CHAPTER NINETEEN

MANAGING
THE FIXED INCOME PORTFOLIO

Practical Investment Management

Robert A. Strong
 Outline

 Fixed Income Security Risk

 Default Risk
 Reinvestment Rate Risk
 Interest Rate Risk
 Duration
 Duration Measures
 Applying Duration

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 Outline

 Convexity
 Problems with Duration
 Simple Convexity
 An Example
 Using Convexity
 Management Strategies
 Active vs. Passive Management
 Classic Passive Management Strategies
 The Risk of Barbells and Ladders
 Indexing
 Active Management

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 Fixed Income Security Risk
 Default risk, or credit risk, is the possibility
that a borrower will be unable to repay
principal and interest as agreed upon in the
loan document.
 Reinvestment rate risk refers to the
possibility that the cash coupons received
will be reinvested at a rate different from
the bond’s stated rate.
 Interest rate risk refers to the chance of
loss because of adverse movements in the
general level of interest rates.

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 Interest Rate Risk : Malkiel’s Theorems

 Malkiel’s theorems are a set of

relationships among bond prices, time to
maturity, and interest rates.
 Theorem One : Bond prices move inversely
with yields.
 Theorem Two : Long-term bonds have
more risk.
 Theorem Three : Higher coupon bonds
have less risk.

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 Interest Rate Risk : Malkiel’s Theorems

 Theorem Four : The importance of theorem

two diminishes with time.
 Theorem Five : Capital gains from an
interest rate decline exceed the capital loss
from an equivalent interest rate increase.

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 Interest Rate Risk : Malkiel’s Theorems

Insert Table 19-1 here.

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 Interest Rate Risk : Malkiel’s Theorems

 Bond A : matures in 8 years, 9.5% coupon

Bond B : matures in 15 years, 11% coupon
Which price will rise more if interest rates
fall?
 Apparent contradictions can be reconciled
by computing a statistic called duration.

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 Duration
 For a noncallable security, duration is
the weighted average time until a
bond’s cash flows are received.
 Duration is not limited to bond analysis. It
can be determined for any cash flow stream.
 Duration is a direct measure of interest rate
risk. The higher it is, the higher is the risk.
 Thinking of duration as a measure of time
can be misleading if the life or the payments
of the bond are uncertain.

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 Duration Measures
 Macaulay duration is the time-value-of-money-
weighted, average number of years necessary
to recover the initial cost of the security.
N Ct
∑ t
×t
t = 1(1 + R )
D=
P
where D = duration
Ct = cast flow at time t
R = yield to maturity (per period)
P = current price of bond
N = number of periods until maturity
t = period in which cash flow is received

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 Duration Measures

 Chua’s closed-form duration is less

cumbersome because it has no summation
requirement.

 ( 1 + R ) N +1 − ( 1 + R ) − RN 
C t   + FN N
R (1 + R)
2 N  (1 + R)
D=  
P
where F = face value (par value) of the bond
and all other variables are as previously defined.

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 Duration Measures

 Modified duration measures the percentage

change in bond value associated with a
one-point change in interest rates.

dP 1 − 1  C1 2C 2 NC N  1
⋅ =  + ++ N 
⋅
dR P ( 1 + R )  ( 1 + R ) ( 1 + R )
1 2
(1 + R)  P
DMacaulay
Dmodified =
(1+ R
2
)

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 Duration Measures
 Effective duration is a measure of price
sensitivity calculated from actual bond
prices associated with different interest
rates. It is a close approximation of
modified duration for small yield changes.

P− − P+
Deffective =
P0 ( R+ − R − )
where P- = price of bond associated with a decline of x basis points
P+ = price of bond associated with a rise of x basis points
R- = initial yield minus x basis points
R+ = initial yield plus x basis points
P0 = initial price of the bond

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 Duration Measures

 Dollar duration determines the dollar amount

associated with a percentage price change.

modified bond price as a

Ddollar = - duration x percentage of par

Pnew = Pold + (Ddollar x change in yield)

 The price value of a basis point is the dollar

price change in a bond associated with a
single basis point change in the bond’s
yield.

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 Applying Duration

 The yield curve experiences a

parallel shift when interest rates
at each maturity change by the
same amount.

 Duration is especially useful in determining

the relative riskiness of two or more bonds
when visual inspection of their
characteristics makes it unclear which is
more vulnerable to changing interest rates.

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 Applying Duration

Insert Table 19-2 here.

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 Problems with Duration

 The bond price - bond yield

price

relationship is not linear.

yield to maturity
 Graphically, duration is the tangent to the
current point on the price-yield curve. Its
absolute value declines as yield to maturity
rises.
 Duration is a first derivative statistic.
Hence, when the change is large, estimates
made using the derivative alone will
contain errors.
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 Problems with Duration

Insert Figure 19-1 here.

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 Problems with Duration

Insert Figure 19-2 here.

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 Problems with Duration

Insert Figure 19-3 here.

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 Convexity

 Convexity measures the difference

between the actual price and that predicted
by duration, i.e. the inaccuracy of duration.
 The more convex the bond price-YTM
curve, the greater is the convexity.

1 N t ( t + 1) C t N ( N + 1 ) F
Convexity = ∑ +
P t =1 ( 1 + R ) t +2
(1 + R) N +2

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 Convexity

Insert Figure 19-4 here.

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 Convexity : An Example
 Price forecasting accuracy is enhanced by
incorporating the effects of convexity.
 Suppose a bond has a 15-year life, an 11%
coupon, and a price of 93%. Macaulay duration =
7.42, yield-to-maturity = 12.00%, modified
duration = 7.00, convexity = 97.71.
If YTM rises to 12.50%, new price= 89.95%
Actual price change = - 3.28%
Price change predicted by duration = - 3.50%
Price change predicted by duration
and convexity = - 3.38%

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 Using Convexity

bond price

yield to maturity

 No matter what happens to interest rates,

the bond with the greater convexity fares
better. It dominates the competing
investment.

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 Using Convexity

Insert Figure 19-6 here.

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 Management Strategies
 An active strategy is one in which the
investment manager seeks to improve
the rate of return on the portfolio by
anticipating events in the marketplace.

 A passive strategy is one in which the

portfolio is largely left alone after its
construction. Changes are made when
securities mature or are called, but
normally not for any other reason.

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 par value Classic Passive Management Strategies

 A laddered strategy distributes fixed

income dollars throughout the yield
maturity
curve.
 A barbell strategy differs from the
par value

laddered strategy in that less

investment is made in the middle
maturity maturities.
 A credit barbell is a bond portfolio containing
a mix of high-grade and low-grade securities.

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 Classic Passive Management Strategies

Insert Figure 19-7 here.

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 Classic Passive Management Strategies

Insert Figure 19-8 here.

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 Classic Passive Management Strategies

Insert Figure 19-9 here.

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 Classic Passive Management Strategies

Insert Figure 19-10 here.

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 The Risk of Barbells and Ladders
 If durationladdered portfolio > durationbarbell portfolio ,
rising interest rate falling interest rate
interest rate barbell ladder
risk favored favored
reinvestment barbell ladder
rate risk favored favored

 Yield curve inversion means short-term rates are

rising faster than long-term rates. Duration as a pure
measure of interest rate risk only works for parallel
shifts in the yield curve.

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 Passive Management Strategies

 Indexing is predicated upon managers

being unable to consistently predict market
movements.
 Indexing involves attempting to replicate
the investment characteristics of a popular
measure of the bond market.
 The two best-known bond indexes are
probably the Merrill Lynch Corporate Bond
Index and the Lehman Brothers Bond
Index.

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 Active Management Strategies

 Active management techniques frequently

involve a bond swap, which is usually
intended to do one of four things:
 increase current income
 increase yield to maturity
 improve the potential for price appreciation
with a decline in interest rates
 establish losses to offset capital gains or
taxable income
 Active management strategies fall into four
broad categories.

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 Strategy 1 : Duration Management
 Duration management techniques involve
creating a structured portfolio - a collection
of securities with characteristics that will
accommodate a specific need or objective.
 A key concept is immunization - a technique
that seeks to reduce or eliminate the
interest rate risk in a portfolio.
 Bank immunization is achieved when the
total dollar duration of a financial
institution’s rate sensitive assets equals the
total dollar duration of its rate sensitive
liabilities.

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 Strategy 1 : Duration Management
 Bullet immunization seeks to ensure that a
specific sum of money will be available at a
point or series of points in the future. Cash
matching is the special case when cash is
generated exactly in line with cash demands.
 Another practice, known as duration matching,
aims to get interest rate risk and reinvestment
rate risk to cancel each other out.
 A dedicated portfolio is a separate portfolio that
will generate cash equal to or greater than
some required amount.

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 Active Management Strategies
 Strategy 2 : Yield Curve Reshaping
 If lower interest rates are expected, long-term
premium bonds may be exchanged for long-
term discount bonds, for example.
 Strategy 3 : Sector Selection
 Differences in market sectors sometimes cause
otherwise similar bonds to behave differently in
response to market changes.
 Strategy 4 : Issue Selection
 Analysts try to correctly anticipate bond rating
changes or make profitable substitution swaps.

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 Review

 Fixed Income Security Risk

 Default Risk
 Reinvestment Rate Risk
 Interest Rate Risk
 Duration
 Duration Measures
 Applying Duration

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 Review
 Convexity
 Problems with Duration
 Simple Convexity
 An Example
 Using Convexity
 Management Strategies
 Active vs. Passive Management
 Classic Passive Management Strategies
 The Risk of Barbells and Ladders
 Indexing
 Active Management

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