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Bond Portfolio Management Active & Passive Strategies
Bond Portfolio Management Active & Passive Strategies
Bond Portfolio Management Active & Passive Strategies
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