Bond Portfolio Management

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Bond Portfolio Management

  1. 1. BOND PORTFOLIO MANAGEMENT
  2. 2. BOND PORTOLIOS <ul><li>METHODS OF MANAGEMENT </li></ul><ul><ul><li>Passive </li></ul></ul><ul><ul><ul><li>rests on the belief that bond markets are semi-strong efficient </li></ul></ul></ul><ul><ul><ul><li>current bond prices viewed as accurately reflecting all publicly available information </li></ul></ul></ul>
  3. 3. BOND PORTOLIOS <ul><li>METHODS OF MANAGEMENT </li></ul><ul><ul><li>Active </li></ul></ul><ul><ul><ul><li>rests on the belief that the market is not so efficient </li></ul></ul></ul><ul><ul><ul><li>some investors have the opportunity to earn above-average returns </li></ul></ul></ul>
  4. 4. BOND PRICING THEOREMS <ul><li>5 BOND PRICING THEOREMS </li></ul><ul><ul><li>for a typical bond making periodic coupon payments and a terminal principal payment </li></ul></ul>
  5. 5. BOND PRICING THEOREMS <ul><li>5 BOND PRICING THEOREMS </li></ul><ul><ul><li>THEOREM 1 </li></ul></ul><ul><ul><ul><li>If a bond’s market price increases </li></ul></ul></ul><ul><ul><ul><li>then its yield must decrease </li></ul></ul></ul><ul><ul><ul><li>conversely if a bond’s market price decreases </li></ul></ul></ul><ul><ul><ul><li>then its yield must increase </li></ul></ul></ul>
  6. 6. BOND PRICING THEOREMS <ul><li>5 BOND PRICING THEOREMS </li></ul><ul><ul><li>THEOREM 2 </li></ul></ul><ul><ul><ul><li>If a bond’s yield doesn’t change over its life, </li></ul></ul></ul><ul><ul><ul><li>then the size of the discount or premium will decrease as its life shortens </li></ul></ul></ul>
  7. 7. BOND PRICING THEOREMS <ul><li>5 BOND PRICING THEOREMS </li></ul><ul><ul><li>THEOREM 3 </li></ul></ul><ul><ul><ul><li>If a bond’s yield does not change over its life </li></ul></ul></ul><ul><ul><ul><li>then the size of its discount or premium will decrease </li></ul></ul></ul><ul><ul><ul><li>at an increasing rate as its life shortens </li></ul></ul></ul>
  8. 8. BOND PRICING THEOREMS <ul><li>5 BOND PRICING THEOREMS </li></ul><ul><ul><li>THEOREM 4 </li></ul></ul><ul><ul><ul><li>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 </li></ul></ul></ul><ul><ul><ul><li>the price-yield relationship is convex </li></ul></ul></ul>
  9. 9. BOND PRICING THEOREMS <ul><li>5 BOND PRICING THEOREMS </li></ul><ul><ul><li>THEOREM 5 </li></ul></ul><ul><ul><ul><li>the percentage change in a bond’s price owing to a change in its yield will be smaller if the coupon rate is higher </li></ul></ul></ul>
  10. 10. CONVEXITY <ul><li>CONVEXITY DEFINITION: </li></ul><ul><ul><li>a measure of the curvedness of the price-yield relationship </li></ul></ul>
  11. 11. CONVEXITY <ul><li>THE PRICE-YIELD RELATIONSHIP </li></ul>YTM Price
  12. 12. CONVEXITY <ul><li>THEOREM 1 TELLS US </li></ul><ul><ul><li>price and yield are inversely related but not in a linear fashion (see graph) </li></ul></ul><ul><ul><li>an increase in yield is associated with a drop in bond price </li></ul></ul><ul><ul><li>but the size of the change in price when yield rises is greater than the size of the price change when yield falls </li></ul></ul>
  13. 13. DURATION <ul><li>DEFINITION: </li></ul><ul><ul><li>measures the “average maturity” of a stream of bond payments </li></ul></ul><ul><ul><li>it is the weighted average time to full recovery of the principal and interest payments </li></ul></ul>
  14. 14. DURATION <ul><li>FORMULA </li></ul><ul><li>where P 0 = the current market price of the bond </li></ul><ul><li> PV(C t )= the present value of the coupon payments </li></ul><ul><li>t = time periods </li></ul>
  15. 15. DURATION <ul><li>THE RELATION OF DURATION TO PRICE CHANGES </li></ul><ul><ul><li>THEOREM 5 implies </li></ul></ul><ul><ul><ul><li>bonds with same maturity date but different coupon rates may react differently to changes in the interest rate </li></ul></ul></ul><ul><ul><ul><li>duration is a price-risk indicator </li></ul></ul></ul>
  16. 16. DURATION <ul><li>DURATION IS A PRICE-RISK INDICATOR </li></ul><ul><ul><li>FORMULA </li></ul></ul><ul><ul><li>rewritten </li></ul></ul><ul><ul><li>where y = the bond’s yield to maturity </li></ul></ul>
  17. 17. DURATION <ul><li>MODIFIED DURATION </li></ul><ul><ul><li>FORMULA: </li></ul></ul><ul><ul><li>reflects the bond’s % price change for a one percent change in the yield </li></ul></ul>
  18. 18. DURATION <ul><li>THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION </li></ul><ul><ul><li>whereas duration would have us believe that the relationship between yield and price change is linear </li></ul></ul><ul><ul><li>convexity shows us otherwise </li></ul></ul>
  19. 19. DURATION <ul><li>THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION </li></ul>YTM P C 0
  20. 20. IMMUNIZATION <ul><li>DEFINITION: a bond portfolio management technique which allows the manager to be relatively certain of a given promised cash stream </li></ul>
  21. 21. IMMUNIZATION <ul><li>HOW TO ACCOMPLISH IMMUNIZATION </li></ul><ul><ul><li>Duration of a portfolio of bonds </li></ul></ul><ul><ul><ul><li>equals the weighted average of the individual bond durations in the portfolio </li></ul></ul></ul><ul><ul><li>Immunization </li></ul></ul><ul><ul><ul><li>calculate the duration of the promised outflows </li></ul></ul></ul><ul><ul><ul><li>invest in a portfolio of bonds with identical durations </li></ul></ul></ul>
  22. 22. IMMUNIZATION <ul><li>PROBLEMS WITH IMMUNIZATION </li></ul><ul><ul><li>default and call risk ignored </li></ul></ul><ul><ul><li>multiple nonparallel shifts in a nonhorizontal yield curve </li></ul></ul><ul><ul><li>costly rebalancing ignored </li></ul></ul><ul><ul><li>choosing from a wide range of candidate bond portfolios is not very easy </li></ul></ul>
  23. 23. ACTIVE MANAGEMENT <ul><li>TYPES OF ACTIVE MANAGEMENT </li></ul><ul><ul><li>Horizon Analysis </li></ul></ul><ul><ul><ul><li>simple holding period selected for analysis </li></ul></ul></ul><ul><ul><ul><li>possible yield structures at the end of period are considered </li></ul></ul></ul><ul><ul><ul><li>sensitivities to changes in key assumptions are estimated </li></ul></ul></ul>
  24. 24. ACTIVE MANAGEMENT <ul><li>TYPES OF ACTIVE MANAGEMENT </li></ul><ul><ul><li>Bond Swapping </li></ul></ul><ul><ul><ul><li>exchanging bonds to take advantage of superior ability to predict yields </li></ul></ul></ul><ul><ul><ul><li>Categories: </li></ul></ul></ul><ul><ul><ul><ul><li>substitution swap </li></ul></ul></ul></ul><ul><ul><ul><ul><li>intermarket spread swap </li></ul></ul></ul></ul><ul><ul><ul><ul><li>rate anticipation swap </li></ul></ul></ul></ul><ul><ul><ul><ul><li>pure yield pickup swap </li></ul></ul></ul></ul>
  25. 25. ACTIVE MANAGEMENT <ul><li>TYPES OF ACTIVE MANAGEMENT </li></ul><ul><ul><li>Contingent Immunization </li></ul></ul><ul><ul><ul><li>portfolio managed actively as long as favorable results are obtained </li></ul></ul></ul><ul><ul><ul><li>if unfavorable, then immunize the portfolio </li></ul></ul></ul>
  26. 26. PASSIVE MANAGEMENT <ul><li>TYPES OF PASSIVE MANAGEMENT </li></ul><ul><ul><li>INDEXATION </li></ul></ul><ul><ul><ul><li>the portfolio is formed to track a chosen index </li></ul></ul></ul>
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