dates.

BULLETS: Staggered purchase of several bonds that mature

at the same time

BARBELLS: Strategy to purchase short term and long term

bonds, maturity in 2 years and in 20-25 years. This gives
weighted average maturity as medium term. This strategy is
used when investor anticipates a fall in interest rates in the long
term and increase in bond prices.
 QUASI- PASSIVE STRATEGIES

ADAVANTAGES OF BARBELLS:
a) Investors can take advantages of interest rates when they
are high thus receiving financial flexibility.

b) As a portion of the assets is invested in security that matures

in every few years, the necessary liquidity is maintained.

c) Allocation of only a part of one’s fixed income portfolio in

long term bonds reduces the risk associated with rising rates,
which has a large impact on the value of long term bonds
 DURATION AND IMMUNISATION - 1
CAPITAL VALUE

INTEREST RATE

RETURN ON RE-
INVESTMENT OF
INTEREST
CAPITAL VALUE

INTEREST RATE

RETURN ON RE-
INVESTMENT OF
INTEREST
FOR IMMUNISATION SET DURATION EQUAL TO
INVESTMENT HORIZON
 DURATION AND IMMUNISATION - 2
MAY BE DEFINED . . PROCESS … FIXED INCOME
PORTFOLIO IS CREATED HAVING . . AN ASSURED RETURN
FOR A SPECIFIED TIME HORIZON IRRESPECTIVE OF
INTEREST RATE CHANGE. MORE CONCISELY, THE
FOLLOWING ARE IMPORTANT CHARACTERISTICS
• SPECIFIC TIME HORIZON
• ASSURED RATE OF RETURN
• INSULATION FROM THE EFFECTS OF POTENTIAL
ADVERSE INTEREST RATE CHANGE ON PORTFOLIO
VALUE
CAPITAL CHANGES
BALANCE
INVESTMENT RETURN
 ILLUSTRATION
AN INVESTOR WHO HAS A FOUR-YEAR INVESTMENT HORIZON
WANTS TO INVEST RS.1,000 SO THAT HIS INITIAL INVESTMENT ALONG
WITH REINVESTMENT OF INTEREST GROWS TO RS.1607.5. THIS
MEANS THAT THE INVESTOR WANTS HIS INVESTMENT TO EARN A
COMPOUND RETURN OF 12.6 PERCENT [1,000 (1.126)4 = 1,607.5
THE INVESTOR IS EVALUATING TWO BONDS, A & B
Bond A Bond B
Par value Rs.1,000 Rs.1,000
Market price Rs.1,000 Rs.1,000
Coupon rate 12.6% 12.6%
Yield to maturity 12.6% 12.6%
Maturity period 4 years 5 years
Duration Less than 4 years 4 years
Rating A A

EXHIBIT 13.4 SHOWS WHAT HAPPENS WHEN THE INVESTOR BUYS

BOND A AND BOND B UNDER DIFFERENT ASSUMPTIONS ABOUT
MARKET YIELD
TERMINAL VALUE WITH BONDS A AND B
Part I : Bond A: Market Yield Remains at 12.6%
Reinvestment
Year Cash flow Accumulated value
rate
1 Rs. 126 12.6% 126 (1.126)3 = 179.9
2 Rs. 126 12.6% 126 (1.126)2 = 159.8
3 Rs. 126 12.6% 126 (1.126)1 = 141.9
4 Rs. 1126 NA 1126.0
Total 1607.6
Part II Bond A: Market Yield Falls to 10% in year 2
Year Cash flow Reinvestment Accumulated value
rate
1 Rs. 126 12.6% 126 (1.10) (1.10) (1.10) = 167.7
2 Rs. 126 10.0% 126 (1.10) (1.10) = 152.5
3 Rs. 126 10.0% 126 (1.10) = 138.6
4 Rs. 1126 NA 1126.0
Total 1584.8

contd
TERMINAL VALUE WITH BONDS A AND B
Part III Bond B: Market Yield Remains at 12.6%
Reinvestment
Year Cash flow Accumulated value
rate
1 126 12.6% 126 (1.126)3 = 179.9
2 126 12.6% 126 (1.126)2 = 159.8
3 126 12.6% 126 (1.126)1 = 141.9
4 126 NA 126.0
4 1000* (sale of bond) NA 1000.0
Total 1607.6
Part III Bond B: Market Yield Falls to 10% in Year 2
Year Cash flow Reinvestment Accumulated value
rate
1 126 12.6% 126 (1.10) (1.10) (1.10) = 167.7
2 126 10.0% 126 (1.10) (1.10) = 152.5
3 126 10.0% 126 (1.10) = 138.6
4 126 NA 126.0
4 1023.6** (sale of NA 1023.6
bond)
Total 1608.4
* (126 + 1000)/ (1.126) = 1000
** (126 + 1000)/ (1.10) = 1023.6
 CASH FLOW MATCHING

CASH FLOW MATCHING INVOLVES BUYING A

ZERO COUPON BOND THAT PROMISES A
PAYMENT THAT EXACTLY MATCHES THE
PROJECTED CASH REQUIREMENT. IT
AUTOMATICALLY IMMUNISES A PORTFOLIO
FROM INTEREST RATE RISK BECAUSE THE CASH
FLOW FROM THE BOND OFFSETS THE FUTURE
OBLIGATION.

A DEDICATION STRATEGY INVOLVES MATCHING

CASH FLOWS ON A MULTIPERIOD BASES. purchase
series of Zero coupon Bonds with different maturities.
 ACTIVE STRATEGIES

• HENRY KAUFMAN, A RENOWNED BOND EXPERT,

ARGUES THAT “BONDS ARE BOUGHT FOR
THEIR PRICE APPRECIATION POTENTIAL AND
NOT FOR INCOME PROTECTION”
• MANY BOND INVESTORS SUBSCRIBE TO THIS
VIEW AND PURSUE ACTIVE STRATEGIES. THEY
SEEK TO PROFIT BY:
• FORECASTING INTEREST RATE CHANGES
AND/OR
• EXPLOITING RELATIVE MISPRICINGS
AMONG BONDS.
 INTEREST RATAE FORECASTING - 1 IRF1
 MODELS BASED UPON FORECASTING EXPECTED
INFLATION
 EXPECTED INFL’N .. KEY DETERMINANT
 SOLID EVIDENCE .. LINK
+S  RELATIVELY SIMPLE APPROACH
-S  MAY NOT HELP IN SHORT TERM FORECASTING
 EXPECTED INFL’N .. NOT EASY .. PREDICT

 MODELS THAT FORECAST INTEREST RATES BASED UPON

PAST INTEREST RATE CHANGES

 THESE MODELS EMPHASIZE THE TIME SERIES
BEHAVIOR OF INTEREST RATES & USE DISTRIBUTED
LAGS OF PAST INTEREST RATES IN PREDICTING
FUTURE INT. RATES
+ SIMPLE .. INFOR’N AVAILABLES
- SHIFTS .. FUNDAMENTAL FACTORS … BREAK IN
 HORIZON ANALYSIS
HORIZON ANALYSIS IS A METHOD OF FORECASTING THE
TOTAL RETURN ON A BOND OVER A GIVEN HOLDING
PERIOD. IT INVOLVES THE FOLLOWING STEPS.
 SELECT A PARTICULAR INVESTMENT PERIOD AND
PREDICT BOND YIELDS AT THE END OF THAT
PERIOD.
 CALCULATE THE BOND PRICE AT THE END OF THE
INVESTMENT PERIOD.
 ESTIMATE THE FUTURE VALUE OF COUPON
INCOMES EARNED OVER THE INVESTMENT PERIOD.
 ADD THE FUTURE VALUE OF COUPON INCOMES
OVER THE INVESTMENT PERIOD TO THE
PREDICTED CAPITAL GAIN OR LOSS TO GET A
FORECAST OF THE TOTAL RETURN ON THE BOND
FOR THE HOLDING PERIOD.
 ANNUALISE THE HOLDING PERIOD RETURN.
 EXPLOITING RELATIVE
MISPRICINGS AMONG BONDS

•SUBSTITUTION SWAP : SIMILAR BOND SELLING

AT DIFFERENT PRICES AT A PARTICULAR TIME
•  PURE
YIELD PICKUP SWAP : FROM LOWER
YIELD TO HIGHER YIELD
•  INTERMARKET
SPREAD SWAP : SWITCH FROM
TREASURY BOND TO UTILITY BOND
•  TAX SWAP :  CAPITAL LOSS TO OFFSET CAPITAL
GAIN
 INTEREST RATE SWAPS
AN INTEREST RATE SWAP (IRS) IS A
TRANSACTION INVOLVING AN EXCHANGE OF
ONE STREAM OF INTEREST OBLIGATIONS FOR
ANOTHER. (FIXED TO FLOATING INTEREST)

KEY FEATURES
• NET INTEREST DIFFERENTIAL IS PAID OR
RECEIVED
• NO EXCHANGE OF PRINCIPAL REPAYMENT
OBLIGATIONS
• STRUCTURED AS A SEPARATE TRANSACTION
• OFF BALANCE SHEET TRANSACTION
 INTEREST RATE SWAP

6.05%
Swap
Dealer
MIBOR MIBOR
5.95%

Company A Company B

6% coupon MIBOR
 SUMMING UP
• Interest rate risk is measured by the percentage change in the
value of a bond in response to a given interest rate change.
• The duration of a bond is the weighted average maturity of
its cash flow stream, where the weights are proportional to
the present value of cash flows.
• The proportional change in the price of a bond in response to
the change in its yield is as follows:
P/P  D* y

• The two commonly followed passive strategies for bond

portfolio management are: buy and hold strategy and
indexing strategy.
• If the duration of a bond equals the investment horizon, the
investor is immunised against interest rate risk.
• Those who follow an active approach to bond portfolio
management seek to profit by (a) forecasting interest rate
changes and /or (b) exploiting relative mispricings among
bonds.
• A wide range of models are used for interest rate forecasting.

• Horizon analysis is a method of forecasting the total return

on a bond over a given holding period.
• An interest rate swap is a transaction involving an exchange
of one stream of interest obligations for another.