CHAPTER TWENTY-TWO

BOND PORTFOLIO
MANAGEMENT

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 BOND PORTOLIOS

• METHODS OF MANAGEMENT
– Passive
• rests on the belief that bond markets are semi-strong
efficient
• current bond prices viewed as accurately reflecting
all publicly available information

2
 BOND PORTOLIOS

• METHODS OF MANAGEMENT
– Active
• rests on the belief that the market is not so efficient
• some investors have the opportunity to earn above-
average returns

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 BOND PRICING THEOREMS

• 5 BOND PRICING THEOREMS

– for a typical bond making periodic coupon
payments and a terminal principal payment

4
 BOND PRICING THEOREMS

• 5 BOND PRICING THEOREMS

– THEOREM 1
• If a bond’s market price increases
• then its yield must decrease
• conversely if a bond’s market price decreases
• then its yield must increase

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 BOND PRICING THEOREMS

• 5 BOND PRICING THEOREMS

– THEOREM 2
• If a bond’s yield doesn’t change over its life,
• then the size of the discount or premium will
decrease as its life shortens

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 BOND PRICING THEOREMS

• 5 BOND PRICING THEOREMS

– THEOREM 3
• If a bond’s yield does not change over its life
• then the size of its discount or premium will
decrease
• at an increasing rate as its life shortens

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 BOND PRICING THEOREMS

• 5 BOND PRICING THEOREMS

– THEOREM 4
• A decrease in a bond’s yield will raise the bond’s
price by an amount that is greater in size than the
corresponding fall in the bond’s price that would
occur if there were an equal-sized increase in the
bond’s yield
• the price-yield relationship is convex

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 BOND PRICING THEOREMS

• 5 BOND PRICING THEOREMS

– THEOREM 5
• the percentage change in a bond’s price owing to a
change in its yield will be smaller if the coupon rate
is higher

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 CONVEXITY

CONVEXITY DEFINITION:

– a measure of the curvedness of the price-yield

relationship

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 CONVEXITY
• THE PRICE-YIELD RELATIONSHIP
Price

YTM
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 CONVEXITY

• THEOREM 1 TELLS US
– price and yield are inversely related but not in a
linear fashion (see graph)
– an increase in yield is associated with a drop in
bond price
– but the size of the change in price when yield
rises is greater than the size of the price change
when yield falls

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 DURATION

• DEFINITION:
– measures the “average maturity” of a stream of
bond payments
– it is the weighted average time to full recovery
of the principal and interest payments

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 DURATION

• FORMULA
T
 PV (Ct ) 
D   t
t 1  P0 
where P0 = the current market price of
the bond
PV(Ct )= the present value of the
coupon payments
t = time periods
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 DURATION

• THE RELATION OF DURATION TO

PRICE CHANGES
– THEOREM 5 implies
• bonds with same maturity date but different coupon
rates may react differently to changes in the interest
rate
• duration is a price-risk indicator

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 DURATION

• DURATION IS A PRICE-RISK
INDICATOR
– FORMULA
p
  D (1  ytm)
p
rewritten p  y 
  D
1 y 

p  
where y = the bond’s yield to maturity

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 DURATION

• MODIFIED DURATION
– FORMULA: D
Dm 
1 y
– reflects the bond’s % price change for a one
percent change in the yield

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 DURATION

• THE RELATIONSHIP BETWEEN

CONVEXITY AND DURATION
– whereas duration would have us believe that the
relationship between yield and price change is
linear
– convexity shows us otherwise

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 DURATION
• THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION
P

0 YTM
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 IMMUNIZATION

• DEFINITION: a bond portfolio

management technique which allows the
manager to be relatively certain of a given
promised cash stream

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 IMMUNIZATION

• HOW TO ACCOMPLISH
IMMUNIZATION
– Duration of a portfolio of bonds
• equals the weighted average of the individual bond
durations in the portfolio
– Immunization
• calculate the duration of the promised outflows
• invest in a portfolio of bonds with identical
durations

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 IMMUNIZATION

• PROBLEMS WITH IMMUNIZATION

– default and call risk ignored
– multiple nonparallel shifts in a nonhorizontal
yield curve
– costly rebalancing ignored
– choosing from a wide range of candidate bond
portfolios is not very easy

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 ACTIVE MANAGEMENT

• TYPES OF ACTIVE MANAGEMENT

– Horizon Analysis
• simple holding period selected for analysis
• possible yield structures at the end of period are
considered
• sensitivities to changes in key assumptions are
estimated

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 ACTIVE MANAGEMENT

• TYPES OF ACTIVE MANAGEMENT

– Bond Swapping
• exchanging bonds to take advantage of superior
ability to predict yields
• Categories:
– substitution swap
– intermarket spread swap
– rate anticipation swap
– pure yield pickup swap

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 ACTIVE MANAGEMENT

• TYPES OF ACTIVE MANAGEMENT

– Contingent Immunization
• portfolio managed actively as long as favorable
results are obtained
• if unfavorable, then immunize the portfolio

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 PASSIVE MANAGEMENT

• TYPES OF PASSIVE MANAGEMENT

– INDEXATION
• the portfolio is formed to track a chosen index

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