Bond

Portfolio Management
Strategies
Alternative Bond Portfolio Strategies
1. Passive portfolio strategies
2. Active management strategies
3. Core-plus management strategy
3. Matched-funding techniques
4. Contingent procedure (structured active
management)
 Passive Portfolio Strategies
• Buy and hold
– A manager selects a portfolio of bonds based on
the objectives and constraints of the client with
the intent of holding these bonds to maturity
• Indexing
– The objective is to construct a portfolio of bonds
that will equal the performance of a specified
bond index (Match performance of a selected
bond index)
– Performance analysis involves examining tracking
error
 Passive Portfolio Strategies
• Advantages to using indexing strategy
– Historical performance of active managers
– Reduced fees
• Indexing methodologies
– Full participation
– Stratified sampling (cellular approach)
– Optimization approach
– Variance minimization
Determinants of Price Volatility
 Determinants of Price Volatility
1. Bond prices move inversely to bond yields (interest rates)

2. For a given change in yields, longer maturity bonds post larger

price changes, thus bond price volatility is directly related to
maturity.

3. Price volatility increases at a diminishing rate as term to

maturity increases

4. Price movements resulting from equal absolute increases or

decreases in yield are not symmetrical

5. Higher coupon issues show smaller percentage price

fluctuation for a given change in yield, thus bond price
volatility is inversely related to coupon
Determinants of Price Volatility
 DURATION

It is a measurement of how long, in

years, it takes for the price of a bond to
be repaid by its internal cash flows.

VANILLA COUPON BOND

ZERO COUPON BOND
 Duration
• It is an important measure for investors to
consider, as bonds with higher durations carry
more risk and have higher price volatility than
bonds with lower durations.
• It includes : present value, yield, coupon, final
maturity and call features.
 Duration

Developed by Frederick R. Macaulay, 1938

Where:
n = number of cash flows
t = time to maturity
C = cash flow
i = required yield
M = maturity (par) value
P = bond price
Betty holds a five-year bond with a par value of $1,000 and
coupon rate of 5%. For simplicity, let's assume that the
coupon is paid annually and that interest rates are 5%.
What is the Macaulay duration of the bond?

= 4.55 years
 Duration and Price Volatility
An adjusted measure of duration can be used to
approximate the price volatility of a bond
Macaulay duration
modified duration 
YTM
1
m

Where:
m = number of payments a year
YTM = nominal YTM
 Duration and Price Volatility
• Bond price movements will vary proportionally with modified
duration for small changes in yields
• An estimate of the percentage change in bond prices equals
the change in yield time modified duration

P
 100   D mod   i
P
Where:
P = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
i = yield change in basis points divided by 100
 Characteristics of Duration
• Duration of a bond with coupons is always less than its term
to maturity because duration gives weight to these interim
payments
– A zero-coupon bond’s duration equals its maturity

• An inverse relation between duration and coupon

• A positive relation between term to maturity and duration,

but duration increases at a decreasing rate with maturity
• An inverse relation between YTM and duration

• Sinking funds and call provisions can have a dramatic effect

on a bond’s duration
Duration in Years for Bonds Yielding 6%
with Different Terms
COUPON RATES
Years to
Maturity 0.02 0.04 0.06 0.08
1 0.995 0.990 0.985 0.981
5 4.756 4.558 4.393 4.254
10 8.891 8.169 7.662 7.286
20 14.981 12.980 11.904 11.232
50 19.452 17.129 16.273 15.829

Source: L. Fisher and R. L. Weil, "Coping with the Risk of Interest Rate Fluctuations:
Returns to Bondholders from Naïve and Optimal Strategies," Journal of Business 44, no. 4
(October 1971): 418. Copyright 1971, University of Chicago Press.
 Duration and Price Volatility
• Longest duration security gives maximum price
variation
• Active manager wants to adjust portfolio duration to
take advantage of anticipated yield changes
– Expect rate declines (parallel shift in YC), increase average
modified duration to experience maximum price volatility
– Expect rate increases (parallel shift in YC), decrease
average modified duration to minimize price decline
Convexity
 Convexity
• Modified duration approximates price change for
small changes in yield
• Accuracy of approximation gets worse as size of yield
change increases
– WHY?
– Modified duration assumes price-yield relationship of
bond is linear when in actuality it is convex.
– Result – MD overestimates price declines and
underestimates price increases
– So convexity adjustment should be made to estimate of %
price change using MD
 Convexity
• Convexity of bonds also affects rate at which prices
change when yields change
• Not symmetrical change
– As yields increase, the rate at which prices fall becomes
slower
– As yields decrease, the rate at which prices increase is
faster
– Result – convexity is an attractive feature of a bond in
some cases
 Convexity
• The measure of the curvature of the price-
yield relationship
• Second derivative of the price function with
respect to yield
• Tells us how much the price-yield curve
deviates from the linear approximation we get
using MD
 Convexity Calculation

Convexity adjustment to the percentage price change =

C x change in yield squared x 100

To find the C in the equation, use this equation that has the same notation
as duration:

C = V3 +V2 - 2(V1) / 2V1(change in yield) squared

 Total Price Change
Total Price change =
(-duration x change in yield x 100)
+
(C x change in yield squared x 100)

Using the Stone & Co. bonds that had duration of 5.5, let's add a
convexity of 93 and an increase of 150 bps in yield.
Active Management Strategies
 Active Management Strategies
• Potential sources of return from fixed income port:
1. Coupon income
2. Capital gain
3. Reinvestment income
• Factors affecting these sources:
1. Changes in level of interest rates
2. Changes in shape of yield curve
3. Changes in spreads among sectors
4. Changes in risk premium for one type of bond
 Active Management Strategies
• Interest-rate anticipation
– Risky strategy relying on uncertain forecasts
– Ladder strategy staggers maturities
– Barbell strategy splits funds between short duration and
long duration securities
– Bullet strategies
– Riding the YC.
• Valuation analysis
– The portfolio manager attempts to select bonds based on
their intrinsic value
• Bonds rating, call feature, interest rate etc.
• Buy the undervalued bond & sell the overvalued bonds
• If bond rating is higher then interest is low and as result income is low
 Active Management Strategies
• Credit analysis
– Involves detailed analysis of the bond issuer to
determine expected changes in its default risk.
• Internal & external Factors affect the credit rating of
the company such as financial ratios, inflation, etc.
• Higher the risk higher the return.
 Active Management Strategies
• High-Yield Bond Research
– Several investment houses such as Merrill Lynch, First
Boston, Lehman Brothers, etc., have developed specialized
high-yield groups that examine high-yield bond issues and
monitor high-yield bond spreads
Ave. Cumul. Default Rates Corp Bonds
Years Since Issue
Ratings 5 10
AAA 0.08% 0.08%
AA 1.20% 1.30%
A 0.53% 0.98%
BBB 2.39% 3.66%
BB 10.79% 15.21%
B 23.71% 35.91%
CCC 45.63% 57.39%
 Active Management Strategies
• Yield spread analysis
– Assumes normal relationships exist between the yields for
bonds in alternative sectors
• Factor affecting yield spread:-
– Business cycle
– Volatility in the market interest rate
• Bond swaps
 Bond Swaps
• Involve liquidating a current position and
simultaneously buying a different issue in its place with
similar attributes but having a chance for improved
return.
 Pure Yield Pickup Swap
– Swapping low-coupon bonds into higher coupon
bonds
 Substitution Swap
– Swapping a seemingly identical bond for one that is
currently thought to be undervalued
 Bond Swaps (Cont.)
Tax Swap
Swap in order to manage tax liability (taxable & munis)

Swap strategies and market-efficiency

Bond swaps by their nature suggest market inefficiency
 A Global Fixed-Income
Investment Strategy
Factors to consider
– The local economy in each country including the
effects of domestic and international demand
– The impact of total demand and domestic monetary
policy on inflation and interest rates
– The effect of the economy, inflation, and interest
rates on the exchange rates among countries
 Core-Plus Bond Portfolio
Management
• This involves having a significant (core) part of the
portfolio managed passively in a widely
recognized sector such as the U.S. Aggregate
Sector or the U.S. Government/Corporate sector.
• The rest of the portfolio would be managed
actively in one or several additional “plus”
sectors, where it is felt that there is a higher
probability of achieving positive abnormal rates of
return because of potential inefficiencies
Matched-Funding Techniques
• Dedicated Portfolios
 Dedication refers to bond portfolio
management techniques that are used to
service a prescribed set of liabilities
– Pure Cash‑Matched Dedicated Portfolios
• Most conservative strategy
– Dedication With Reinvestment
• Cash flows do not have to exactly match
the liability stream
 Matched-Funding Techniques

• Immunization Strategies
– A portfolio manager (after client consultation)
may decide that the optimal strategy is to
immunize the portfolio from interest rate
changes
– The immunization techniques attempt to
derive a specified rate of return during a given
investment horizon regardless of what
happens to market interest rates
 Immunization Strategies

• The process intended to eliminate interest rate

risk is referred to as immunization
• Components of Interest Rate Risk
– Price Risk
– Coupon Reinvestment Risk
 Classical Immunization
• Immunization is neither a simple nor a
passive strategy
• An immunized portfolio requires
frequent rebalancing because the
modified duration of the portfolio
always should be equal to the
remaining time horizon (except in the
case of the zero-coupon bond)
 Classical Immunization

• Duration characteristics
– Duration declines more slowly than term to
maturity, assuming no change in market
interest rates
– Duration changes with a change in market
interest rates
– There is not always a parallel shift of the yield
curve
– Bonds with a specific duration may not be
available at an acceptable price
 Matched-Funding Techniques

• Horizon matching
– Combination of cash-matching dedication and
immunization
– Important decision is the length of the horizon
period
 Contingent Procedures
• A form of structured active management
– Constrains the manager if unsuccessful
• Contingent immunization
– duration of portfolio must be maintained at
the horizon value
– cushion spread is potential return below
current market
– safety margin
– trigger point
Implications of Capital Market Theory and the
EMH on Bond Portfolio Management
• Bonds and Total Portfolio Theory
• Bonds and Capital Market Theory
• Bond Price Behavior in a CAPM Framework
• Bond-Market Efficiency