BOND PORTFOLIO MANAGEMENT – THE ACTIVE & PASSIVE STRATEGY

INTEREST RATE RISK

Bond price & yields are inter related.

As interest rate fluctuate bondholders experience capital losses and gains. Why?

The reason is that in a competitive market securities are priced to offer fair expected rates of return.

E.g. If a bond is issued with a 10% coupon when the competitive yield is 10%, then it will sell at par. If the market rate rises to 11% the bond price must fall so that its yield rises to 11%; conversely if the market rate falls to 9% its price must rise.

INTEREST RATE SENSITIVITY

Investors are concerned about the sensitivity of bond prices to change in market rates.

DETERMINANTS OF SESITIVITY

1. There is an inverse relationship between bond price & yields.

2. An increase in yield cause a proportionately smaller price change than a decrease in yield of the same magnitude.

3. Price of long term bond are more sensitive to interest rate change than prices of short term bonds.

4. As maturity increases, interest rate risk increase but a decreasing rate.

5. Prices of low-coupon bonds are more sensitive to interest rate change than price of high coupon bonds.

6. Bond prices are more sensitive to yield changes when the bond is initially selling at a lower yield.

DURATIONDuration is the measure of the weighted average life of bond which consider the size and timing of each cash flow.

Duration : [PV (C1) *1 + PV (C2) *2+…+ PV (Cn) * n] / V0

Where,

PV (Ct) = present value of the cash flow receivable at the end of year t ( t = 1,2,…n)

V0 = current value of the bond

DURATION & PRICE CHANGE

Duration reflects coupon, maturity 7 yield, the three key variable that determine the response of price to interest rate changes.

Duration can be used to measure interest rate exposure.

D* = D / ( 1 + y)

D* = modified duration

D = duration

Y = the bond’s yield to maturity

PROPERTIES OF DURATION

The duration of a zero coupon bond is the same as its maturity.

For a given maturity, a bond’s duration is higher when its coupon rate is lower.

For a given coupon rate a bond’s duration generally increases with maturity.

The duration of a level perpetuity is :

( 1 + yield ) / yield

The duration of a level annuity approximately is:

1 + yield - Number of payments

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Yield ( 1+ yield)number of payments - 1

The duration of a coupon bond approximately is:

1 + y - ( 1 + y) + T ( c – y)

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y c[( 1 + y )t - 1] - y

Bond Portfolio Strategies

1. Passive portfolio strategies

2. Active management strategies

Passive Portfolio Strategies

Passive strategies emphasize buy-and-hold, low energy management

Try to earn the market return rather than beat the market return

Buy and hold strategy Buy a portfolio of bonds and hold them to maturity Can by modified by trading into more desirable

positions

Indexing strategy Match performance of a selected bond index Performance analysis involves examining tracking

error for differences between portfolio performance and index performance

IMMUNISATION : A HYBRID STRATEGY

Immunization StrategiesDifficulties in Maintaining Immunization

StrategyRebalancing required as duration declines

more slowly than term to maturityModified duration changes with a change in

market interest ratesYield curves shift

CASH FLOW MATCHING

Buy a zero coupon bond that promise a payment that exactly matches the projected cash requirements. This is called cash flow matching.

It automatically immunises portfolio from interest rate risk b’coz the cash flow from the bond offsets the future obligations.

In this the bond portfolio manager buy a series of zero coupon bond that match the stream of future obligations. Such a strategy eliminates interest rate risk and the need for periodic rebalancing.

Active Management Strategies

Active management strategies attempt to beat the market

Mostly the success or failure is going to come from the ability to accurately forecast future interest rates

FORECASTING INTEREST RATE CHANGES

Bond prices & interest rates are inversely related. If an investor expects interest rates to fall, he should buy bounds, preferably bonds with longer maturity for price appreciation & vice versa.

HORIZON ANALYSIS

It is a method of forecasting the total return on a bond over a given holding period.

It involves the following steps:

1. Select a particular investment period & predict bond yields at the end of that period.

2. Calculate the bond price at the end of the investment period.

3. Estimate the future value of coupon income earned over the investment period.

4. Add the future value of coupon incomes over the investment period to the predicted capital gains or loss to get a forecast of the total return on the bond for the holding period.

5. Annualize the holding period return.

EXPLOITING MISPRICING AMONG SECURITIES

Bond portfolio managers regularly monitor the bond market to identify temporary relative mispricings.

They try to exploit such opportunities by engaging in bond swaps purchase & sale of a bond to improve the rate of return.

BOND SWAP

SUBSTITUTION SWAP: It involves bonds that are very similar in terms of credit rating, coupon payments, maturity, call provisions, & liquidity.

INTERMARKET SPREAD SWAP: It seek to benefit from the expected changes in the yield difference between various sector of the bond market.

Pure yield pickup swapSwapping low-coupon bonds into higher

coupon bondsTax swap

Swap in order to manage tax liability (taxable & munis

INTEREST RATE SWAP

An Interest rate swap is a transaction involving an exchange of one stream of interest obligations for another.

PRINCIPAL OF AN INTERST RATE SWAP

It effectively translates a floating rate borrowing into a fixed rate borrowing & vice versa.There is no exchange of principal repayment obligations.It is structured as a separate contract distinct from the underlying loan agreement.

It is applicable to new as well as existing borrowings.

It is treated as an off-the-balance sheet transaction.