CHAPTER 20 BOND PORTFOLIO MANAGEMENT STRATEGIES

1. 1. Answers to Questions What is meant by an indexing portfolio strategy and why is it used? An indexing portfolio strategy is one in which the investor selects a bond portfolio that matches the performance of some bond-market index. The basic ustification for this strategy is that many empirical studies have shown that portfolio managers on average can!t match the risk-return performance in the bond market using active portfolio management. #riefly define the following bond swaps$pure yield pickup swap%substitution swap and tax swap. A pure yield pickup swap is selling a bond and buying another one with a higher coupon. &ormally% both current yield and yield-to-maturity are enhanced. A substitution swap is the swapping of one bond for another between which a yield spread imbalance exists. The investor expects the imbalance to disappear through the mechanism of having the yield on the purchased bond drop 'through a price increase( to the level of the swapped bond% leading to attractive capital gains. A tax swap is simply a bond swap that enables an investor to reali)e capital losses on one bond to offset capital gains that she has reali)ed on some other investment. #riefly describe three active bond porfolio management strategies. These active management strategies include interest rate anticipation% credit analysis% and spread analysis. Interest rate anticipation is the riskiest strategy because it relies on forecasting uncertain future interest rate behavior. The strategy involves altering the maturity 'duration( structure of the portfolio to preserve capital when an increase in interest rates is anticipated and achieve capital gains when they are expected to decline. A credit analysis strategy involves attempting to pro ect changes in +uality ratings assigned to bonds. ,t is necessary to analy)e internal changes in the firm and external changes in the environment to pro ect rating changes prior to the actual announcement by rating agencies. Spread analysis involves monitoring the yield relationships between various bond sectors to take advantage of abnormal relationships by executing various sector swaps. -i+uidity is a key factor in this strategy% as abnormal relationships are only believed to be temporary. The ability to immune a bond portfolio is very desirable for bond portfolio managers in some instances. a( /iscuss the components of interest rate risk.Assuming a change in interest rates over time%explain the two risks faced by the holder of a bond. b( /efine immuni)ation and discuss why a bond manager would immuni)e a portfolio. c( 0xplain why a duration-matching strategy is a superior techni+ue to maturitymatching strategy for the minimi)ation of interest rate risk. d( 0xplain in specific terms how you would use a )ero coupon bond to immuni)e a bond portfolio./iscuss why a )ero coupon bond is an ideal ideal instrument in this regard. e( 0xplain how contingent immuni)ation% another bond portfolio management techni+ue%differs from classical immuni)ation./iscuss why a bond portfolio manager would engage in contingent immuni)ation. "1 - 1

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1.

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23A 0xamination ,,, '145*(

1.'a(. ,nterest rate risk comprises two risks - a price risk and a coupon reinvestment risk. Price risk represents the chance that interest rates will differ from the rates the manager expects to prevail between purchase and target date. 6uch a change causes the market price for the bond 'i.e.% the reali)ed price( to differ from the expected price. 7bviously% if interest rates increase% the reali)ed price for the bond in the secondary market will be below expectations% while if interest rates decline% the reali)ed price will exceed expectations. Reinvestment risk arises because interest rates at which coupon payments can be reinvested are unknown. ,f interest rates change after the bond is purchased% coupon payments will be reinvested at rates different than that prevailing at the time of the purchase. As an example% if interest rates decline% coupon payments will be reinvested at lower rates than at the time of purchase and their contribution to the ending wealth position of the investor will be below expectations. 2ontrariwise% if interest rates increase there will be a positive impact as coupon payments will be reinvested at rates above expectations. 1.'b(. A portfolio of investments in bonds is immuni)ed for a holding period if the value of the portfolio at the end of the holding period% regardless of the course of interest rates during the holding period% is at least as large as it would have been had the interest rate function been constant throughout the holding period. 8ut another way% if the reali)ed return on an investment in bonds is sure to be at least as large as the computed yield to the investment hori)on% then that investment is immuni)ed. As an example% if an investor ac+uired a portfolio bond when prevailing interest rates were 119 and had an investment hori)on of four years% then the investor would expect the value of the portfolio at the end of four years to be 1..:.1 x the beginning value. This particular value is e+ual to 119 compounded for four years. A bond manager would want to immuni)e the portfolio in the instance where he;she had a specified investment hori)on and had a definite re+uired or promised yield for the bond portfolio. ,n the case where this re+uired or expected yield was below current prevailing market rates% it would be worthwhile for the bond managers to immuni)e the portfolio and therefore <lock in= the prevailing market yield for this period. 8ut another way% it is when the bond portfolio manager is willing to engage in non-active bond portfolio management and accept the current prevailing rate during the investment hori)on. 1.'c(. As set forth by a number of authors% the techni+ue used to immuni)e a portfolio is to set the duration of the portfolio e+ual to the investment hori)on for the portfolio. ,t has been proven that this techni+ue will work because during the life of the portfolio% the two ma or interest rate risks 'price risk and reinvestment risk( offset each other at this point in time. The )ero coupon bond is an ideal immuni)ation instrument because% by its very nature% it accomplishes these two purposes when the maturity of the )ero coupon bond e+uals the investment hori)on because the duration of a )ero coupon bond is e+ual to its maturity period. ,n contrast% when you match the maturity of the bond to the investment hori)on% you are only taking account of the price risk whereby you will receive the par value of the bond at the maturity of the bond. The problem is that you are not sure of how the investment risk will work out. ,f rates rise% you will receive more in reinvestment than expected. Alternatively% if rates decline% you will not benefit from the price advantage and% in fact% will lose in terms of the reinvestment assumptions. 1.'d(. The )ero coupon bond is a superior immuni)ation security because it eliminates both interest rate risks-price and reinvestment. "1 - "

A )ero coupon bond is a perfect immuni)er when its duration 'or maturity% as they are the same( is e+ual to the liability or planning hori)on of the portfolio. >iven ade+uate availability% the portfolio manager would match these elements and no further activity is necessary to the end of the hori)on. The )ero coupon bond is superior to a coupon paying instrument because the lack of cash flow prior to maturity eliminates any coupon reinvestment and% therefore% the risk of reali)ed return changes due to uncertainty of these levels. 8rice risk is also nonexistent regardless of the timing or nature of yield curve shifts. 1.'e(. The primary difference between contingent and classical immuni)ation is the role of active management. 2lassical immuni)ation precisely matches the duration of the portfolio with the hori)on of the particular liability. ?anagement of such a portfolio is limited to periodic rebalancing necessitated by yield curve shifts% yield changes% and time effects on duration. 2ontingent immuni)ation is an active form of management% initially% and can continue in this mode until the manager@s results are unfavorable to the extent that a predetermined target return is unlikely to be achieved. At this point% the active mode is triggered to a classical passive immuni)ation to <lock-in= the minimum desired return. 2ontingent immuni)ation achieves its risk control by establishing two parameters$ '1( The minimum return target for more specifically the difference between the minimum return target and the immuni)ation return than available in the market% and '"( the acceptable range for the terminal hori)on date of the program. The chart below illustrates the potential rewards from contingent immuni)ation based on possible moves in interest rates. ,t is interesting to note the similarity of this curve to that of option strategies. 8otential Aeturn '9( "1 2ontingent 14 ,mmuni)ation 1B 1C 2lassical 1* ,mmuni)ation 11 4 ,mmediate Dield 2hange 3rom 1"9 '8ercent 8oints( 2areful monitoring of the value achieved by the manager in the portfolio is important. A return or portfolio value line can be established% initially which traces the re+uired dollar value of the portfolio at any given point in time and would be a minimum level necessary for the portfolio to reach its minimum return target. ,f the return or value falls to this% the <safety net= is activated. A key facet of contingent immuni)ation is the benefit from flexibility or loosening of rigid conditions. 6ubstantial flexibility is granted the portfolio@s manager if either the hori)on "1 - * -: -. -" 1 " . : 5 ?inimum Aeturn Target

time is widened to a range rather than a single point or if the minimum return is meaningfully below that available currently through classical immuni)ation. #y granting this flexibility and being willing to accept a slightly lower than current market return% the plan sponsor or portfolio manager has the opportunity to achieve much greater returns through interest rate anticipation% swapping and other facets of active management. This approach is attractive to a portfolio manager who believes his;her skills will provide <excess returns= yet establishes a downside risk control that assures achievement of a minimum target return.

CHAPTER 20
Answers to Prob e!s 1 Dou have a portfolio with a market value of EC1 million and a ?acaulay duration of seven years'assuming a market interest rate of 119(.,f interest rates increase to 1"9%what would be the estimated value of your portfolio using modified duration?6how all your computations. ?odified duration F B;1.11 F :.*: years 8ercentage change in portfolio F G" x -:.*: F -1".B" percent Halue of portfolio F EC1 million x '1 - .1"B"( F E.*.:. million Answer the following +uestions assuming that at the initiation of an investment account%the market value of your portfolio is E"11 million%and you immuni)e the portfolio at 1"9 for : years./uring the first year%interest%interest rates are constant at 1"9. a( What is the market value of the portfolio at the end of year 1? b( ,mmediately after the end of the year%interest rates declines to 119.0stimate the new value of the portfolio%assuming you did the re+uired rebalancing 'use only modified duration(. "'a(. E"11 million x '1.1:(" F E""..B" million "'b(. 6ince modified duration will e+ual the remaining hori)on 'C years(% the change in bond price must be G119 or '-C(x'-"9(. The new value of the portfolio would then be E".B.14" million or E""..B" million x '1.11(. * 2ompute the ?acaulay duration under the following conditions$ a( A bond with a five year term to maturity%a 1"9 coupon 'annual payments(%and a market yield of 119. b( A bond with a four year term to maturity%a 1"9 coupon 'annual payments(%and a market yield of 119. c( 2ompare your answers to parts a I b .Assuming it was an immediate shift in yields%discuss the implications of this for classical immuni)ation. *'a(. Co!"ut#tion o$ Dur#tion %#ssu!in& '0( !#r)et *ie +, '1( '"( '*( '.( 'C( ':( Dear 2ash 3low 8HJ119 8Hof 3low 8H as 9 of 8rice '1( x 'C( 1 1"1 .4141 114.14 .111. .111. " "1 - .

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1"1 1"1 1"1 11"1

.5":. .BC1* .:5*1 .:"14

44.1B 41.1: 51.4: :4C..1 11BC.B4

.14"" .15*5 .1B:" .:.:. 1.1111

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/uration F ..1B years Co!"ut#tion o$ Dur#tion %#ssu!in& '0( !#r)et *ie +, '1( '"( Dear 2ash 3low 1 1"1 " 1"1 * 1"1 . 11"1 '*( '.( 8HJ119 8Hof 3low .4141 114.14 .5":. 44.1B .BC1* 41.1: .:5*1 B:..4: 11:*.*5 /uration F *.." years 'C( ':( 8H as 9 of 8rice '1( x 'C( .11": .11": .14** .15:: .15.5 ."C.. .B14. ".5BB: 1.1111 *.."1"

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The duration of the portfolio should always be e+ual to the remaining time hori)on and duration declines slower than term-to-maturity assuming no change in market interest rates as shown in a and b above. 2ompute the ?acaulay duration under the following conditions$ d( A bond with a four year term to maturity%a 119 coupon 'annual payments(%and a market yield of 59. e( A bond with a four year term to maturity%a 119 coupon 'annual payments(%and a market yield of 1"9. f( 2ompare your answers to parts a I b .Assuming it was an immediate shift in yields%discuss the implications of this for classical immuni)ation.

.'a(.

Co!"ut#tion o$ Dur#tion %#ssu!in& -( !#r)et *ie +, '1( '"( Dear 2ash 3low 1 111 " 111 * 111 . 1111 '*( '.( 8HJ59 8Hof 3low .4"C4 4".C4 .5CB* 5C.B* .B4*5 B4.*5 .B*C1 515.C1 11::.". /uration F *.C years 'C( ':( 8H as 9 of 8rice '1( x 'C( .15:5 .15:5 .151. .1:15 .1B.C .""*. .BC5* *.1**" 1.1111 *.C1."

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Co!"ut#tion o$ Dur#tion %#ssu!in& '2( !#r)et *ie +, '1( '"( '*( '.( "1 - C 'C( ':(

Dear 2ash 3low 8HJ1"9 8H of 3low 1 111 .54"4 54."4 " 111 .B4B" B4.B" * 111 .B115 B1.15 . 1111 .:*CC :44.1C 4*4.". /uration F *..B years .'c(.

8H as 9 of 8rice '1( x 'C( .14C1 .14C1 .15.4 .1:45 .1BC5 .""B. .B.." ".4B:5 1.1111 *..:41

A portfolio of bonds is immuni)ed from interest rate risk if the duration of the portfolio is always e+ual to the desired investment hori)on. ,n this example% although nothing changes regarding the bond% there is a change in market rates% which causes a change in duration which would mean that the portfolio is no longer perfectly immuni)ed. A ma or re+uirement in running a contingent immuni)ation policy is monitoring the relation ship between the current market value of the portfolio and the re+uired value of the floor portfolio.,n this regard%assume a E*11 million portfolio with a hori)on of five years.The available market rate at the initiation of the portfolio is 1.9 but the client is willing to accept 1"9 as a floor rate to allow you to use active management strategies.The current market values and current market rates at the end of years 1%"%* are as follows$
END OF .EAR MAR/ET 0AL1E %2MIL, MAR/ET .IELD REQ1IRED FLOOR PORTFOLIO SAFET. MARGIN%DEFICIENC.,

' 2 3

340500 367500 380520

05'2 05'0 05'4

a( What is the re+uired ending-wealth value for this portfolio? b( What is the re+uired floor portfolio at the end of years 1%"%*? c( 2ompute the safety margin or deficiency at the end of years 1%"%*. C'a(. C'b(. E*11 million x '1.1:(11 F EC*B%"C.%*11 8H of EC*B."C million for . years J 1" percent C*B."C '.:"B( F E**:.5: million 8H of EC*B."C million for * years J 11 percent C*B."C '.B.:( F E.11.B4 million 8H of EC*B."C million for " years J 1. percent C*B."C '.B:*( F E.14.4" million C'c(. 4 *.1 - **:.5: F E*.1. million safety margin *BC - .11.B4 F E"C.B4 million deficiency *:1." - .14.4" F E.4.B" million deficiency A ma or re+uirement in managing a fixed-income porfolio using a contingent immuni)ation policy is monitoring the relationship between the current value of the portfolio and the re+uired value of the floor portfolio.This difference is defined as the margin of error.,n this regard%assume a E*11 million portfolio with a time hori)on of five years.The available market rate at the initiation of the portfolio is 1"9%but the client is willing to accept 119 as a floor rate to allow use of active management strategies.The current market values and "1 - :

current market rates at the end of years 1%"%* are as follows$

END OF .EAR MAR/ET 0AL1E %2MIL, MAR/ET .IELD REQ1IRED FLOOR PORTFOLIO MARGIN OF ERROR%2MIL,

' 2 3

34059 40757 39752

'0( -( '2(

a( b( c( d(

2alculate the re+uired ending-wealth value for this portfolio. 2alculate the value of the re+uired floor portfolios at the end of years 1%"%*. 2ompute the margin of error at the end of years 1%"%*. ,ndicate the action that a portfolio manager utili)ing a contingent immuni)ation policy would take if the margin of error at the end of any year had been )ero or negative.

4. 4'a(.

23A 0xamination ,,, 'Kune 145C( The re+uired ending wealth value to e+ual to$

E*11 million x 1.:"4 'C9for ten periods( F E.55.B1 million 4'b(. and 4'c(. ?AAL0T A0MN,A0/ 3-77A 6A30TD HA-N0 ?AAL0T 87AT37-,7 ?AA>,& 73 0AA7A D0AA '?,- E( D,0-/ '?,- E( '?,- E( 1 *.1.14 119 **1.5C 11.1C " .1C.C1 159 *5:.1B 14..* * *4C."1 1"9 *:B.1C 5.1C ,n general% the re+uired floor portfolio is the present value of the re+uired ending value 'E55.B1 million( at the current market yield. 3or Dear 7ne The re+uired floor portfolio is the present value of E.55.B1 at 119 for four years 'C9 for eight periods(. 3or Dear Two E.55.B1 O .::B F E**1.5C -ee re+uired floor portfolio is the present value of E.55.B1 at 59 for three years '.9 for six periods(. E.55.B1 O .B41 F E*5:.1B The re+uired floor portfolio is the present value of E.55.B1 at 1"9 for two years ':9 for four periods(.

3or Dear Three -

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E.55.B1 O .B4" F E*5B.1C ,f the margin of error at the end of any year had been )ero or negative% the portfolio manager would discontinue active management of the portfolio and immuni)e it. ,f the margin of error had been negative% the manager would immuni)e the portfolio and thereby minimi)e any further losses to the portfolio.

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