Managing Bond Portfolios

Passive Strategies (with a review of term

structures)

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Managing Fixed Income Securities:

Basic Strategies
Passive strategy

Control risk
Balance risk and return

Active strategy

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Trade on interest rate predictions

Trade on market inefficiencies

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Review of Term Structure of

Interest Rates
Overview of term structures

Various rates used in practice

Bond yields
Spot rates
Short rates
Forward rates

Yield curve

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Yield Curves

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What does the record say?

Yield curves are mostly upward-sloping
Inverted yield curves generally point to declining
interest rates
Steeply rising yield curves are generally interpreted
as signaling impending rate increases

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Using Spot Rates to price

Coupon Bonds
A coupon bond can be viewed as a series of zero
coupon bonds
To find the value, each payment is discounted at the
zero coupon rate
Once the bond value is found, one can solve for the
yield

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Similar maturity and default risk bonds may sell at

different yields to maturity

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Sample Bonds
Bonds CFs and current yield curve

Assuming annual compounding

Maturity
Coupon Rate
Par Value
Cash flow in 1-3
Cash flow in 4

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4 years

4 years

Period

6%

8%

1,000

1,000

60

80

1,060

1,080

Spot Rate

.05

.0575

.063

.067

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Calculation of Price Using Spot

Rates (Bond A and B)
Period

Spot
Rate

Cash
Flow

PV of
Cash
Flow

Period

Spot
Rate

Cash
Flow

PV of
Cash
Flow

.05

60

57.14

.05

80

76.19

.0575

60

53.65

.0575

80

71.54

.063

60

49.95

.063

80

66.60

.067

1,060

817.80

.067

1,080

833.23

978.54

Total

Total

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1,047.56

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Solving for the YTM

Bond A
Bond Price = 978.54
YTM
= 6.63%
Bond B
Price
YTM

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= 1,047.56
= 6.61%

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Passive Management
Bond-Index Funds
Cash flow matching and dedication
Immunization of interest rate risk

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Target date immunization

Holding Period matches Duration
Net worth immunization
Duration of assets = Duration of liabilities

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Passive Management
Bond Indexing
Design a bond portfolio so that its performance will match that of some
bond index
Performance is measured through its total return over some
investment horizon
Motivation: low advisory fee, and the overall poor performance of active
bond managers
When constructing the portfolio

Flexibility level: frequency of transaction,

The difficulty?
Impossible to fully replicate the index

Bond-Index Funds
Indexation: how does it work?

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Liability Funding Strategies

Classification of liabilities
Type I liabilities: both amount and timing are known
E.g., GICs
II: amount is known, timing is unknown
E,g., Life insurance policy
III: timing is known, but amount is unknown

Equity linked GIC

IV: both timing and amount are unknown

Insurance policies
American options,
Different types of liabilities needs different investment strategies

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Cash Flow Matching

Also called dedicating a portfolio

a bond is selected with a maturity that matches the last liability stream: the amount of
coupon + principal equal to the last liability stream. The reminding elements of the
liability stream are then reduced by the coupon payment on this bond, and then
another bond is chosen for the new, reduced amount of the next-to-last liability. Going
back in time, this cash flow matching process is continued until all liabilities have
been matched.

Difference from immunization:

no duration requirement
no rebalance required
no risk that liabilities wont be satisfied
Disadvantage?

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Cash flow matching and dedication

example
Consider the problem of funding a stream of pension liabilities consisting
of $100 million at the end of each for the next three years.
Assume that the following securities are available for investment (annual
coupon)

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Securities

P0

CF1

CF2

CF3

100.000

10

110

95.000

108

105.000

12

12

112

94.3396

100

85.7339

100

75.1315

100
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How to set up portfolio?

One way is to use strips

Total cost: 94.3396+ 85.7339+ 75.1315=255.20

Can you do better?

Can also achieve the goal by

1

0.8117

0.00

0.8929

0.8117

0.00

0.00

Cost: 251.49

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Target Date Immunization

Consider the following case: a life insurance company sells a GIC that
guarantees an interest of 6.25% every 6 months for 5.5 years. Suppose
the payment made by the policy holder is $8,820.262. An amount of
has been guaranteed after 5.5 years.
Suppose that the portfolio manager buys $ 8,820.262 par value of a bond
selling at par with a 12.5% yield and matures in 5.5 years
what will happen?
Is the cash flow hedged?

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What affects total returns?

A bonds total return is impacted by

Its interest income and interest-on-interest

Its price fluctuations

These two forces work in the opposite direction

Is there some point where they exactly offset each other?

Yes, when the bond has been held for the length of the bonds
duration

Target date immunization:

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Make portfolio duration close to your holding period

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Example: Immunizing the

Palmer Corporations $1,000 Liability
Given information

Palmer Corporation has a $1,000 liability due in 6.79 years

If Palmer purchased a default-free bond with a 9% coupon

rate, par of $1,000 and maturity of 10 years for $1,000 (has
a duration of 6.79 years) to repay the liability due in 6.79
years

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Example: Immunizing the

Palmer Corporations $1,000 Liability
The total return from this bond held under different reinvestment assumptions
Holding Period (years)
Return Sources

Rate

Coupon income

5%

$90

$270

$287

Interest on coupon
Total Return

Capital gain

As time passes,
the interest on
coupon
component has
a greater
impact on total
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return.
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Total yield
Coupon income
Capital gain
Interest on coupon
Total Return

7%

6.79

10

$450

$611

$810

$900

$234

$175

$100

$39

$0

$1.13

$17

$54

$105

$191

$241

$378

$521

$679

$816

$1040

$1141

37.0%

15.0%

11.0%

9.00%

8.5%

8.2%

$90

$270

$450

$611

$810

$900

$132

$109

$83

$56

$19

$0

$2

$25

$78

$149

$279

$355

$92

$302

$554

$816

$1197
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Example: Immunizing the

Palmer Corporations $1,000 Liability
Holding Period (years)
Return Sources

Rate

Coupon income

9%

$90

$270

$450

$611

$810

$900

Capital gain

$0

$0

$0

$0

$0

$0

Interest on coupon

$2

$32

$103

$205

$387

$495

$92

$302

$554

$816

$1197

$1395

9.0%

9.0%

9.0%

9.0%

9.0%

9.0%

$90

$270

$450

$611

$810

$900

-$112

-$95

-$75

-$56

-$18

$0

$2

$40

$129

$261

$502

$647

$20

$215

$504

$816

$1294

$1547

2.0%

6.7%

8.5%

9.0%

Total Return
Total yield
Coupon income
Capital gain
Interest on coupon
Total Return

Note that theTotal

totalyield
yield is 9%
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regardless
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20 of the reinvestment rate.

11%

6.79

10

9.7%
9.8%
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Net Worth Immunization

PV of asset must equal the PV of liabilities
Duration of the assets must match the duration of liabilities
Why match duration?
The assets must have a dominance patter over the liabilities
for prescribed yield changes (e.g., higher convexity)
Immunization provides a hedge for the portfolios value,
but not its cash flow!!!

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Example

Three strips with maturity T=1, 2 and 3, and YTM of 6%, 8% & 10%, respectively.
Liability 100 million at the end of each year when market yields are at 10%:
Duration =1.942,
Use strip 3 to immunize the liability. We make the weighted average of durations
for the hedged portfolio (asset+liability) to be zero. The price of stripe 3 is Then
( is the number of stripe 3 to buy)
=0
where
Or
To get =-2.14

What will happen at end of year 1 and 2?

Note: we can also use strip 1 and 3 together to form a portfolio that matures PV and
duration of the liability

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Notes on duration of bond

portfolios
For assets with equal yields, the duration of a bond portfolio
is equal to the weighted average of the durations of the
bonds in the portfolio
Portfolio needs to be rebalanced when interest rate changes
Immunization risk
non-parallel shift in the yield curve
credit risk, and call risk
The immunization technique can be generalized to satisfy
multi-period liabilities

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Notes on duration of bond

portfolios
The portfolio duration, however, does not change linearly with time. The
portfolio needs, therefore, to be rebalanced periodically to maintain
target date immunization

Example:

with $19,487 in liability in 7 years, with current market interest rate at 7%: PV =
$10,000
Immunize the liability with 3 year zero and perpetuity paying annual coupon:
duration = (1+10%)/10% = 11 year
Assume portfolio has w% in zero, (1-w)% in perpetuity: w=50%
Next year, interest rate does not change
PV of obligation = $11,000
Portfolio grows to $11,000 too: zero grows from $5,000 to $55,000 and perpetuity paid

$500 and still worth $5,000

Duration: 2 years and 11 years: w = 5/9: needs (5/9)*11000 = 6,111.11 in zero

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