Managing Bond Portfolio: Content

7/15/2022
CONTENT
Chapter 5: 2
MANAGING BOND PORTFOLIO  1. The Analysis and Valuation of Bonds

 2. Interest Rate Sensitivity, Duration and Convexity
 3. Bond Portfolio Management Strategies
Lecturer: D r. L I N H D . N G U Y E N
FA C U LT Y O F F I N A N CE
BANKING UNIVERSITY OF HCMC
TS. Nguyễn Duy Linh
1 2
1. THE ANALYSIS AND VALUATION OF BONDS A. THE FUNDAMENTALS OF BOND VALUATION

3 4
 A. The fundamentals of bond valuation  The Present Value Model

 B. Computing bond yields  The Price-Yield Curve
 The Yield Model
 C. Bond Yield Curves
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THE FUNDAMENTALS OF BOND VALUATION THE FUNDAMENTALS OF BOND VALUATION

THE PRESENT VALUE MODEL THE PRESENT VALUE MODEL
5 6
 The value of a bond is the present value of the periodic interest  Example: Assuming a yield to maturity for this bond of 10%,
payments plus the present value of the principal payment: calculate the value of an 8% coupon bond that matures in 20
years with a par value of $1,000 in the following cases:
= + +. . . + +
(1 + ) (1 + ) (1 + ) (1 + )  A. Semiannual Compounding
Where:  B. Annual Compounding

 Annual interest payment:
o C = the annual coupon
1 payment
= 1− +
(1 + ) (1 + ) o i = the prevailing yield to
maturity for this bond issue
 Semi-annual interest payment: o n = the number of years to
maturity
/2 1
= 1− + o F = the par (face) value of the
/2 (1 + /2) (1 + /2)
bond
5 6
THE FUNDAMENTALS OF BOND VALUATION THE FUNDAMENTALS OF BOND VALUATION

THE PRICE-YIELD CURVE THE PRICE-YIELD CURVE
7 8
The Price-Yield Curve for a 20-Year, 8% Coupon Bond

 The price for a fixed-coupon bond moves in the
Price
2,500
opposite direction to changes in yield to maturity:
 1. When the yield is below the coupon rate, the bond will be
1,985
2,000 priced at a premium to its par value.
1,547
 2. When the yield is above the coupon rate, the bond will be
1,500
1,231
priced at a discount to its par value.
1,000
1,000 828  3. The price-yield relationship is convex (not a straight line)
699
600
523
 As yields decline, the price increases at an increasing rate; and, as
500
yields increase, the price declines at a declining rate
- YTM  This concept of a convex price–yield trade-off is referred to as
0% 2% 4% 6% 8% 10% 12% 14% 16% 18%
convexity
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THE FUNDAMENTALS OF BOND VALUATION

B. COMPUTING BOND YIELDS
THE YIELD MODEL
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 Instead of determining the value of a bond in dollar terms,  Nominal yield

investors often price bonds in terms of their yields—the
 Current yield
promised rates of return on bonds under certain assumptions
 If the computed promised bond yield is equal to or greater  Promised yield to maturity
than your required rate of return, you should buy the bond;
 If the computed promised yield is less than your required rate
of return, you should not buy the bond and you should sell it if
you own it
9 10
COMPUTING BOND YIELDS COMPUTING BOND YIELDS

NOMINAL YIELD CURRENT YIELD
11 12
 Nominal yield is the coupon rate of a particular issue,  A measure of how much of the investor’s return comes
e.g. a bond with an 8 percent coupon has an 8 percent in the form of annual cash payments would be to take
nominal yield. the ratio of the bond’s annual coupon and its current
 This provides a convenient way of describing the price
coupon characteristics of an issue. C
CY=
MP0
Where
 C is the fixed annual coupon
 MP0 is the bond’s current market price
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COMPUTING BOND YIELDS COMPUTING BOND YIELDS

PROMISED YIELD TO MATURITY PROMISED YIELD TO MATURITY
13 14
Prices of 8% semiannual coupon Bond, par value $1000

 YTM indicates the fully compounded rate of return
$1,000 x (1+4%)50 = $7,100
promised to an investor who buys the bond at $7,000
B
prevailing prices, if two assumptions hold true: $ 6,000
 The investor holds the bond to maturity $ 5,000

 The investor reinvest all the interim cash flows at the Interest-on-interest
$ 4,000 ($4,100)
computed YTM rate $3,000 A
$ 3,000
$ 2,000 Coupon Receipts $1,000 x 8% x 25 years

($2,000)
$ 1,000
Principal ($1,000)
0
5 10 15 20 25 Year
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COMPUTING BOND YIELDS

C. BOND YIELD CURVES
PROMISED YIELD TO MATURITY
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 Computing the Promised Yield to Maturity  The Determinants of Bond Yields

−  The Term Structure of Interest Rates
/2 +
= +
~  Determining the Shape of the Term Structure (Term
1+ 2 1+ 2 +
2 Structure Theories)
 YTM for a Zero-Coupon Bond
= = −1 ×2
1+
2
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BOND YIELD CURVES BOND YIELD CURVES

THE DETERMINANTS OF BOND YIELDS THE DETERMINANTS OF BOND YIELDS
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 Factors causing interest rates (i) to rise or fall are  Effect of Economic Factors
described by the following model:  The real risk-free rate of interest (RFR) is the economic cost of
money—that is, the opportunity cost necessary to compensate
= (RFR + ) + individuals for forgoing consumption
 RFR is determined by the real growth rate of the economy with
Economic Forces Issue Characteristics
short-run effects due to easing or tightening in the capital
market
 Where:
 The expected rate of inflation (I) is the other economic
 RFR = real risk-free rate of interest
influence on interest rates
 I = expected rate of inflation
 Add the expected level of inflation to the real risk-free rate
 RP = risk premium (RFR) to specify the nominal RFR, which is an observable rate
like the current yield on government T-bills
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THE DETERMINANTS OF BOND YIELDS THE TERM STRUCTURE OF INTEREST RATES
19 20
 The Impact of Bond Characteristics  The term structure of interest rates (or the yield curve)
 Issue characteristics are unique to individual securities relates the term to maturity to the yield to maturity for a
 Market sectors, countries will influence the bond’s risk premium
sample of bonds at a given point in time
 Bond investors separate the risk premium into four components:
1. The quality of the issue as determined by its risk of default  It represents a cross section of yields for a category of
relative to other bonds bonds that are comparable in all respects but maturity
2. The term to maturity of the issue, which can affect price  The quality of the issues should be constant, and ideally
volatility you should have issues with similar coupons and call
3. Indenture provisions, including collateral, call features, and
features within a single industry category
sinking-fund provisions
4. Foreign bond risk, including exchange rate risk and country
risk
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THE TERM STRUCTURE OF INTEREST RATES THE TERM STRUCTURE OF INTEREST RATES
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Yield to Maturity
A rising yield curve is formed when the A flat yield curve has approximately equal
yields on short-term issues are low and yields on short-term and long-term issues.
rise consistently with longer maturities
and flatten out at the extremes.
Term to Maturity A humped yield curve is formed when
yields on intermediate-term issues are
A declining yield curve is formed when
above those on short-term issues and the
the yields on short-term issues are high rates on long-term issues decline to levels
and yields on subsequently longer below those for the short term and then
maturities decline consistently. level out.
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DETERMINING THE SHAPE OF THE TERM STRUCTURE DETERMINING THE SHAPE OF THE TERM STRUCTURE
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 Expectations Hypothesis  Liquidity Preference Theory

 Any long-term interest rate simply represents the  Long-term securities should provide higher returns than
geometric mean of current and future one-year interest short-term obligations because investors are willing to
rates expected to prevail over the life of the issue sacrifice some yields to invest in short-maturity obligations
 It can explain any shape of yield curve to avoid the higher price volatility of long-maturity bonds
• Expectations for rising short-term rates in the future cause a  This theory argues that the yield curve should generally
rising yield curve slope upward and that any other shape should be viewed as a
• Expectations for falling short-term rates in the future will temporary aberration
cause a declining yield curve
• Similar explanations account for flat and humped yield
curves
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BOND YIELD CURVES 2. INTEREST RATE SENSITIVITY,

DETERMINING THE SHAPE OF THE TERM STRUCTURE DURATION AND CONVEXITY
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 Segmented-Market Hypothesis  A. Characteristics of interest rate sensitivity

 Different institutional investors have different maturity  B. Duration
needs that lead them to confine their security selections to
specific maturity segments; and yields for a segment depend  C. Convexity
on the supply and demand within that maturity segment
 This theory contends that the shape of the yield curve
ultimately is a function of the investment policies of major
financial institutions
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A. CHARACTERISTICS OF CHARACTERISTICS OF
INTEREST RATE SENSITIVITY INTEREST RATE SENSITIVITY
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D Initial
Bond Coupon Maturity  Bond prices and yields are inversely related: As yields
YTM
A 12% 5 years 10% increase, bond prices fall; as yields fall, bond prices rise.
Percentage Change in Bond Price
C
B 12% 30 years 10%
C 3% 30 years 10%
B  An increase in a bond’s YTM results in a smaller price
D 3% 30 years 6%
A
change than a decrease in yield of equal magnitude.
Face value ($) 1000 1000 1000
0 Time to maturity 20 20 20
0 Coupon rate 8% 8% 8%
A Coupon 80 80 80
B YTM 6% 10% 14%
C Price of bond 1,229.40 829.73 602.61
Change in Yield to Maturity (%) D Change in price 48% -27%
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CHARACTERISTICS OF CHARACTERISTICS OF
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 Long-term bonds tend to be more price sensitive to interest rate  Interest rate risk is inversely related to the bond’s coupon rate.
changes than short-term bonds (bond A vs. bond B) Prices of low-coupon bonds are more sensitive to changes in
 The sensitivity of bond prices to changes in yields increases at a interest rates than prices of high-coupon bonds. (B vs. C)
decreasing rate as maturity increases. Or interest rate risk is less than
proportional to bond maturity
 The sensitivity of a bond’s price to a change in its yield is
Face value ($) 1000 1000 1000 1000 1000 1000
Time to maturity 5 5 5 5 5 5 inversely related to the yield to maturity at which the bond
Coupon rate 8% 8% 8% 8% 8% 8%
Coupon 80 80 80 80 80 80 currently is selling. (C vs. D)
YTM 10% 12% 14% 16% 20% 22%
Price of bond 924.18 855.81 794.02 £738.06 641.13 599.09
Change in price -7% -14% -20% -31% -35%
Time to maturity 10 10 10 10 10 10
Change in price -16% -26% -34% -46% -51% Δ= -9% 120%
Change in price -24% -35% -43% -55% -59% Δ= -8% 48%
Change in price -27% -38% -46% -57% -61% Δ= -3% 14%
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CHARACTERISTICS OF CHARACTERISTICS OF
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 Prices of 8% semi-annual coupon bond, par value $1000  Prices of Zero-Coupon Bond (Semiannual Compounding)
Yield to Maturity (APR) T = 1 Year T = 10 Years T = 20 Years

Yield to Maturity (APR) T = 1 Year T = 10 Years T = 20 Years
8%
8% 9%
9% Fall in price (%)*
Fall in price (%)*
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DURATION
B. DURATION
DEFINITION
36 37
 Definition  A bond’s duration is often considered the second most

 Duration and Interest Rate Risk important statistic used to evaluate a bond, after the
 Duration Rules
YTM A measure of the effective maturity of a bond
 The notion of bond duration was first developed by
Frederick R. Macaulay (1938).
 Macaulay’s duration equals the weighted average of
the times to each coupon or principal payment
 The weights are proportional to the present value of the
payment
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DURATION
DEFINITION
38
 Macaulay’s duration formula:
/ 1+
= × =
 Where CFt = Cash flow at time t; P = Price of bond; y = YTM
 E.g: Let calculate duration of the two following bonds for a

yield to maturity of 10%:
 A coupon bond matures in 2 years, makes semiannual coupon
payments of 8% of the face value (1000$).
 A zero bond matures in 2 years, face value (1000$).
(semiannual compounding)
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/ 1+
= × =
 C = (8% × $1,000)/2 = $40

 P = $964.54
40 40 40 1,040
=1× +2× +3× +4×
(1 + 5%) × 964.5 (1.05) × 964.5 (1.05) × 964.5 (1.05) × 964.5
 D = 3.77 semi-annuals = 1.885 years
0 0 0 1,000/(1.05)
=1× +2× +3× +4×
(1 + 5%) × 964.5 (1.05) × 964.5 (1.05) × 964.5 1,000/(1.05)
• Duration = Maturity for zero coupon bonds

 D = 4 semi-annuals = 2 years • Duration < Maturity for coupon bonds
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DURATION DURATION
DEFINITION DURATION AND INTEREST RATE RISK
42 43
 Duration-Price Relationship  Two bonds have duration of 1.8852 years

 Price change is proportional to duration  Bond A: 2-year, 8% coupon bond with YTM = 10%
 Bond B: Zero coupon bond maturing
P   1  y  
 D     Suppose the semiannual interest rate (y, YTM) increases
P  1 y 
by 0.01%, from 5% to 5.01%. Let calculate changes in
 D* = Modified duration = D/(1+y) prices of these two bond.
Δ ∗
=− ×Δ
 Note: Δ(1 + y) = (1+y2) - (1+y1) = y2 - y1 = Δy
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DURATION
DURATION AND INTEREST RATE RISK
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Coupon Bond Zero

 The coupon bond price  The zero-coupon bond
drops from $964.540 to price drops from
$964.1942, when its yield $831.9704
increases to 5.01% ($1,000/1.053.7704) to
$831.6717
($1,000/1.05013.7704)
 Percentage decline of  Percentage decline of

0.0359% 0.0359%
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DURATION DURATION
DURATION RULES DURATION RULES
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 Rule 1  Rule 4
 The duration of a zero-coupon bond equals its time to  Holding other factors constant, the duration of a coupon
maturity bond is higher when the bond’s yield to maturity is lower
 Rule 2
 Holding maturity constant, a bond’s duration is higher when  Rule 5
the coupon rate is lower
 The duration of a level perpetuity is equal to:
 Rule 3
1 y
 Holding the coupon rate constant, a bond’s duration
generally increases with its time to maturity y
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DURATION DURATION
EXAMPLE EXAMPLE
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Bond Duration versus Bond Maturity Bond Durations (YTM = 8% APR; Semiannual Coupons)
35.0
Zero-Coupon Bond
30.0 Coupon Rates (per Year)
25.0 Maturity (years) 2% 4% 6% 8% 10%
20.0
1 0.995 0.990 0.985 0.981 0.976
Duration (Years)
5 4.742 4.533 4.361 4.218

15.0
15% Coupon 6% YTM 10 8.762 7.986 7.454 7.067 6.772
10.0
3% Coupon 15% YTM 20 14.026 11.966 10.922 10.292 9.870
15% Coupon 15% YTM
5.0
Infinite (perpetuity) 13.000 13.000 13.000 13.000
0.0
2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Maturity Settlement date 01/01/2000
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CONVEXITY
C. CONVEXITY
INTRODUCTION
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 Introduction  The relationship between bond prices and yields is

 Why Do Investors Like Convexity? not linear
 Duration rule is a good approximation for only small
changes in bond yields
 Bonds with greater convexity have more curvature
in the price-yield relationship
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CONVEXITY CONVEXITY
INTRODUCTION INTRODUCTION
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 30-Year Maturity, 8% Coupon; Initial YTM = 8%

1
= ( + )
Actual Price Change × (1 + ) (1 + )
Duration Approximation
 Correction for Convexity:
Δ ∗
1
=− × Δ + [Convexity × (Δ ) ]
0 2
0
Change in Yield to Maturity (%)

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CONVEXITY CONVEXITY
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 Example: Compute the convexity of 3-year bond, 12%  Example: 30-Year Bond, 8% Coupon, 8% YTM, Price
annual coupon, 9% YTM. = par value = $1,000; Modified Duration: 11.26 years;
Convexity: 212.4.
 A. Calculate the price of bond when:
 A1. YTM = 10%
 A2. YTM = 8.1%
 B. Calculate changes in bond price by using duration,
convexity when:
 B1. Bond’s yield increases from 8% to 10%
 B2. Bond’s yield increases from 8% to 8.1%
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CONVEXITY CONVEXITY
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 Bond’s yield increases from 8% to 10%  ΔP/P = ________.  Bond’s yield increases from 8% to 8.1%  ΔP/P = _________
 The duration rule would predict a price decline of:  The duration rule would predict a price decline of:
 Accounting for convexity, we get almost the precisely correct

 which is considerably ___________ the bond price actually falls.
answer:
The duration-with-convexity rule is far more accurate:
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CONVEXITY CONVEXITY
WHY DO INVESTORS LIKE CONVEXITY? WHY DO INVESTORS LIKE CONVEXITY?
63 64
 Convexity of Two Bonds  Higher Convexity  Bigger price increases when

yields fall than loses when yields rise
 The more volatile interest rates, the more attractive
this asymmetry
 Bonds with greater convexity  higher prices
and/or lower yields, all else equal
0
0
Bond A  Is bond A or B better?
Change in Yield to Maturity (%) Bond B

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SMART GOALS
3. BOND PORTFOLIO MANAGEMENT STRATEGIES
HOW TO MAKE YOUR GOALS ACHIEVABLE
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 A. Passive Bond Management  SMART is an acronym that you can use to guide your goal
setting. To make sure your goals are clear and reachable,
 B. Active Bond Management
each one should be:
 Specific (simple, sensible, significant).
 Measurable (meaningful, motivating).
 Achievable (agreed, attainable).
 Relevant (reasonable, realistic and resourced, results-based).
 Time bound (time-based, time limited, time/cost limited,

timely, time-sensitive).
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PASSIVE BOND MANAGEMENT

A. PASSIVE BOND MANAGEMENT
A1. BOND-INDEX FUNDS
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 A1. Bond-index funds  In principle, bond market indexing is similar to stock market
indexing. The idea is to create a portfolio that mirrors the
 A2. Immunization composition of an index that measures the broad market
 A3. Cash flow matching and dedication  Three major indexes of the U.S. bond market are:
 Barclays Capital U.S. Aggregate Bond Index,
 Citigroup U.S. Broad Investment Grade (USBIG) Index
 Bank of America/Merrill Lynch Domestic Master index.
 All are market-value-weighted indexes of total returns. All
three include government, corporate, mortgage-backed, and
Yankee bonds in their universes.
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PASSIVE BOND MANAGEMENT PASSIVE BOND MANAGEMENT

BOND-INDEX FUNDS BOND-INDEX FUNDS
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 Stratification of bonds into cells

Contains thousands of
issues, many of which
are infrequently traded
They only hold a
representative
sample of the
bonds in the actual
index
Turnover more than
stock indexes as the
bonds mature
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A2. IMMUNIZATION IMMUNIZATION
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 Control interest rate risk  Example: An insurance company that issues a guaranteed
investment contract, or GIC, for $10,000 (Essentially, GICs are
 Widely used by pension funds, insurance companies, zero-coupon bonds issued by the insurance company to its
and banks customers. They are popular products for individuals’ retirement-
 The interest rate exposure of assets and liabilities are savings accounts.) If the GIC has a 5-year maturity and a
guaranteed interest rate of 8%, the obligation of this firm after 5
matched in the portfolio years will be:
 Match the duration of the assets and liabilities $10,000 × 1.085= $14,693.28
 Price risk and reinvestment rate risk exactly cancel out  What should this firm do to fund this obligation?
 Value of assets match liabilities whether rates rise/fall  Suppose that the insurance company chooses to fund its
obligation with $10,000 of 8% annual coupon bonds, selling at
par value, with six years to maturity.
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IMMUNIZATION IMMUNIZATION
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 The obligation of this firm after 5 years = $14,693.28  The obligation of this firm after 5 years = $14,693.28
 If rates (discount rate, market rate) remain at 8%,
0 1 2 3 4 5 6  If rates (discount rate, market rate) fall to 7%,
800 800 800 800 800 800 +

 The accumulated funds from the bond = __________
10,000  Net position = __________
 If rates (discount rate, market rate) increase to 9%,

 Net position = __________
 Net position = ___________________
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IMMUNIZATION
78
 Calculate Duration of GIC and of the annual coupon bond.
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IMMUNIZATION IMMUNIZATION – EXAMPLE 1
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Accumulated Value of Invested Funds

 An insurance company must make a payment of
Figure: Growth of invested funds. $19,487.171 at the end of the seventh years. The market
interest rate is 10%.
The solid-coloured curve
represents the growth of portfolio  The company’s portfolio manager wishes to fund the
Funds
value at the original interest rate. If obligation using 3-year zero-coupon bonds and perpetuities
interest rates increase at time t*, paying annual coupons.
the portfolio value initially falls but
a) How can the manager immunize the obligation?
increases thereafter at the faster
rate represented by the broken b) Suppose that one year has passed, and the interest rate
curve. At time D (duration), the remains at 10%. The portfolio manager needs to re-
curves cross. examine her position. Is the position still fully funded? Is it
0 t* D
still immunized? If not, what actions are required?
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IMMUNIZATION – EXAMPLE 1A
82
 The present value of the obligation is __________.

 Immunization requires that the duration of the portfolio
of assets ________ the duration of the liability:
 Calculate the duration of the liability: It is a single-payment
obligation with duration of ____________.
 Calculate the duration of the asset portfolio: The duration of
the zero-coupon bond is simply its maturity, ___________.
The duration of the perpetuity is ____________. Hence, the
portfolio duration will be:
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IMMUNIZATION – EXAMPLE 1A IMMUNIZATION – EXAMPLE 1B
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 Find the asset mix that sets the duration of assets  b) Suppose that one year has passed, and the interest rate remains
equal to the 7-year duration of liabilities: We have to at 10%. The portfolio manager needs to re-examine her position.
Is the position still fully funded? Is it still immunized? If not,
solve for w in the following equation:
what actions are required?
 Fully fund the obligation: w = _____, should buy:

 _____ of the zero-coupon bond (YTM = 10%)
 _____ of the perpetuity (coupon rate = 10%)
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IMMUNIZATION – EXAMPLE 1B IMMUNIZATION – EXAMPLE 1B
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 First, examine funding.  w = 5/9

 The present value of the obligation will have grown to $________.  To rebalance the portfolio and maintain the duration match, the
 The manager’s funds also have grown to $_______: The zero-coupon manager now must invest a total of ____________________ in
bonds have increased in value from $5,000 to $________ with the the zero-coupon bond.
passage of time, while the perpetuity has paid its annual ____ coupon
and remains worth $_______.
 Total income =  This requires that the entire ______ coupon payment be invested
 Therefore, the obligation is still fully funded.
in the zero, with an additional _______ of the perpetuity sold and
invested in the zero-coupon bond.
 Second, the portfolio weights must be changed. The zero-coupon
bond now has a duration of ____ years, while the perpetuity’s
duration remains at 11 years. The obligation is now due in ____
years. The weights must now satisfy the equation:
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IMMUNIZATION – EXAMPLE 2
91
 In next 2 years, firm A will be paying $5,000 to firm B at the

end of each year. Bonds currently yield 5%.
a. What is the present value and duration of your obligation?
b. What maturity zero-coupon bond would immunize your
obligation?
c. Suppose you buy a zero-coupon bond with value and
duration equal to your obligation. Now suppose that rates
immediately increase to 7%. What happens to your net
position?
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INDEXING VS. IMMUNIZATION
CASH FLOW MATCHING
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 Both see market prices as being correct  Cash Flow Matching and Dedication
 Differ greatly in terms of risk  Cash flow matching = Automatic immunization
 Cash flow matching is a dedication strategy
 Not widely used because of constraints associated with bond

choices
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ACTIVE BOND MANAGEMENT

B. ACTIVE BOND MANAGEMENT
B1. SOURCES OF POTENTIAL PROFIT
96 97
 B1. Sources of potential profit  Two sources of potential value in active bond management:
 The first is interest rate forecasting, which tries to anticipate
 B2. Horizon analysis
movements across the entire spectrum of the fixed-income
market. If interest rate declines are anticipated, managers will
increase portfolio duration (and vice versa).
 The second is identification of relative mispricing within the
fixed-income market. An analyst, for example, might believe
that the default premium on one particular bond is
unnecessarily large and therefore that the bond is underpriced.
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ACTIVE BOND MANAGEMENT ACTIVE BOND MANAGEMENT

SOURCES OF POTENTIAL PROFIT SOURCES OF POTENTIAL PROFIT
98 99
 Swapping Strategies  Swapping Strategies (cont.)

 Substitution swap: is an exchange of one bond for a nearly  Rate anticipation swap: is pegged to interest rate
identical substitute, but the market has temporarily forecasting. If investors believe that rates will fall, they will
mispriced the two bonds, and that the discrepancy between swap into bonds of longer duration.
the prices of the bonds represents a profit opportunity.
 Pure yield pickup swap: is pursued not in response to
 Intermarket spread swap: is pursued when an investor perceived mispricing, but as a means of increasing return
believes that the yield spread between two sectors of the by holding higher-yield bonds.
bond market is temporarily out of line.
 Tax swap: to exploit some tax advantage
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ACTIVE BOND MANAGEMENT ACTIVE BOND MANAGEMENT

B2. HORIZON ANALYSIS HORIZON ANALYSIS - EXAMPLE
100 101
 Select a particular holding period and predict the yield  A 20-year maturity bond with a 10% coupon rate (paid
curve at end of period annually) currently sells at a yield to maturity of 9%.
 A portfolio manager with a 2-year horizon needs to forecast the
 Given a bond’s time to maturity at the end of the
total return on the bond over the coming two years. In two
holding period, its yield can be read from the predicted
years, the bond will have an 18-year maturity. The analyst
yield curve and the end-of-period price can be forecasts that two years from now, 18-year bonds will sell at
calculated yields to maturity of 8%, and that coupon payments can be
 Then the analyst adds the coupon income and reinvested in short-term securities over the coming two years
prospective capital gain of the bond to find the total at a rate of 7%.
return on the bond over the holding period.  What is his total return on the bond over the coming two
years?
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ACTIVE BOND MANAGEMENT

HORIZON ANALYSIS - EXAMPLE
102
 To calculate the 2-year return on the bond, the analyst would

perform the following calculations:
 Current price = $100 × Annuity factor (9%, 20 years) + $1,000
× PV factor (9%, 20 years) = $1,091.29
 Forecast price = $100 × Annuity factor (8%, 18 years) + $1,000
× PV factor (8%, 18 years) = $1,187.44
 The future value of reinvested coupons will be ($100 × 1.07) +
$100 = $207
 The 2-year return is [$207 + ($1,187.44 − $1,091.29)]/
$1,091.29 = 0.278, or 27.8%
 The annualized rate of return over the 2-year period would then
be 1.2781/2 − 1 = 0.13, or 13%.
TS. Nguyễn Duy Linh
102

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7/15/2022

MANAGING BOND PORTFOLIO  1. The Analysis and Valuation of Bonds

TS. Nguyễn Duy Linh

1. THE ANALYSIS AND VALUATION OF BONDS A. THE FUNDAMENTALS OF BOND VALUATION

 A. The fundamentals of bond valuation  The Present Value Model

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

THE FUNDAMENTALS OF BOND VALUATION THE FUNDAMENTALS OF BOND VALUATION

Where:  B. Annual Compounding

THE FUNDAMENTALS OF BOND VALUATION THE FUNDAMENTALS OF BOND VALUATION

The Price-Yield Curve for a 20-Year, 8% Coupon Bond

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

THE FUNDAMENTALS OF BOND VALUATION

 Instead of determining the value of a bond in dollar terms,  Nominal yield

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

COMPUTING BOND YIELDS COMPUTING BOND YIELDS

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

COMPUTING BOND YIELDS COMPUTING BOND YIELDS

Prices of 8% semiannual coupon Bond, par value $1000

 The investor holds the bond to maturity $ 5,000

$ 2,000 Coupon Receipts $1,000 x 8% x 25 years

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

COMPUTING BOND YIELDS

 Computing the Promised Yield to Maturity  The Determinants of Bond Yields

 YTM for a Zero-Coupon Bond

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

BOND YIELD CURVES BOND YIELD CURVES

BOND YIELD CURVES BOND YIELD CURVES

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

BOND YIELD CURVES BOND YIELD CURVES

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

BOND YIELD CURVES BOND YIELD CURVES

 Expectations Hypothesis  Liquidity Preference Theory

BOND YIELD CURVES 2. INTEREST RATE SENSITIVITY,

 Segmented-Market Hypothesis  A. Characteristics of interest rate sensitivity

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

Yield to Maturity (APR) T = 1 Year T = 10 Years T = 20 Years

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

 Definition  A bond’s duration is often considered the second most

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

 Macaulay’s duration formula:

 Where CFt = Cash flow at time t; P = Price of bond; y = YTM

 E.g: Let calculate duration of the two following bonds for a

 C = (8% × $1,000)/2 = $40

 D = 3.77 semi-annuals = 1.885 years

• Duration = Maturity for zero coupon bonds

TS. Nguyễn Duy Linh 40 TS. Nguyễn Duy Linh 41

 Duration-Price Relationship  Two bonds have duration of 1.8852 years

 Note: Δ(1 + y) = (1+y2) - (1+y1) = y2 - y1 = Δy

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

Coupon Bond Zero

 Percentage decline of  Percentage decline of

TS. Nguyễn Duy Linh 44 TS. Nguyễn Duy Linh

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

5 4.742 4.533 4.361 4.218

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

 Introduction  The relationship between bond prices and yields is

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

 30-Year Maturity, 8% Coupon; Initial YTM = 8%

 Correction for Convexity:

Change in Yield to Maturity (%)

TS. Nguyễn Duy Linh TS. Nguyễn Duy Linh

 Accounting for convexity, we get almost the precisely correct