CHAPTER 16

Managing Bond Portfolios

INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
 Bond Pricing Relationships
• Bond prices and yields are inversely related.
• An increase in a bond’s yield to maturity
results in a smaller price change than a
decrease of equal magnitude.
• Long-term bonds tend to be more price
sensitive than short-term bonds, but price
sensitivity increases at a decreasing rate.
• Interest rate risk is higher for lower bond’s
coupon rates.
• Price sensitivity is inversely related to the
bond’s yield to maturity.
INVESTMENTS | BODIE, KANE, MARCUS 16-2
 Coupon, Yield, and Price
Check your intuition about Coupons and Yield.
Which of the following bonds are par, discount
or premium bonds?

a) Coupon rate > current yield > YTM

b) Coupon rate = current yield = YTM
c) Coupon rate < current yield < YTM

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Figure 16.1 Change in Bond Price as a Function
of Change in Yield to Maturity

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Table 16.1,2 Prices of 8% semiannual coupon bond,
and a Zero Coupon Bond

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 Duration and effective life
• A measure of the effective maturity of a bond
• The weighted average of the times until each
payment is received; weights are proportional
to the present value of the payment
• Duration is obviously equal to maturity for
zero coupon bonds (one cash flow only!)
• Duration is shorter than maturity for all bonds,
except zero coupon bonds

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 Duration: Calculation
PV CFt  CFt 1  y t 
t

wt  
Price Price
T
D   t wt
t 1

CFt = cash flow at time t

Q. What are the units of measure of D?

INVESTMENTS | BODIE, KANE, MARCUS 16-7
 Key Duration Relationship
• Duration is important because it leads to the
following key relationship between the
change in the yield on the bond, and the
change in its price (notice the sign):

P
  D * y
P
Think of Δ𝑦 as a change to interest rates…

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Duration/Price Relationship - Derivation
Compute price sensitivity w.r.t. yield y:
1 𝜕𝑃 1 𝜕 𝐶𝑡
= 𝑡
𝑃 𝜕𝑦 𝑃 𝜕𝑦 𝑡 1 + 𝑦
1 −𝑡 × 𝐶𝑡
= 𝑡+1
𝑃 𝑡 1 + 𝑦
1 𝑡 × 𝐶𝑡 1
=− 𝑡
×
𝑃 𝑡 1+𝑦 1+𝑦
1 ∗
=−𝐷 × = −𝐷
1+𝑦
INVESTMENTS | BODIE, KANE, MARCUS 16-9
 Duration/Price Relationship

Price change is proportional to duration

(not to maturity). Notice the sign.
P  (1  y ) 
 D   
P  (1  y ) 
D* = modified duration = D/(1 + 𝑦)
[note: Δ(1 + 𝑦) = Δ𝑦]
P
Therefore:   D  y
*

P
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 Modified Duration
• When the yield y is expressed with
compounding m times per year

P  D  y
P  
1 y m
• The modified duration becomes:
D
1 y m

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 Example 16.1 Duration
• Two bonds have duration of 1.8852 years:
1. A 2-year, 8% semiannual coupon bond with
YTM=10%
2. zero coupon bond with maturity =1.8852 years
• Duration of both bonds is 1.8852 x 2 =
3.7704 semiannual periods
• Remember: semiannual yield y= 10%/2 = 5%
3.7704
• Modified D* = = 3.591 periods
(1+0.05)

INVESTMENTS | BODIE, KANE, MARCUS 16-12

 Example 16.1 Duration
• Suppose the semiannual interest rate
increases by 0.01%. Bond prices fall by:

P
  D y
*

• Δ𝑃/𝑃 = -3.591 x 0.01% = -0.03591%

• Bonds with equal D have the same
interest rate sensitivity
INVESTMENTS | BODIE, KANE, MARCUS 16-13
 Example 16.1 Duration

Coupon Bond Zero coupon bond

• The coupon bond, • The zero-coupon bond
initially sells at initially sells for
$964.540 $1,000/(1.05)3.7704 =
• it falls to $964.1942 = $831.9704
when its yield • At higher yield, it sells
increases to 5.01% for $1,000/(1.05)3.7704 =
= $831.6717
• Percentage decline is • This price also falls by
0.0359% 0.0359%
INVESTMENTS | BODIE, KANE, MARCUS 16-14
 Duration of a Portfolio
• The duration for a portfolio is the weighted
average duration of the instruments in the
portfolio with weights proportional to PVs
• The key duration relationship for a portfolio
describes the effect of small parallel shifts in
the yield curve
• What exposures remain if the duration of the
portfolio assets equals the duration of the
portfolio liabilities?

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 Duration – Check your intuition
How does each of these changes affect
duration?
• Having no coupon payments
• Decreasing the coupon rate
• Increasing the time to maturity
• Decreasing the yield-to-maturity

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 Pictorial look at duration
• Cash flows of a 7 year par 12% bond
• Shaded area of each box is PV of cash flow

Duration

• Duration, measured as time, is the position of

the center of mass of the shaded areas
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 Lower Coupon
• Duration is similar to the distance to the
fulcrum
• Lower coupons shift the center of mass to the
right. Higher coupons shift the center of mass
to the left

Duration
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 Higher Coupon
• Duration is similar to the distance to the
fulcrum
• Lower coupons shift the center of mass to the
right. Higher coupons shift the center of mass
to the left

Duration
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 Example of the coupon effect
• Consider the durations of a 5-year and 20-
year bond with varying coupon rates (semi-
annual coupon payments):

5 year bond 20 year bond

Zero coupon 5 20
6% coupon 4.39 11.90
9% coupon 4.19 10.98

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 Effect of maturity on duration
• Duration increases with increased maturity
• Example: add one period

Duration

Duration

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 Lower Yield
• Higher Yield discounts more heavily longer
dated cash flows and shift the center of mass
to the left

Duration

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 Higher Yield
• Higher Yield discounts more heavily longer
dated cash flows and shift the center of mass
to the left

Duration

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Rules of Thumb for Bond Duration
• The duration of a zero-coupon bond equals its
time to maturity
• Holding maturity constant, duration is higher
when the coupon rate is lower
• Holding coupon rate constant, duration generally
increases with time to maturity
• Holding other factors constant, duration is higher
(longer) when YTM is lower
• The minute after a coupon is paid, duration
jumps up, as that cash flows disappears
INVESTMENTS | BODIE, KANE, MARCUS 16-24
Figure 16.2 Bond Duration versus
Bond Maturity

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 Table 16.3 Bond Durations
(YTM = 8%; Semiannual Coupons)

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Industry calc. of Rate Sensitivity: dv01
• Traders in practice use dv01: dollar value of
1bp increase in rates
• Shock interest rates by +1bp and compute
dollar impact  dv01
• Also compute bucketed dv01 by shocking
interest rates by 1bp at various tenor buckets,
and then compute dollar impact

INVESTMENTS | BODIE, KANE, MARCUS 16-27

 Convexity
• The relationship between bond prices and
yields is not linear.
• Duration rule is a good approximation for only
small changes in bond yields.
• Bonds with greater convexity have more
curvature in the price-yield relationship.

INVESTMENTS | BODIE, KANE, MARCUS 16-28

Figure 16.3 Bond Price Convexity: 30-Year
Maturity, 8% Coupon; Initial YTM = 8%

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 Convexity

1 n
 CFt 
Convexity 
P  (1  y ) 2   (1  y ) t (t  t )
t 1 
2


Correction for Convexity:

P 1
  D  y  Convexity  y 
2

P 2

INVESTMENTS | BODIE, KANE, MARCUS 16-30

Figure 16.4 Convexity of Two Bonds

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Why do Investors Like Convexity?
• Bonds with greater curvature gain more in
price when yields fall than they lose when
yields rise.
• The more volatile interest rates, the more
attractive this asymmetry.
• Bonds with greater convexity tend to have
higher prices and/or lower yields, all else
equal.

INVESTMENTS | BODIE, KANE, MARCUS 16-32

 Callable Bonds
• As rates fall, there is a ceiling on the bond’s
market price, which cannot rise above the call
price.
• Negative convexity
• Use effective duration:

P / P
Effective Duration =
r

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fig 16.5 Price–Yield Curve for a Callable Bond

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 Mortgage-Backed Securities
• The number of outstanding callable
corporate bonds has declined, but the MBS
market has grown rapidly
• MBS are based on a portfolio of callable
amortizing loans
– Homeowners have the right to repay their loans
at any time
– MBS have negative convexity

INVESTMENTS | BODIE, KANE, MARCUS 16-35

 Mortgage-Backed Securities
• Often sell for more than their principal
balance
• Homeowners do not refinance as soon as
rates drop, so implicit call price is not quite a
firm ceiling on MBS value
• Tranches – the underlying mortgage pool is
divided into a set of derivative securities

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Figure 16.6 Price-Yield Curve for a Mortgage-
Backed Security

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Figure 16.7 Cash Flows to Whole Mortgage
Pool; Cash Flows to Three Tranches

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 Passive Management
• Two passive bond portfolio strategies:

• Indexing
• Immunization

• Both strategies see market prices as being

correct, but the strategies have very different
risks.

INVESTMENTS | BODIE, KANE, MARCUS 16-39

 Bond Index Funds
• Bond indices contain thousands of issues,
many of which are traded infrequently
• Bond indices turn over more than stock
indices as the bonds mature
• Therefore, bond index funds hold only a
representative sample of the bonds in the
actual index

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Figure 16.8 Stratification of
Bonds into Cells

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 Immunization
• Immunization is a way to mitigate interest
rate risk
• Widely used by pension funds, insurance
companies, and banks
• Requires deep understanding of duration and
convexity of your portfolio

INVESTMENTS | BODIE, KANE, MARCUS 16-42

 Immunization
• Immunize a portfolio by matching the interest
rate exposure of assets and liabilities
– Match the duration of the assets and liabilities
– Price risk and reinvestment rate risk cancel out
for small interest rate movements
• Result: Value of assets will track the value of
liabilities whether rates rise or fall
(for small movements, need to rebalance)

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Table 16.4 Terminal value of bond after 5 yrs

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Table 16.5 Market Value Balance Sheet

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Figure 16.10 Immunization

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 Cash Flow Matching and Dedication

• Cash flow matching = automatic

immunization
• Cash flow matching is a dedication
strategy
• Not widely used because of
constraints associated with bond
choices

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Active Management: Swapping Strategies

• Substitution swap
• Intermarket swap
• Rate anticipation swap
• Pure yield pickup
• Tax swap

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 Horizon Analysis

• Select a particular holding period and

predict the yield curve at end of period
• Given a bond’s time to maturity at the
end of the holding period, its yield can
be read from the predicted yield curve
and the end-of-period price can be
calculated

INVESTMENTS | BODIE, KANE, MARCUS 16-49