Portfolio Management and Financial Analysis

Managing Bond Portfolios

Tian Luan
Chair in Business Administration, Banking and Financial Management
Institute for Finance
Version November 2021
Slides are based on Bodie, Z., Kane, A., & Marcus, A. (2021) Investments (12th ed.). McGraw-Hill. Chapter 16.

Chapter 16 – Managing Bond Portfolios 1

Table of Content

Managing Bond Portfolios

− Duration
− Convexity
− Passive Bond Management
− Active Bond Management

Chapter 16 – Managing Bond Portfolios 2

 Bond Pricing Relationships
► Inverse relationship between price and yield
► An increase in a bond’s yield to maturity results in a smaller price decline than the gain
associated with a decrease in yield
► Long-term bonds tend to be more price sensitive than short-term bonds
► As maturity increases, price sensitivity increases at a decreasing rate
► Price sensitivity is inversely related to a bond’s coupon rate
► Price sensitivity is inversely related to the yield to maturity at which the bond is selling

Duration is a better measure of term than maturity:

► Duration for 30-year zero bond = 30
► Duration for 30-year coupon bond = 12.64
Maturity is same for both; however, interest rate sensitivity is smaller for coupon bonds.

Chapter 16 – Managing Bond Portfolios 3

Changes in Yield and Price

A vs. B – B has a longer TTM and is

more sensitive to changes in rates
B vs. C – B has the higher coupon,
which can be reinvested at the new
market rate and is less sensitive
C vs. D – both have the same coupon
and maturity, but different YTM.
Either C sold at discount or D at
premium.

Chapter 16 – Managing Bond Portfolios 4

Macaulay‘s Duration

So far, we stated…
► longer TTM implies a higher interest rate sensitivity
► higher coupon implies lower interest rate sensitivity
However, is this actually correct and how can we put both into perspective?

Duration
► Measure of the price sensitivity to changes in market yield rates
► A measure of the effective maturity of a bond.
► Incorporates timing and size of a securities cash flows.
► is shorter than maturity for all bonds except zero coupon bonds.
► is equal to maturity for zero coupon bonds.

Duration is a weighted average of the time until the expected cash flows from a
security will be received, relative to the security’s price.

Chapter 16 – Managing Bond Portfolios 5

 Duration of a Bond EXCEL

► Consider a 7% semi-annual coupon bond with 3 years to maturity and FV $100.

Assume that the bond is selling at 8% yield.

► Here, l = 0.08, m = 2, y = 0.04, n = 6, C = 3.5, F = 100.

Chapter 16 – Managing Bond Portfolios 6

Derivation of Macaulay's Duration
We know that the price of a bond (PB) equals the present value (PV) of its cash flows (CF):
T
CFt
PB = 
(1 + r )
t
t =1

If we want to measure the sensitivity of the price (PB) to changes in interest rate (r), we have to take the first
order derivative of PB with respect to r:
dPB T
− t  CFt
=
t =1 (1 + r )
t +1
dr
1
When the value of r is small, which is usually the case, it is fair to say, that the fraction (1 + r ) equates to 1.
Subsequently we can state the fraction separately and set it equal to 1:
dPB 1 T
− t  CFt T
− t  CFt
=   1  
dr (1 + r ) t =1 (1 + r ) t
t =1 (1 + r )
t

What is left is PB, which is the sum of the cash flows present values multiplied by –t:
T T
dPB CFt
=  −t  =  − t  ( PV ) CF
(1 + r ) t =1
t
dr t =1

According to Macaulay (1938) duration is defined as: „…total weighted average time for recovery of the
payments and principal in relation to the current market price of the bond.” So we have to divide by PB:
− t  CFt
− t  ( PV ) CF (1 + r )
t
T
Duration =  =
t =1 PB PB Chapter 16 – Managing Bond Portfolios 7
Practice Questions

1. What is the duration of a bond with a face value of $1,000, 10% annual coupon payments, 3
years until maturity and 12% YTM? The bond price is $951.96.
100  1 100  2 100  3 1,000  3
+ + +
(1.12) 1 (1.12) 2 (1.12) 3 (1.12) 3 2,597.6
D= 3
= = 2.73 years
100 1000 951.96
 (1.12) t + (1.12) 3
t =1

2. What is the duration of a bond with a face value of $1,000, 10% coupon, 3 years until
maturity and YTM of 5%? The bond price is $1,136.16.
100 * 1 100 * 2 100 * 3 1,000 * 3
1
+ + +
(1.05) (1.05) 2 (1.05) 3 (1.05) 3 3,127.31
D= = = 2.75 years
1136.16 1,136.16

3. What is the duration of a bond with a face value of $1,000, 10% coupon, 3 years until
maturity but the YTM is 20%? The bond’s price is $789.35.
100 * 1 100 * 2 100 * 3 1,000 * 3
1
+ + +
(1.20) (1.20) 2 (1.20) 3 (1.20) 3 2,131.95
D= = = 2.68 years
789.35 789.35

Chapter 16 – Managing Bond Portfolios 8

Duration/Price Relationship

► Price change is proportional to duration and not to maturity

P   (1 + y ) 
D* = −
D P
= −D    (1 + y ) = − D *  y
P  1+ y  P
Note:  y =  ( 1 + y )

► Normally the second equation (in the middle) is preferred to the first equation on the left-
hand side.→ Modified Duration (D*) → the percentage change in bond price is just the
product of the modified duration and the change in the bond’s yield to maturity.
► Because the percentage change in the bond price is proportional to modified duration,
modified duration is a natural measure of the bond’s exposure to changes in interest rates

BUT: This is only an approximation and not valid for large changes in the bond‘s yield. In case of
very small interest changes, the approximation becomes precise

Chapter 16 – Managing Bond Portfolios 9

Modified Duration

► By now we know that duration is a measures the sensitivity of a bond to interest changes
► Bonds with high (low) duration will lose (gain) more in value when rates increase (decrease)
► Modified duration helps to express the percentage change in the bonds value according to the percentage
change in the interest rate
D
D* = − Let's look at an example:
► Modified Duration:  y
1+  Semi-annual coupon bond with annual rate of 6%, TTM
 k of 3 years, Macaulay duration of 2.777 and a market rate
► Using modified duration, we can of 10%.
approximate the %-change in bond value Modified duration = 2.777 / (1+0.05)= 2.644
for a respective %-change in the yield:
Let us assume market rates increase by 0.05%.
P What is the effect on the bond value?
= − D * y %-change in PB = -2.644 * 0.05 = -1.322%
P
New price = 904.17 – (904.17 * 0.01322) = 892.22
Based on the exact excel calculation we get:
► The duration is a good approximation
Price Duration
for small interest changes, however, for longer TTM 10.5% 892.855 2.775
and larger interest rate changes the differences 10.0% 904.167 2.777
get more significant. The difference is because the Macaulay formula assumes
Figure
a linear bond value curve, although it is convex.

Chapter 16 – Managing Bond Portfolios 10

Practice Question

► Assume a 3-year annual coupon bond with a coupon rate of 10%

and a current market rate of 7%.

• What is the price?

$100 $100 $1100
PB = + + = $93.46 + $87.34 + $897.93 = $1'078.73
(1 + 0.07) (1 + 0.07)
1 2
(1 + 0.07) 3

• What is the Macaulay duration?

1 $93.46 2  $87.34 3  $897.93
Duration = + + = 2.7458
$1'078.73 $1'078.73 $1'078.73

• What is the modified duration?

Chapter 16 – Managing Bond Portfolios 12

Effective Duration

► Also referred to as “Option Adjusted Duration”

► Used to estimate a security’s price sensitivity when the security contains embedded options.
► Compares a security’s estimated price in a falling and rising rate environment.
► This is a more appropriate measure for any bond with an embedded option.
► Effective duration is usually evaluated with reference to modified duration, for a non-option bond ED = MD
► If an option is embedded, one can calculate ED for different interest rates (scenario analysis). The
difference between ED and MD gives an idea about the risk level of the embedded option
P
effective duration = P
r

( Pi- - Pi + ) / P0
ED =
(i + - i - )
Pi- = Price if rates fall
Pi+ = Price if rates rise
P0 = current market price
i+ = initial rate plus the increase in rate
i- = initial rate minus the decrease in rate

Chapter 16 – Managing Bond Portfolios 13

Practice Question

Consider a 3-year, 9.4 percent semi-annual coupon bond, which is selling for $10,000 (par-value). The YTM
is 9.4%

► Macaulay’s Duration for the option-free version of this bond is 5.36 semiannual periods, or 2.68 years.

► Modified Duration of this bond is 5.12 semiannual periods or 2.56 years.

Assume, instead, that the bond is callable at par in the near-term .

► If rates fall, the price will not rise much above the par value since it will likely be called.

► If rates rise, the bond is unlikely to be called and the price will fall.

What is the effective duration, if…

► rates rise 30 basis points to 5% semiannually, the price will fall to $9,847.72.

► rates fall 30 basis points to 4.4% semiannually, the price will remain at par

( $10,000 - $9,847.72 ) / $10,000

Effective Duration = = 2.54
(0.05 - 0.044)

Chapter 16 – Managing Bond Portfolios 14

Rules for Duration

Rule 1 The duration of a zero-coupon bond equals its time to maturity.

Rule 2 Holding maturity constant, a bond’s duration is higher when the coupon rate is lower.
Rule 3 Holding the coupon rate constant, a bond’s duration generally increases with its time
to maturity.
Rule 4 Holding other factors constant, the duration of a coupon bond is higher when the
bond’s yield to maturity is lower.
1+ y
Rule 5 The duration of a level perpetuity is equal to: D=
y

What Determines Duration?

► Duration of bonds of various coupon rates,
yields to maturity, and times to maturity are
plotted
► Duration allows to quantify the sensitivity,
which greatly enhances the ability to formulate
investment strategies.

Chapter 16 – Managing Bond Portfolios 15

Duration and Bond Portfolio

► The duration of a portfolio is the weighted average duration of all bonds in the portfolio
► Portfolio Managers can change the portfolios interest rate risk by changing duration
► Duration can be reduced by: (1) shorter maturities and (2) higher coupons
► Duration can be increased by: (1) longer maturities and (2) lower coupon bonds
► We can differentiate between active and passive investment management
► Passive, e.g. index tracker, where duration matches the benchmark
► Active, e.g. increasing (decreasing) portfolio duration to 105% (95%) of the benchmark in
times of falling (rising) interest rates

Portfolio Weight
Market Value Duration
Bond weight Duration
A $100'000 0.1 4 0.4
B $200'000 0.2 7 1.4
C $300'000 0.3 6 1.8
D $400'000 0.4 2 0.8
$1'000'000 1.0 - 4.4

Chapter 16 – Managing Bond Portfolios 16

Why is Duration better than Time-to-Maturity?

► Maturity is the point in time when you receive back your principal, which makes up the main
part of your payments
► Duration is the time it takes to recover your initial investment
► Therefore, the longer TTM and the lower the coupon → the higher the duration
► The following points have an impact on duration:
− The longer the maturity, the higher the duration
− The lower the coupon payment (i.e. interest rate) the higher the duration
→ the more cash you receive back, and the faster you receive it back, the lower the
duration.
► Duration combines the impact of both
components: maturity and coupon
► TTM is not a sufficient measure of interest rate
sensitivity, as instruments with the same
time-to maturity have different interest rate
sensitivity (e.g. zero-coupon vs. annual coupon)
Source: California Debt and Investment Advisory Commission

Chapter 16 – Managing Bond Portfolios 17

Wrap Up

► Changes in the value of a bond are inversely related to changes in the rate of return

► Long-term bonds have greater interest rate risk than short-term bonds

► Low coupon bonds have greater interest rate sensitivity than high coupon bonds

► As maturity increases, duration increases and the bond’s price becomes more sensitive to
interest rate changes
► As the bond coupon increases, its duration decreases and the bond becomes less sensitive to
interest rate changes
► As interest rates increase, duration decreases and the bond becomes less sensitive to further
rate changes

► Duration allows bonds of different maturities and coupon rates to be directly compared
► The higher the duration, the higher the risk of price changes as interest rates change

Source: California Debt and Investment Advisory Commission

Chapter 16 – Managing Bond Portfolios 18

Practice Question

How does each of these changes affect duration?

1. Having no coupon payments.

A zero coupon bond has a longer duration than a coupon paying one.

2. Decreasing the coupon rate.

A lower coupon has a higher duration, as money is received later.

3. Increasing the time to maturity.

Duration increases as maturity raises, since the principal (major CF stream) is received later.

4. Decreasing the yield-to-maturity.

Duration increases as YTM decreases.

Chapter 16 – Managing Bond Portfolios 19

Table of Content

Managing Bond Portfolios

− Duration
− Convexity
− Passive Bond Management
− Active Bond Management

Chapter 16 – Managing Bond Portfolios 20

Convexity

► So far, we have estimated the sensitivity of fixed income instruments to interest changes
through the first derivative of the present value.
► Duration is a precise approximation for small interest changes. Estimation error increases
when interest rate changes raise.
► Problem: present value curve is convex and therefore the linear approximation (tangent) is
not appropriate
► Convexity is the second order derivative of bond price with respect to yield divided by price
► Illustration shows the actual bond price movement on the red line and the duration
approximation sensitivity on the blue line

Chapter 16 – Managing Bond Portfolios 21

Convexity (II) EXCEL

► The first derivative of bond price (duration) is negative

… we can observe a downward sloping straight line
► Second derivative on bond price (convexity) is positive
… the ends of the curve are upward sloping
► The box below provides an example of a convexity calculation for a 4-year annual coupon
bond with a coupon rate of 4% and a market rate of 5%.
► Convexity can be annualized (e.g. for semi-annual coupon payments) by dividing the result by
m2 (m = no. payments per year)

(t 2
+ t )  ( PV ) CF
t  ( PV ) CF (1 + r )
T 2
CF
Pr ice = 
T T
Duration =  Convexity = 
(1 + r )
t
t =1 P P
t =1 t =1

Chapter 16 – Managing Bond Portfolios 22

Practice Question

► Given is a 6-year annual coupon bond with a coupon rate of 4% and par value of
$1‘000. The market interest rate is 4%. You are expected to calculate the following:
a) Price of the bond (P)
b) Duration (D)
c) Modified Duration (MD)
d) Convexity (C) Present
Period Payment Value Weight Duration Convexity
0 -1000
1 40 38.46 0.038 0.038462 0.07692
2 40 36.98 0.037 0.073964 0.22189
3 40 35.56 0.036 0.10668 0.42672
4 40 34.19 0.034 0.136769 0.68384
5 40 32.88 0.033 0.164385 0.98631
6 1040 821.93 0.822 4.931563 34.52094
SUM 1000.00 1.00 5.452 36.917
Duration = 5.452
Modified Duration = 5.242
Convexity = 34.1315

Chapter 16 – Managing Bond Portfolios 23

 Convexity (III)
► Assumption of Duration: For a bond with positive convexity (curvature), the number for convexity is
positive, regardless of whether the yield rises or falls. → correct, as the „old“ duration formula
always underestimates the new value of a bond following a change in its yield → the accountancy for
convexity always predicts a higher bond price.

► Investor Behavior: Convexity is generally considered a desirable trait. Bonds with greater curvature
gain more in price when yield falls than they lose less when yields rise; see chart: A and B have the
same duration at the initial yield. The plots of proportional price changes as a function of interest
rate changes are tangent, meaning that their sensitivities to changes in yields at that point are equal.

Convexity of two Bonds

► Bond A is more convex than bond B.
It enjoys greater price increases and smaller price
decreases. If rates are volatile, this is an attractive
asymmetry.
► Convexity can be increased by e.g. increasing maturity

Chapter 16 – Managing Bond Portfolios 24

Practice Question

Let's recall our earlier example:

► Given is a 6-year annual coupon bond with a coupon rate of 4% and par value of
$1‘000. The market interest rate is 4%. This time the same bond has a maturity of 4
years. You are expected to calculate the following:
a) Price of the bond (P)
b) Duration (D)
Present
c) Modified Duration (MD) Period Payment Value Weight Duration Convexity
0 -1000
d) Convexity (C) 1 40 38.46 0.038 0.03846 0.07692
2 40 36.98 0.037 0.07396 0.22189
3 40 35.56 0.036 0.10668 0.42672
4 1040 889.00 0.889 3.55599 17.77993
What are the differences? SUM 1000.00 1.00 3.775 18.505
Duration = 3.775
Modified Duration = 3.630

Convexity = 17.109

Chapter 16 – Managing Bond Portfolios 25

Combining Duration and Convexity EXCEL

P
► We recall the following relationship: = − D * y
P
► This implies, that the percentage price change is directly proportional to the change in bonds
yield

► However, this would mean that the change in yield would plot as a straight line (duration)

► We know that this is not true, therefore we correct for convexity, which yields the revised
relationship:
P 1
= − D *  y +  C o n v e x ity  (  y )
2

P 2

► Named also: the „duration-with-convexity rule“

See Bodie, Kane & Marcus (2011) page 520 – Example 16.2

Chapter 16 – Managing Bond Portfolios 26

Duration & Convexity of Callable Bonds

► Callable bonds show negative convexity below a certain yield.

► Negative convexity implies that if market yields decrease, duration decreases as well.

► In the chart, the callable bond behaves like an option-free bond at a rate above yield Y*.
► Positive convexity because, when interest rate > Y* bonds won’t be called, otherwise
issuer would have to refinance at higher rate.

► For market rate < Y*, we observe negative

convexity. This reflects the higher risk
that the bond will be called.
► At rates < *Y, the price of a callable bond P*

won't rise as much as the price of a plain

vanilla bond.
Y*

Chapter 16 – Managing Bond Portfolios 27

Duration & Convexity of Mortgage-Backed Securities

► The prepayment risk gives MBS the undesirable property of "negative convexity.“
► when market rates move, MBS prices adjust less favorably than prices of alternative securities
► MBS entail a similar property to callable bonds, since the mortgage lenders can pre-pay their
credit and take advantage of lower current market rates
► However, they are not as sensitive to a decline in interest rates, because homeowners do not
refinance their loans as soon as rates drop (e.g. plan to move soon, not worth the hustle, etc.)

Source: Nomura Fixed Income Research

Chapter 16 – Managing Bond Portfolios 28

Practice Question

1. Rank the following bonds in order of descending duration:

Bond A B C D E
Coupon (%) 15 15 0 8 15
Time to Maturity (Years) 20 15 20 20 15
Yield to Maturity (%) 10 10 10 10 15

2. Suppose you invest in zero coupon bonds. One matures in 1 year, paying $100, and its price is
$56.93. The other matures in 2 years, paying $1100, and its price is $943.07.
a) Compute the yield of each bond.
b) Compute the duration of each bond.
c) What is the weighted-average duration of a portfolio comprising each of these two
bonds. (Hint: for each bond, its portfolio weight is the fraction of the portfolio’s value
that is made up by each bond’s price)
d) Compute the duration of the portfolio composed of the two bonds.

Chapter 16 – Managing Bond Portfolios 29

Practice Question - Solution
1. C, D, A, B, E
2. a) Yield on 1-year bond = [($100/$56.93) *1]– 1 = 75.65%
Yield on a 2-year bond = [($1100/$943.07)* 1/2 ] – 1 = 8%
b) Duration for 1-year bond = 1 year (single payment).
Duration for 2-year bond = 2 years (single payment).
c) The weighted average duration for the portfolio is equal to:
1-year times ($56.93/$1000) + 2 years times ($943.07/$1000) = 1.943 years
d) Notice that the bond portfolio has the same payoff profile as a 2-year coupon bond with a 10%
coupon rate. It sells for a total price of $1,000=$56.93+$943.07. Since it sells at par value, its YTM
should be 10%. This is the YTM we will use for the duration of the portfolio computation. Specifically,
the duration for the portfolio is equal to:
1.909

Chapter 16 – Managing Bond Portfolios 30

Table of Content

Managing Bond Portfolios

− Duration
− Convexity
− Passive Bond Management
− Active Bond Management

Chapter 16 – Managing Bond Portfolios 31

Passive Bond Management
► Bond-Index Funds: Bond market indexing is similar to stock market indexing. The idea is to create
a portfolio that mirrors the composition of an index that measures the broad market. However:
− Those indexes include more than 5‘000 securities, making it quite difficult to purchase each
security in the index in proportion to its market value. Moreover, many bonds are thinly
traded (level of liquidity, secondary market).
− Rebalancing-Problems may occur as bonds are continually dropped from the index as their
maturities fall below 1 year. Additionally, new bonds are added when issued. Therefore, in
contrast to equity indexes, the portfolio of securities used to construct the index is
constantly changing.
► Immunization: In contrast to indexing, many institutions try to insulate their portfolios from
interest rate risk altogether. Generally, there are two ways of viewing this risk, depending on the
circumstances of the particular investor.
− Institutions such as banks, are concerned with protecting the current net worth or net
market value against interest rate fluctuations. → Duration of Assets = Duration of
Liabilities
− Other investors, such as pension funds, may face an obligation to make payments after a
given number of years. These investors are more concerned with protecting the future
values of their portfolios (target date immunization) → Holding period matches duration

Chapter 16 – Managing Bond Portfolios 32

Portfolio Immunisation

If the average duration of a portfolio equals the investor’s desired holding period, the investor’s
total return remains constant regardless of whether interest rates rise or fall.

Example:

► Assume we are interested in a $1,000 par value bond that will mature in two years.

► The bond has a coupon rate of 8 percent and pays $80 in interest at the end of each year.

► Interest rates on comparable bonds are also at 8 percent but may fall to as low as 6 percent
or rise as high as 10 percent.

► The buyer knows he will receive $1000 at maturity, but in the meantime, he faces the
uncertainty of having to reinvest the annual $80 in interest earnings at 6%, 8%, or 10%.

Chapter 16 – Managing Bond Portfolios 35

Immunisation – Example
Case 1 – Let interest rates fall to 6%.

► The bond will earn $80 in interest payments for year one, $80 for year two, and $4.80 ($80 x 0.06) when
the $80 interest income received in year 1 is reinvested at 6% rate during year 2.

How much will the investor earn over the two years?

► First year’s interest earnings + Second year’s interest earnings + Interest earned by reinvesting the first
year’s interest earnings at 6% + Par value of the bond at maturity.

► $80 + $80 + $4.80 + $1,000 = $1,164.80

Case 2 – Let interest rates rise to 10%.

► The bond will earn $80 in interest payments for year one, $80 for year two, and $8.00 ($80 x 0.10) when
the $80 interest income received in year 1 is reinvested at 10% during year 2.

How much will the investor earn over the two years?

► First year’s interest earnings + Second year’s interest earnings + Interest earned by reinvesting the first
year’s interest earnings at 10% + Par value of the bond at maturity.

► $80 + $80 + $8 + $1,000 = $1,168.00

Chapter 16 – Managing Bond Portfolios 36

Portfolio Immunisation & Duration

► The investor’s earnings could drop to $1,164.80 or rise to $1,168.

► But, if the investor can find a bond whose duration matches his or her planned holding
period, he or she can avoid this fluctuation in earnings.

▪ The bond can have a maturity that exceeds the investor’s holding period, but its
duration has to match.
Case 1 – Let interest rates fall to 6%.

► The bond will earn $80 in interest payments for year one, $80 for year two, and $4.80 ($80 x 0.06) when
the $80 interest income received the first year is reinvested at 6% rate during year 2.

▪ However, the bond’s market price will rise to $1,001.60 due to the decrease in interest rates.

How much will the investor earn over the two years?

► First year’s interest earnings + Second year’s interest earnings + Interest earned by reinvesting the first
year’s interest earnings at 6% + Market price of the bond at the end of the investor’s planned holding
period.

► $80 + $80 + $4.80 + $1,001.60 = $1,166.40

Chapter 16 – Managing Bond Portfolios 37

Immunisation – Example (continued)
Case 2 – Let interest rates rise to 10%.

► The bond will earn $80 in interest payments for year one, $80 for year two, and $8.00 ($80 x 0.10) when
the $80 interest income received the first year is reinvested at 10% during year 2.

▪ However, the bond’s market price will fall to $998.40, due to the rise in interest rates.

How much will the investor earn over the two years?

► First year’s interest earnings + Second year’s interest earnings + reinvestment gain of the first year’s
interest earnings reinvested at 10% + Par value of the bond at maturity.

► $80 + $80 + $8 + $998.40 = $1,166.40

► The investor earns identical total earnings even if interest rates go up or down.

▪ When the duration is set equal to the buyer’s planned holding period, a fall (rise) in the
reinvestment rate is completely offset by an increase (decrease) in the bond’s market price.

► Immunization using duration seems to work reasonably well.

► Investors can achieve effective immunization strategies by approximately matching the duration of their
portfolios with their planned holding periods.

Chapter 16 – Managing Bond Portfolios 38

Immunisation – Rebalancing

► Even if a position is immunized, the portfolio manager must rebalance the position in response to
changes in interest rates.

► Moreover, even if rates do not change, also the passage of time will affect duration and requires
rebalancing.

Of course, rebalancing of the portfolio entails transaction costs as assets are bought or sold, so one
cannot rebalance continuously.

The manager must find an appropriate tradeoff between the desire for perfect immunization, which
requires continual rebalancing, and the trading costs, which dictate less frequent rebalancing.

Chapter 16 – Managing Bond Portfolios 39

Cash Flow Matching and Dedication

Dedication Strategy: If an investor follows the principle of cash flow matching, one can
automatically immunize the portfolio from interest rate movements since the cash flow from the
bond and the obligation exactly offset each other.

− The strategy of cash flow matching on a multi-period basis is called dedication strategy. In
this case, the manager either selects zero-coupon or coupon bonds that provide in each
period total cash flows that match a series of obligations.

− The advantage of this strategy is the fact that it is a once-and-for-all approach to

eliminate interest rate risk. However, cash flow matching is not widely applied because of
the constraints on bond selection.

− Question: How would an increase in trading costs affect the attractiveness of dedication
versus immunization?
→ Dedication more attractive. Dedication does not require rebalancing.

Chapter 16 – Managing Bond Portfolios 40

Table of Content

Managing Bond Portfolios

− Duration
− Convexity
− Passive Bond Management
− Active Bond Management

Chapter 16 – Managing Bond Portfolios 41

Active Bond Management

Portfolio strategy of actively managing assets by restructuring the portfolio to take

advantage of market opportunities:
► Taking advantage of market inefficiencies
► Portfolio adjustment with changing market conditions
► Duration management
► Diversification of the portfolio.
► Selecting specific securities to enhance portfolio performance

Bond portfolios are commonly adjusted according to change in…

► Level of interest rates
► Shape of the yield curve
► Interest spreads across and between sectors
► Relative value of single investments

Chapter 16 – Managing Bond Portfolios 42

 Potential Sources of Profit
► Forecasting of interest rates
− If interest rates are expected to decline, managers will increase portfolio duration
− Thereby they increase the portfolio sensitivity, to gain from decreasing interest
rates.
− In case of an expected rise in rates, portfolio managers will decrease their portfolio
duration
► Identification of mispricing
− An analyst may disagree with a default premium associated with a certain firm
− Therefore the bond may be overpriced

* Homer, S. & Leibowitz, M. 2004. Inside the Yield Book. Bloomberg Press

Chapter 16 – Managing Bond Portfolios 43

Potential Sources of Profit (II)
► Substitution swap
− The two securities being swapped have similar coupon rates, maturity dates, call
features, credit quality, etc.
− Investors will most often participate in substitution swaps when they believe
there is a temporary discrepancy in bond prices due to market disequilibrium.
► Intermarket spread swap
− When an investor believes that the yield spread between two sectors of the
bond market is temporarily out of line.
− For example, if the current spread between corporate and government bonds is
considered too wide and is expected to narrow, the investor will shift from
government bonds into corporate bonds

Chapter 16 – Managing Bond Portfolios 44

Potential Sources of Profit (III)

► Rate anticipation swap

− Pegged to interest rate forecasting
− If investors believe that rates will fall, they will swap into bonds with longer
duration
− Conversely, when rates are expected to rise, they will swap to shorter duration
bonds
► Pure yield pickup swap
− When the yield curve is upward-sloping, the yield pickup swap entails moving
into longer-term bonds. This must be viewed as an attempt to earn an expected
term premium in higher-yield bonds.

Chapter 16 – Managing Bond Portfolios 45

Active Bond Management: Horizon Analysis

• Horizon analysis involves forecasting the realized compound yield over various
holding periods of investment horizons

– An analyst selects a particular holding period and predicts the yield curve at
the end of the period

– Given a bond’s time to maturity at the end of the holding period, its yield can
be read from the predicted yield curve and its end-of-period price can be
calculated

Chapter 16 – Managing Bond Portfolios 46

Practice Question
A newly issued bond has a maturity of 10 years and pays a 7% coupon rate (with annual coupon
payments). The bond sells at par value.

a) Calculate the convexity and the duration of the bond?

b) Find the actual price of the bond assuming that its yield to maturity immediately increases
from 7% to 8% (with maturity still 10 years).

c) What price would be predicted by the duration rule (equation 16.2)? What is the percentage
error of that rule?

d) What price would be predicted by the duration-with-convexity rule (equation 16.4)? What is
the percentage error of that rule?

Chapter 16 – Managing Bond Portfolios 47

Practice Question
A newly issued bond has a maturity of 10 years and pays a 7% coupon rate (with coupon payments coming
once annually). The bond sells at par value.

a) What are the convexity and the duration of the bond?

Convexity = 64.93 Duration = 7.515 years

a) Find the actual price of the bond assuming that its yield to maturity immediately increases from 7% to 8%
(with maturity still 10 years).
If the yield to maturity increases to 8%, bond price will fall to 93.29% of par value, a decrease of 6.71%.

a) What price would be predicted by the duration rule (equation 16.2)? What is the percentage error of that
rule?
The duration rule predicts a percentage price change of:
This overstates the actual percentage decrease in price by 0.31%. The price predicted by the duration rule
is 7.02% less than face value, or 92.98% of face value.

a) What price would be predicted by the duration-with-convexity rule (equation 16.4)? What is the
percentage error of that rule?
The duration-with-convexity rule predicts a percentage price change of:

The percentage error is 0.01%, which is substantially less than the error using the
Duration rule.

Chapter 16 – Managing Bond Portfolios 48

Thank you for your attention!

Chapter 16 – Managing Bond Portfolios 49