Chapter 14 Fixed Income Portfolio Management

Business 4179

Important Terms

Barbell strategy Bond swap Bullet strategy Confidence index convexity

Flight to quality Laddered strategy Macaulay duration Modified duration Yield curve inversion

Definitions Confidence Index

Confidence Index is the ratio of the yield on AAA bonds to the yield on BBB bonds. It has an upper boundary of 1.0 because the yield on safe bonds should never exceed the yield on risky bonds. It is a measure of yield spreadas spreads widen, this indicates smart money is becoming increasingly pessimistic about the future. The confidence index will fall. Some equity analysts use this index to forecast trends in the equity markets based on the assumption that it takes longer for equity markets to respond to new expectations. They base this upon the assumption that equity markets have larger numbers of novice/inexperienced investorsbond markets are dominated by institutional money and portfolio managers.

CI1 = CI 2 =

Yield AAA 4.5% = = .918 Yield BBB 4.9% Yield AAA 4.6% = = .8846 Yield BBB 5.2%

Yield Curves

YTM % Yield curve for BBB corporates Yield Spread Yield curve for AAA corporates

Term to Maturity In Years

Definitions - Duration

Is the first derivative of the bondpricing equation with respect to yield.

Types of Duration

Macaulay duration a measure of time flow of cash from a bond. Modified duration a slight modification of Macaulays to account for semi-annual coupon payments Effective duration a direct measure of interest rate sensitivity of a bond price Empirical duration measures directly the percentage price change of a bond for an actual change in interest rates.

Definitions Modified Duration

Is Macaulays duration adjusted for semi-annual coupon payments:

Macaulay duration Modified Duration = Annual Yield to Maturity [1 + ( )] 2

Duration

An alternative measure of bond price sensitivity is the bonds duration. Duration measures the life of the bond on a present value basis. Duration can also be thought of as the average time to receipt of the bonds cashflows. The longer the bonds duration, the greater is its sensitivity to interest rate changes.

Duration and Coupon Rates

A bonds duration is affected by the size of the coupon rate offered by the bond. The duration of a zero coupon bond is equal to the bonds term to maturity. Therefore, the longest durations are found in stripped bonds or zero coupon bonds. These are bonds with the greatest interest rate elasticity. The higher the coupon rate, the shorter the bonds duration. Hence the greater the coupon rate, the shorter the duration, and the lower the interest rate elasticity of the bond price.

Duration
The numerator of the duration formula represents the present value of future payments, weighted by the time interval until the payments occur. The longer the intervals until payments are made, the larger will be the numerator, and the larger will be the duration. The denominator represents the discounted future cash flows resulting from the bond, which is the bonds present value. n
DUR =

(1 + i) (1 + i)
t =1 t =1 n

Ct (t ) Ct

where : Ct = the coupon or principal payment generated by the bond t = the time at which the payments are provided i = the bond ' s yield to maturity

Duration Example

As an example, the duration of a bond with $1,000 par value and a 7 percent coupon rate, three years remaining to maturity, and a 9 percent yield $70 $70(2) to maturity is:

$1070(3) (1.09)1 (1.09) 2 (1.09) 3 DUR = $70 $70 $1070 + + 1 2 (1.09) (1.09) (1.09) 3 = 2.80 years + +

2.8 years Modified duration = = 2.68 years .09 (1 + ) 2

Duration Example

As an example, the duration of a bond with $1,000 par value and a 7 percent coupon rate, three years remaining to maturity, and a 9 percent yield to maturity is:
Yield to Maturity = 0.09 Time Weighted Present Value Relative Weights 0.0676448 0.1241188 2.6108875 2.8026511 years 2.6819627 years

Time

Cashflow PVIF 1 70 0.917431 2 70 0.84168 3 1070 0.772183 Bond Price =

Present Relative Value Weights 64.22018349 0.067645 58.91759953 0.062059 826.2363237 0.870296 949.3741067 Duration = Modified Duration =

Duration Example ...

As an example, the duration of a zero-coupon bond with $1,000 par value and three years remaining to maturity, and a 9 percent yield to maturity is:

$1000(3) (1.09) 3 DUR = $1000 (1.09) 3 = 3.0 years

Duration

is a handy tool because it can encapsule interest rate exposure in a single number. rather than focus on the formula...think of the duration calculation as a process... semi-annual duration calculations simply call for halving the annual coupon payments and discounting every 6 months.

23

Duration Rules-of-Thumb

duration of zero-coupon bond (strip bond) = the term left until maturity. duration of a consol bond (ie. a perpetual bond) = 1 + (1/R)

where: R = required yield to maturity

duration of an FRN (floating rate note) = 1/2 year

24

Other Duration Rules-ofThumb

Duration and Maturity


duration increases with maturity of a fixed-income asset, but at a decreasing rate.

Duration and Yield



duration decreases as yield increases.

Duration and Coupon Interest



the higher the coupon or promised interest payment on the security, the lower its duration.

25

Economic Meaning of Duration

duration is a direct measure of the interest rate sensitivity or elasticity of an asset or liability. (ie. what impact will a change in YTM have on the price of the particular fixed-income security?) interest rate sensitivity is equal to: dP P = - D [ dR/(1+R)]
Where: P= C= R= N= F= Price of bond Coupon (annual) YTM Number of periods Face value of bond

26

Problems with Duration

It assumes a straight line relationship between the changes in bond price given the change in yield to maturity however, the actual relationship is curvilineartherefore, the greater the change in YTM, the greater the error in predicted bond price using duration as can be seen

The Problem with Duration

Bond Price
Error from using duration only

Current bond price

$1,200 $1,100 $1,000 $900

Bond Price predicted by duration

Actual Bond Price

Yield to Maturity (%)

Uses of Duration

Immunization strategies:

If you equate the duration of an asset (bond) with the duration of a liability, you will (subject to some limitations) immunize your investment portfolio from interest rate risk.

Used in predicting bond prices given a change in interest rates (yields)

Predicting a Bond Price using Duration

Price movements of bonds will vary proportionally with modified duration for small changes in yields. An estimate of the percentage change in bond price equals the change in yield times the modified duration.
P 100 = Dmod i P Where : P = the change in the price for the bond P = the beginning price for the bond - D mod = the modified duration of the bond i = the yield change in basis points divided by 100.

Predicting a Bond Price Using Duration

Yield to Maturity = 0.09 Time Weighted Present Value Present Relative Relative Time Cashflow PVIF Value Weights Weights 1 70 0.917431 64.22018349 0.06764476 0.067645 2 70 0.84168 58.91759953 0.06205941 0.124119 3 1070 0.772183 826.2363237 0.87029583 2.610887 Bond Price = 949.3741067 Duration = 2.802651 years Modified Duration = 2.681963 years Predicted change in interest rates (basis points) = 0.5 Predicted percentage change in bond price=-D(mod) times 0.5-1.340981 = Predicted bond price = 936.6431768

Actual Bond Price

Yield to Maturity = 0.095

Time

Cashflow PVIF 1 70 0.913242 2 70 0.834011 3 1070 0.761654 Bond Price =

Present Value 63.92694064 58.38076771 814.969621 937.2773293

As you can see from the previous slide, using modified duration and predicting an increase of 0.5% in yield, we forecast the bond price to be $936.64 where as it will actually be $937.27.

Definitions - Convexity

Bond convexity is the difference between the actual price change of a bond and that predicted by the duration statistic. It is the second derivative of the bond-pricing equation with respect to yield. The importance of convexity increases as the magnitude of rate changes increases. Other rules:

The higher the yield to maturity, the lower the convexity, everything else being equal. The lower the coupon, the greater the convexity, everything else being equal. The greatest convexity would be observed for stripped bonds at low yields.

Second Derivative of the Bond Pricing Equation

The basic bond pricing Equation is : Ct t t =1 (1 + R ) We can re - express the bond pricing equation to move the discount factors to the numerator : P=
n n

P = Ct (1 + R) t
t =1

Now take the first derivative of the price with respect to the rate : dP n = tCt (1 + R) t 1 dR t =1 Now take the second derivative of the price with respect to the rate : d 2P n = t (t 1)Ct (1 + R) t 2 2 dR t =1 =
t =1 n

t (t + 1)Ct (1 + R) t + 2

Convexity
Bond Price $1,200 $1,100 $1,000 $900

Notice the slope is less as the yield increases.

Yield to Maturity (%)

Computation of Convexity

3-year bond, 12% coupon, 9% YTM

0.09 "(3) (4) (5) t squared plus t 2 6 12 (6) =(4) times (5) 220.1834862 606.0095952 10378.14597 $11,204.34 years Present Cashflow PVIF Value 120 0.917431 110.0917431 120 0.84168 101.0015992 1120 0.772183 864.8454977 Bond Price = $1,075.94

Yield to Maturity = (1) (2) Time 1 2 3

d 2 P / di 2 Convexity = Price 1 1 1 = = = 0.88 2 2 (1 + i ) (1.09) 1.19 $11,204.50 0.84 = $9,411.78 9,411.78 Convexity = = 8.75 1,075.95

Bond Portfolio Strategy

Selection of the most appropriate strategy involves picking one that is consistent with the objectives and policy guidelines of the client or institution. There are two basic types of strategies:

Active Laddered Barbell Bullet

Swaps (substitution, inter-market or yield spread, bond-rating, rate anticipation)

Passive buy and hold, and indexing

Active Bond Portfolio Strategies

Other authors categorize bond strategies as follows (see Frank K. Reilly and Keith C. Brown, Investment Analysis and Portfolio Management.)

Passive Portfolio Strategies Buy and hold Indexing Active Management Strategies Interest rate anticipation Valuation analysis Credit analysis Yield spread analysis Bond swaps Matched-funding strategies Dedicated portfolio exact cash match Dedicated portfolio optimal cash match and reinvestment Classical (pure) immunization Horizon matching Contingent procedures (structured active management) Contingent immunization Other contingent procedures

Buy-and-Hold Strategy

Involves: Finding issues with desired quality, coupon levels, term to maturity, and important indenture provisions, such as call features Looking for vehicles whose maturities (or duration) approximate their stipulated investment horizon to reduce price and reinvestment rate risk. A modified buy and hold strategy involves: Investing with the intention of holding until maturity, however, they still actively look for opportunities to trade into more desirable positions.

Indexing Strategy

The manager builds a portfolio that will match the performance of a selected bond-market index such as the Lehman Brothers Index, Scotia McLeod bond index, etc.

In such a case, the bond manager is NOT judged on the basis of risk and return compared to an index, BUT on how closely the portfolio tracks the index.

Tracking error equals the difference between the rate of return for the portfolio and the rate of return for the bond-market index. When a portfolio has a return of 8.2 percent and the index an 8.3 percent return, the tracking error would be 10 basis points.

Active Portfolio Strategies

There are three sources of return from holding a fixed-income portfolio:

coupon income any capital gain (or loss), reinvestment income

in general, the following factors affect a portfolios return:

changes in the level of interest rates changes in the shape of the yield curve changes in the yield spreads among bond sectors changes in the yield spread (risk premium) for a particular bond (perhaps the default risk associated with a particular bond increases or decreases)

Manager Expectations vs. Market Consensus

A money manager who pursues an active strategy will position a portfolio to capitalize on expectations about future interest rates. But the potential outcome (as measured by total return) must be assessed before an active strategy is implemented.

The primary reason for assessing the potential outcome is that the market (collectively) has certain expectations for future interest rates, and these expectations are embodied in the market price of bonds.

Yield Curve Strategies

Yield curve strategies involve positioning a portfolio to capitalize on expected changes in the shape of the yield curve. A shift in the yield curve refers to the relative change in the yield for each Treasury maturity.

A parallel shift in the yield curve refers to a shift in which the change in the yield on all maturities is the same. A nonparallel shift in the yield curve means that the yield for each maturity does not change by the same number of basis points.

Historically, two types of nonparallel yield curve shifts have been observed: a twist in the slop of the yield curve and a change in the humpedness of the yield curve.

Upward Parallel Shift

Yield change

0 Short Intermediate maturity Long

Downward Parallel Shift

Yield change

0 Short Intermediate maturity Long

Nonparallel Shifts

A nonparallel shift in the yield curve means that the yield for each maturity does not change by the same number of basis points.

Historically, two types of nonparallel yield curve shifts have been observed: a twist in the slope of the yield curve and a change in the humpedness of the yield curve.

Yield Curve Shifts

A flattening of the yield curve means that the yield spread between the yield on a long-term and a short-term Treasury has decreased. A steepening of the yield curve means that the yield spread between a longterm and a short-term Treasury has increased.

Flattening Twist

Yield change

Short

Intermediate maturity

Long

Steepening Twist

Yield change

Short

Intermediate maturity

Long

Non-parallel Yield Curve Shifts

A change in the humpedness of the yield curve is referred to as a butterfly shift. This is also an example of a nonparallel shift.

Positive Butterfly

Yield change

Short

Intermediate maturity

Long

Negative Butterfly

Yield change

Short

Intermediate maturity

Long

Yield Curve Shifts 1979-1990

Frank Jones found that the three types of yield curve shifts are NOT independent. (parallel, twists and butterfly) The two most common shifts:

a downward shift combined with a steepening of the yield curve, and an upward shift combined with a flattening of the yield curve.

Upward shift/flattening/positive butterfly

Positive butterfly Flattening Parallel

Yield

Term to Maturity

Downward shift/steepening/ negative butterfly

Parallel

Yield

Steepening Negative butterfly

Term to Maturity

Yield Curve Shifts and returns

Jones found that parallel shifts and twists in the yield curve are responsible for 91.6% of Treasury returns, while 3.4% of the returns is attributable to butterfly shifts, and the balance, 5%, to unexplained factor shifts. This indicates that yield curve strategies require a forecast of the direction of the shift and a forecast of the type of twist.

Yield Curve Strategies

In portfolio strategies that seek to capitalize on expectations based on short-term movements in yields, the dominant source of return is the change in the price of the securities of the portfolio. This means that the maturity of the securities in the portfolio will have an impact on the portfolios return

a total return over a 1-year investment horizon for a portfolio consisting of securities all maturing in 1 year will not be sensitive to changes in how the yield curve shifts 1 year from now. In contrast, the total return over a 1-year investment horizon for a portfolio consisting of securities all maturing in 30 years will be sensitive to how the yield curve shifts because, 1 year from now, the value of the portfolio will depend on the yield offered on 20-year securities.

Yield Curve Strategies

(bullet, barbell, and ladder)
Bullet Strategy Spikes indicate maturing principal Comment: Bullet concentrated around year 10

9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Barbell Strategy Spikes indicate maturing principal Comment: Barbell below and above 10 years
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Ladder strategy Spikes indicate maturing principal Comment: Laddered up to year 20

9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Yield Curve Strategies

Each of these strategies (bullet, barbell, ladder) will result in different performance when the yield curve shifts. The actual performance will depend on both the type of shift and the magnitude of the shift.thus, no general statements can be made about the optimal yield curve strategy.

Duration and Yield Curve Shifts

Duration is a measure of the sensitivity of the price of a bond or the value of a bond portfolio to changes in market yields.

A portfolio with a duration of 4 means that if market yields increase by 100 basis points, the portfolio will change by approximately 4%. If a portfolio of bonds is made up of 5-year, 10-year and 20-year bonds, and the portfolios duration is 4the portfolios value will change by 4% if the yields on all bonds change by 100 basis points. That is, it is assumed that there is a parallel yield curve shift.

Analysis of Expected Yield Curve Strategies

The proper way to analyze any portfolio strategy is to look at its potential total return. Example:

consider the following two yield curve strategies:

Bullet portfolio: 100% bond C Barbell portfolio: 50.2% bond A and 49.8% bond B

Three Hypothetical Treasury Securities

Bond Coupon Maturity (years) 5 20 1 0 Price Plus Accrued Interest 1 00 1 00 1 00 Yield to Maturity 8.50% 9.50% 9.25% Dollar Duration 4.005 8.882 6.434 Dollar Convexity 1 64 9.81 1 702 24.1 55.4506

A B C

8.50% 9.50 9.25

The bullet portfolio consists of only bond C, the 10-year bond. All principal is received when bond C matures in 10 years. The barbell portfolio consists of almost equal amount of the short-term and long-term securities. The principal will be received at two ends of the maturity spectrum. (5 year and 20 year dates).

Barbell and Bullet Duration

Bond Coupon Maturity (years) 5 20 1 0 Price Plus Accrued Interest 1 00 1 00 1 00 Yield to Maturity 8.50% 9.50% 9.25% Dollar Duration 4.005 8.882 6.434 Dollar Convexity 1 64 9.81 1 702 24.1 55.4506

A B C

8.50% 9.50 9.25

The dollar duration of the bullet portfolio per 100-basis-point change in yield is 6.43409. Dollar duration is a measure of the dollar price sensitivity of a bond or a portfolio. The dollar duration for the barbell portfolio is just the weighted average of the dollar duration of the two bonds: = .502(4.005) + 0.498(8.882) = 6.434

Dollar Convexity

Duration is just a first approximation Convexity is the second derivative and simply gives a more accurate indication of sensitivity of bond price to a change in interest rates. Both duration and convexity assume a parallel shift in the yield curve!! Two general rules for convexity: The higher the yield to maturity, the lower the convexity, everything else being equal The lower the coupon, the greater the convexity, everything else being equal.

Managers should seek high convexity while meeting other constraints in their bond portfoliosby doing so, they minimize the adverse effects of interest rate volatility for a given portfolio duration.

Swaps

Swaps are used to do one of four things:

Increase current income Increase yield to maturity Improve the potential for price appreciation with a decline in interest rates Establish losses to offset capital gains or taxable income.

Substitution Swap

Purpose- to increase current yield Assumes market inefficiencythat results in equally risky bonds (default risk, same duration) to have different pricesthis is an arbitrage action In an efficient market, we expect few of these situations to arise.

Intermarket or Yield Spread Swap

Purpose- to take advantage of expected changes in the default risk premiums that may occur as a result of changes in market optimism or pessimism. A confidence index measures these changes.

Bond-Rating Swap

Purpose- to take advantage of expected changes in the default risk premiums that may occur as a result of changes in bond ratings. Fundamental analysis of the prospectus of the individual issuer and of their financial health is used to predict changes in bond ratings (but this must be done in conjunction with analysis of changes in the overall market returns (ie. yield curve changes).)

Rate Anticipation Swap

The purpose is to take advantage of expected changes in interest rates by positioning the bond portfolio with an appropriate duration, AND an appropriate default risk category.