Bond Portfolio Management II

Lecture 7

FIXED INCOME SECURITIES

DR Richard

FACULTY OF
ECONOMICS & BUSINESS

Introduction
Liability driven strategies
Performance measurement

Reading:
- Fabozzi Ch. 24 25

Immunization of a Portfolio to Satisfy a Single

Liability
An immunization strategy refers to the investment of the assets in such a
way that the existing business is immune to a general change in the rate
of interest.
Suppose that a life insurance company sells a GIC that guarantees an
interest rate of 6.25% every six months (12.5% on a bond-equivalent yield
basis) for 5.5 years (11 six-month periods).
The payment made by the policyholder is $8,820,262.
Then, the value that the life insurance company has guaranteed the
policyholder 5.5 years from now is
$8,820,2621(1.06252)11 = $17,183,033
3

Immunization of a Portfolio to Satisfy a Single

Liability
Suppose that the portfolio manager buys $8,820,262 par value of a bond
selling at par with a 12.5% yield to maturity that matures in 5.5 years.
The portfolio manager will realize a 12.5% yield only if the coupon interest
payments can be reinvested at 6.25% every six months.
That is, the accumulated value will depend on the reinvestment rate.

Immunization of a Portfolio to Satisfy a Single

Liability
Which bond should the portfolio manager choose to invest in?

Bond Description

Name

5.5-year 12.5% coupon, selling at par

15-year 12.5% coupon, selling at par

6-month 12.5% coupon, selling at par

8-year 10.125% coupon, selling for 88.20262

Lets look at the return of these bonds under various scenarios

Bond A total Return

Holding Bond A for 5.5 years.
- Price of bond is same regardless of yield change
- Only interest on interest varies with yield change
After 5.5 years

New
Yield a

Coupon
Interest

Interest on
Interest

Price of
Bond b

Accumulated
Value

Total
Return

0.160

$6,063,930

$3,112,167

$8,820,262

$17,996,360

0.1340

0.155

6,063,930

2,990,716

8,820,262

17,874,908

0.1326

0.145

6,063,930

2,753,177

8,820,262

17,637,369

0.1300

0.140

6,063,930

2,647,037

8,820,262

17,521,230

0.1288

0.065

6,063,930

1,088,003

8,820,262

15,972,195

0.1109

0.060

6,063,930

996,577

8,820,262

15,880,769

0.1098

0.055

6,063,930

906,511

8,820,262

15,790,703

0.1087

0.050

6,063,930

817,785

8,820,262

15,701,977

0.1077

Immediate change in yield. b Maturity value.

6

Bond B total Return

Holding Bond B for 5.5 years
- Capital appreciation (depreciation) if yield decreases (increases)
- Interest of interest increases (decreases) if yield increases (decreases)
After 5.5 years

New
Yield a

Coupon
Interest

Interest on
Interest

Price of
Bond

Accumulated
Value

Total
Return

0.160
0.155
0.145
0.140
.
0.065
0.060
0.055
0.050

$6,063,930
6,063,930
6,063,930
6,063,930
.
6,063,930
6,063,930
6,063,930
6,063,930

$3,112,167
2,990,716
2,753,177
2,637,037
.
1,088,003
996,577
906,511
817,785

$7,337,902
7,526,488
7,925,481
8,136,542
.
12,527,914
12,926,301
13,341,617
13,774,677

$16,513,999
16,581,134
16,742,588
16,837,509
.
19,679,847
19,986,808
20,312,058
20,656,392

0.1173
0.1181
0.1200
0.1211
.
0.1514
0.1544
0.1576
0.1609

Immediate change in yield.

7

Bond C Total Return

Holding Bond C for 6 months (until expiry) then reinvest at new rate
- Fixed capital amount after 6 months
- Capital after 5.5 years depends on new yield available after 6 months
After 5.5 years

New
Yield a

After Six Months

Accumulated Value

Total Return

0.160

9371,528

20,232,427

0.1568

0.155

9371,528

19,768,932

0.1523

0.145

9371,528

18,870,501

0.1432

0.140

9371,528

18,435,215

0.1386

9371,528

0.065

9371,528

12,903,604

0.0704

0.060

9371,528

12,594,550

0.0658

0.055

9371,528

12,292,175

0.0613

0.050

9371,528

11,996,349

0.0567

Immediate change in yield.

8

Bond D Total Return

Holding Bond D for 5.5 years
- Capital appreciation (depreciation) if yield decreases (increases)
- Interest of interest increases (decreases) if yield increases (decreases)
- Note, total return practically the same for all change in yields
After 5.5 years
New
Yield a

Coupon
Interest

0.160
$5,568,750
0.155
5,568,750
0.145
5,568,750
0.140
5,568,750
.
.
0.065
5,568,750
0.060
5,568,750
0.055
5,568,750
0.050
5,568,750
a
Immediate change in yield.

Interest on
Interest

Price of
Bond

Accumulated
Value

Total
Return

$2,858,028
2,746,494
2,528,352
2,421,697
.
999,156
915,197
832,486
751,005

$8,827,141
8,919,852
9,109,054
9,205,587
.
10,824,180
10,944,565
11,066,660
11,190,494

$17,253,919
17,235,096
17,206,156
17,196,034
.
17,392,086
17,428,512
17,467,896
17,510,249

0.1258
0.1256
0.1253
0.1251
.
0.1273
0.1277
0.1282
0.1268
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Bond D Total Return (A Closer Look)

The value gained (lost) by the change in interest on interest is almost
perfectly offset by the value lost (gained) in change in price due for all
changes in the yield
New
Yield

Change in Interest
on Interest

Change in Price

Total Change in
Accumulated Value

0.160
0.155
0.145
0.140
0.135
0.130
0.125
0.120
.
0.060
0.055
0.050

$746,911
635,377
417,235
310,580
205,504
101,985
0
100,473
.
1,195,921
1,278,632
1,360,112

$676,024
583,314
394,112
297,579
199,730
100,544
0
101,925
.
1,441,399
1,563,494
1,687,328

$70,887
52,063
23,123
13,001
5,774
1,441
0
1,452
.
245,478
284,862
327,216

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Modified Duration of the bonds

What is so special about bond D?
- Observe its Macaulay duration
- Macaulay duration = 5.18*(1.0625) = 5.5
- We are holding a bond for its duration. Known as Immunisation
Bond

Name

Modified Duration

5.5-year 12.5% coupon, selling at par

3.90

15-year 12.5% coupon, selling at par

6.70

6-month 12.5% coupon, selling at par

0.48

8-year 10.125% coupon, selling for

88.20262

5.18

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Immunization of a Portfolio to Satisfy a Single

Liability (continued)
To immunize a portfolios target accumulated value (target yield), a
portfolio manager must construct a bond portfolio such that
1. The duration of the portfolio is equal to the duration of the liability
2. The present value of the cash flow from the portfolio equals to the
present value of the future liability.
Rebalancing an Immunized Portfolio
- A portfolio can be immunized if it is rebalanced periodically so that its duration is
equal to the duration of the liabilitys remaining time.
- The more frequent rebalancing increases transactions costs, thereby reducing
the likelihood of achieving the target yield.
- However, less frequent rebalancing will result in the duration wandering from the
target duration, which will also reduce the likelihood of achieving the target yield.
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Immunization of a Portfolio to Satisfy a Single

Liability (continued)
Immunization Risk
- A portfolio will be immunized against interest-rate changes only if the yield curve
is flat and any changes in the yield curve are parallel changes (i.e., interest rates
move either up or down by the same number of basis points for all maturities).
- When there is a high dispersion of cash flows around the liability due date, the
portfolio is exposed to high reinvestment risk.
- When the cash flows are concentrated around the liability due date, as in the
case of the bullet portfolio, the portfolio is subject to low reinvestment risk.
- Immunization risk is the risk of reinvestment.

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Structuring a Portfolio to Satisfy Multiple Liabilities

There are two strategies that can be used to satisfy a liability stream:
1. Multiperiod Immunisation
- A portfolio is created that will be capable of satisfying more than one
predetermined future liability regardless if interest rates change.

Three conditions must be satisfied:

1. The duration of the portfolio is equal to the duration of the liabilities
2. The present value of the cash flow from the bond portfolio must equal the
present value of the future liability stream.
3. The distribution of durations of individual portfolio assets must have a wider
range than the distribution of the liabilities

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Structuring a Portfolio to Satisfy Multiple Liabilities

2. Cash flow matching (Dedicating a portfolio)
A bond is selected with a maturity that matches the last liability stream.
An amount of principal plus final coupon equal to the amount of the last
liability stream is then invested in this bond.
The remaining elements of the liability stream are then reduced by the
coupon payments on this bond, and another bond is chosen for the new,
reduced amount of the next-to-last liability.
Going backward in time, this cash flow matching process is continued until
all liabilities have been matched by the payment of the securities in the
portfolio.
(See diagram in lecture)

15

Measurement vs. Evaluation

Performance measurement
- Calculation of return realised by a manager over some time interval (evaluation
period)

Performance evaluation
- Whether manager outperformed benchmark
- Performance attribution: how the manager achieved the calculated return, i.e.
what strategies were employed

Three desired requirements of performance measurement and evaluation

process
- Accurate: correct return measurement
- Informative: address key management skill and how it is reflected in performance
- Simple: easily understood by managers and clients

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Performance Measurement
Return is defined as the sum of

Rp

MV1 MV0 D
MV0

Where MV1 is the market value at time 1, MV0 is the market value at time 0
and D is any dividends paid between time 0 and time 1.
The rate of return, or simply return, expresses the dollar return in terms of
the amount of the market value at the beginning of the evaluation period
This return formula can be viewed as the amount that can be withdrawn at
the end of the evaluation period expressed as a fraction of the initial
portfolio value, while maintaining that initial portfolio value

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Performance Measurement
This equation has shortcomings due to its assumptions
- Return calculations over longer time periods may be inaccurate
- The longer the evaluation period, the more likely the assumptions will be violated

- Difficult to compare across different time periods such as one month vs. three
year performance evaluation (path dependence)

To mitigate these issues the subperiod return method is used

- Calculate return over a shorter time frame such as monthly subperiod and then
average across a longer evaluation period such as one year
- The logic behind this is that the return formula will be more accurate over the
shorter time frame and the averaging process allows us to build up to the longer
time frame
- Result is a more accurate characterization of managers performance over any
time frame

18

Arithmetic Average of Subperiod Returns

Arithmetic average rate of return

RA

R p1 R p 2 ...R pN
N

Suppose a manager begins with $10 and the next period the investment is
worth $20 and the period after that, it returns back to $10. The first period
return is 100% and second period return is -50%
The arithmetic average return for the two periods is 25% but actually the
manager made nothing over the evaluation period
The method implicitly assumes withdrawals take place, hence the method
assumes returns are not compounded. Failure to compound is the source
of measurement problem with the arithmetic average rate of return
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Time-weighted or Geometric Returns

Arithmetic and time-weighted average returns will give different values for
the portfolio return over some evaluation period because of compounding.
The arithmetic average return will exceed the time-weighted average
By compounding, time-weighted rate of return fixes measurement problem
for arithmetic returns outlined on previous slide
Calculate the geometric return using the example on the previous slide
should be 0% (try it)

RT 1 R p1 1 R p 2 ... 1 R pN

1/ N

Generally, use geometric returns when averaging returns in time series

and use arithmetic returns when averaging in cross section

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