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Chapter 11

Chapter 11. Managing Bond Portfolios. Interest Rate Sensitivity (Duration we will cover in Finc420). The concept: Any security that gives an investor more money back sooner (as a % of your investment) will have lower price volatility when interest rates change.

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Chapter 11

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  1. Chapter 11 Managing Bond Portfolios

  2. Interest Rate Sensitivity(Duration we will cover in Finc420) The concept: • Any security that gives an investor more money back sooner (as a % of your investment) will have lower price volatility when interest rates change. • Maturity is a major determinant of bond price sensitivity to interest rate changes, but • It is not the only factor; in particular the coupon rate and the current ytm are also major determinants. 11-2

  3. More on Duration • Duration increases with maturity • A higher coupon results in a lower duration • Duration is shorter than maturity for all bonds except zero coupon bonds • Duration is equal to maturity for zero coupon bonds • All else equal, duration is shorter at higher interest rates 11-3

  4. Duration/Price Relationship D = Duration Price change is proportional to duration and not to maturity DP/P = -D x [Dy / (1+y)] D* = modified duration D*= D / (1+y) DP/P = - D* x Dy 11-4

  5. Interest Rate Risk Interest rate risk is the possibility that an investor does not earn the promised ytm because of interest rate changes. A bond investor faces two types of interest rate risk: • Price risk: The risk that an investor cannot sell the bond for as much as anticipated. An increase in interest rates reduces the sale price. • Reinvestment risk: The risk that the investor will not be able to reinvest the coupons at the promised yield rate. A decrease in interest rates reduces the future value of the reinvested coupons. The two types of risk are potentially offsetting. 11-5

  6. Immunization • Immunization: An investment strategy designed to ensure the investor earns the promised ytm. • A form of passive management, two versions • Target date immunization • Attempt to earn the promised yield on the bond over the investment horizon. • Accomplished by matching duration of the bond to the investment horizon 11-6

  7. Immunization • Net worth immunization • The equity of an institution can be immunized by matching the duration of the assets to the duration of the liabilities. 11-7

  8. Cash Flow Matching and Dedication • Cash flow from the bond and the obligation exactly offset each other • Automatically immunizes a portfolio from interest rate movements • Not widely pursued, too limiting in terms of choice of bonds • May not be feasible due to lack of availability of investments needed 11-8

  9. Problems with Immunization • May be a suboptimal strategy • Does not work as well for complex portfolios with option components, nor for large interest rate changes • Requires rebalancing of the portfolio periodically, which then incurs transaction costs • Rebalancing is required when interest rates move • Rebalancing is required over time 11-9

  10. The Need for Convexity(calculation in Finc 420) • Duration is only an approximation • Duration asserts that the percentage price change is linearly related to the change in the bond’s yield • Underestimates the increase in bond prices when yield falls • Overestimates the decline in price when the yield rises 11-10

  11. Convexity: Definition and Usage Where: CFt is the cash flow (interest and/or principal) at time t and y = ytm The prediction model including convexity is: 11-11

  12. Swapping Strategies - active • Substitution swap • Exchanging one bond for another with very similar characteristics but more attractively priced • Intermarket spread swap • Exploiting deviations in spreads between two market segments • Rate anticipation swap • Choosing a duration different than your investment horizon to exploit a rate change. • Rate increase: Choose D > Investment horizon • Rate decrease: Choose D < Investment horizon 11-12

  13. Swapping Strategies • Pure yield pickup • Switching to a higher yielding bond, may be longer maturity if the term structure is upward sloping or may be lower default rating. • Tax swap • Swapping bonds for tax purposes, for example selling a bond that has dropped in price to realize a capital loss that may be used to offset a capital gain in another security 11-13

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