Investment Management

University of Colombo

Fixed Income Securities and Bond

Portfolio Management

P.D. Nimal

8/18/2023 Prepared by P D Nimal 1

Types of Fixed Income Securities
 Savings Deposits
 Money Market Instruments
 Commercial Papers
 Certificate of Deposits
 Bankers Acceptance
 Repo
 Government Securities
 Treasury Bills
 Treasury Notes
 Treasury Bonds
 Corporate Bonds
Bond Attributes
 Length time until maturity
 Coupon rate
 Call and put provisions
 Tax status
 Marketability - Liquidity
 Likelihood of default
 Bond rating are often interpreted as an
indication of likelihood of default by issuer
 Bond Pricing
Price at a coupon date

 Present Value of Future Cash flows

 Future Cash Flows
 Spot/Zero Rates
 Discount Factors

8/18/2023 Prepared by P D Nimal 4

Example
 A Rs.1000 bond, redeemable at par
on October 1, 2016, is paying bond
interest at rate j2=9%. Find the
purchase price on October 1, 2014,
to yield 10% per annum
compounded semiannually.

8/18/2023 Prepared by P D Nimal 5

PV Rs.1000, Maturity Oct. 1, 2016, CR j2=9%. Find the
purchase price on Oct. 1, 2014, to yield 10% per annum
compounded semiannually.

TTM Coupon Adjustmen

T Yield Earned Price B/C Price A/C
(Years) received t

2 - - -
0 982.27
49.11 45.00 1031.38 -4.11
1 1.5 986.38
49.32 1035.70
2 1.0 45.00 -4.32 990.70
49.54 1040.24
3 0.5 45.00 -4.54 995.24
49.76 1045.00
4 0.0 45.00 -4.76 1000.00
197.73 180.00 -17.73

8/18/2023 Prepared by P D Nimal 6

Behavior of BP at 10% yield

T Price
0 982.27
1 1,031.38
1 986.38
2 1,035.70
2 990.70
3 1,040.24
3 995.24
4 1,045.00
4 1,000.00

8/18/2023 Prepared by P D Nimal 7

PV Rs.1000, Maturity Oct. 1, 2016, CR j2=9%. Find the
purchase price on Oct. 1, 2014, to yield 8% per annum
compounded semiannually.

Coupon
TTM (Years) Yield Earned Price B/C Adjustment Price A/C
received

2 - - -
1018.15
40.73 45.00 1058.88 4.27
1.5 1013.88
40.56 1054.43
1.0 45.00 4.44 1009.43
40.38 1049.81
0.5 45.00 4.62 1004.81
40.19 1045.00
0.0 45.00 4.81 1000.00
161.86 180.00 18.14 1000.00

8/18/2023 Prepared by P D Nimal 8

 Behavior of the BP at 8% yield

T Price

0 1,018.15
1 1,058.88
1 1,013.88
2 1,054.43
2 1,009.43
3 1,049.81
3 1,004.81
4 1,045.00
4 1,000.00

8/18/2023 Prepared by P D Nimal 9

 Convergence of BP to the FV at the
maturity

Y-
TTM Y - 8% 10%

2 1018.15 982.27

1.5 1013.88 986.38

1 1009.43 990.70

0.5 1004.81 995.24

0 1000.00 1000.00

8/18/2023 Prepared by P D Nimal 10

Price between interest dates

Po P P1

 Theoretical price

 Practical calculation

8/18/2023 Prepared by P D Nimal 11

Price between interest dates
 Practical purchase price

 Price at next coupon date

 Market quoted price

 Accrued interest

 Thus the purchase price equal to

8/18/2023 Prepared by P D Nimal 12

Example cont.
 Find the purchase price of the bond
on February 14, 2015, to yield 10%
per annum compounded
semiannually and determine the
market price, accrued bond interest,
and market quotation on February
14, 2015

8/18/2023 Prepared by P D Nimal 13

Days counting
 Days from Oct. 01 to Apr. 01 of 2012 is 183
days (31+30+31+31+28+31=182)

 Days from Oct. 01 to Feb. 14 of 2012 is 136

days (31+30+31+31+13=136)

 Days from Feb. 14 to Apr. 01 of 2012 is 47

days (15+31=46)

8/18/2023 Prepared by P D Nimal 14

Calculate the Bond Price at Feb. 14th
when Yield is 10%
 Price at Oct. 01 2014 P0 =982.27
 Practical purchase price

 Price at next coupon date

 Market quoted price

 Accrued interest

 Thus the purchase price equal to

8/18/2023 Prepared by P D Nimal 15

Calculate the Bond Price at Feb. 14th
when Yield is 8%
 Price at Oct. 01 2014 P0 =1018.15
 Practical purchase price

 Price at next coupon date

 Market quoted price

 Accrued interest

 Thus the purchase price equal to

8/18/2023 Prepared by P D Nimal 16

 Bond Pricing Theorems

Bond pricing theorems deal with how bond

prices move in response to changes in the
bonds YTM.

Depending on the price at which bond is

traded the price of the bond can be
categorized as;

Par : MP=PV; YTM=CR

Discount : MP<PV; YTM>CR
Premium : MP>PV; YTM<CR

17
Five Theorems of Bond Pricing

1. If MP increases, then its yield must decrease

2. If a bond’s yield does not change over its life, then the size of
its discount or premium will decrease as its life gets shorter

3. If a bond’s yield does not change over its life, then the size of
its discount or premium will decrease at an increasing rate as
its life gets shorter

4. A decrease in a bond’s yield will raise the 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 bonds yield

5. The percentage change in a bond’s price owing to a change in

its yield will be smaller if its coupon rate is higher

See figure 1, & 2

18
Figure 1: Behavior of the prices of
Premium and Discount bonds

8/18/2023 Prepared by P D Nimal 19

Figure 2:
Convexity of Bond price and YTM

8/18/2023 Prepared by P D Nimal 20

Convexity - The relationship between
Bond P and YTM

The first and fourth bond pricing theorems have led

to the concept in bond valuation known as
convexity.

 If MP increases, then its yield must decrease (Inverse

Relation) Theorem 1

 A decrease in a bond’s yield will raise the 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 bonds yield, Theorem 4

 See figure 2, a convex curve

21
Fixed Income Securities
Duration and Immunization

8/18/2023 Prepared by P D Nimal 22

 Duration _ Average Maturity

Duration is a measure of the “Average Maturity” of the stream of payments

associated with a bond. It is the weighted average of the lengths of time
until the remaining payments are made.

For Ex. A bond with annual coupon payments of Rs 80, a remaining life of 3
years, and a par value of Rs 1000. If it has a YTM of 10%, calculate the
price and the duration.

Time Until receipt Amount of Discount Present value Present value

of cash flow cash flow Factor of cash flow of cash flow *Time
1 80 0.9091 72.73 72.73
2 80 0.8264 66.12 132.23
3 1080 0.7513 811.4 2434.21

950.25 2639.17

Duration = 2639.17/950.25 = 2.78 years

23
Immunization

 Concept of Duration lead to the development

of immunization of bond portfolios

 This allows a manager to be relatively certain

of meeting a promised stream of cash
outflows

 Thus, once a bond portfolio is being

immunized, it is protected from any adverse
effects of future changes in interest rates
24
How Immunization is Accomplished
 Investing in a portfolio of bonds that has an
identical duration
 This takes the advantage of the observation
that the duration of a portfolio of bonds is
equal to the weighted average of the
durations of the individual bonds in the
portfolio
 For Ex.
 1/3 of funds invested in bonds with 6y duration
 2/3 in bonds with 3-y duration,
 then the portfolio duration is=1/3*6+2/3*3=4

25
 Ex.
 A manager has one outflow of Rs.1m to be paid in two years
(since it has only one CF, the duration is 2)
 Manager is considering investing in 2 different issues
 One shown earlier with maturity of 3y and duration of 2.78
 Second is 1y bond with a single payment at maturity (1070). Thus
the duration is 1 and currently selling for 972.73.
 Choices open to the manager are
 One is all funds could be invested in the 1y bond for 1y and
reinvesting them in another 1y bond (reinvestment-rate risk)
 Second is that all funds are invested in the 3y issue and selling
them after two years to meet the cash flow of 1m (interest-rate
risk/Market Price risk)
 A solution is to invest in both bonds.

26
 Ex. Cont…
 The question is how much should be invested in each bond?
 If immunization is to be used, the solution can be reached by
solving following equations

 Calculate W1 and W3
 If the current rate of interest is 10%, what is the portfolio?
 Calculate the value of the portfolio if the interest rate of the
market
 Remained at 10% until the end of the 2nd year
 Changed to 9% after 1 year and remained at 9% until the end of the 2nd year
 Changed to11% after 1 year and remained at 9% until the end of the 2nd year
27
Bond Portfolio Management
Active Management
 AM of a bond portfolio is based on the belief
that the bond market is not perfectly efficient

 AM tries to identify mispriced bonds and

select the portfolio or

 Market timing, the manager forecast general

movements in interest rates

 There are many methods

28
Bond Portfolio Management
Passive Management

 PM of a bond portfolio is based on the

belief that the bond market is highly
efficient

 The most common passive approach

involves indexation where the manager
select a bond index that is consistent
with his/her risk-return preferences
29