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.
 DURATION
Duration 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
------------ -----------------------------
Yield ( 1+ yield)number of payments - 1
 The duration of a coupon bond
approximately is:
1 + y - ( 1 + y) + T ( c – y)
------- ----------------------------
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 Strategies
 Difficulties in Maintaining Immunization
Strategy
 Rebalancing required as duration declines
more slowly than term to maturity
 Modified duration changes with a change in

market interest rates

 Yield 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 swap
 Swapping low-coupon bonds into higher
coupon bonds
 Tax 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.