C. Passive Management

1. C. Passive Management • Believe bond market is fairly efficient • Do not attempt to beat the market • Two main passive strategies • Bond index funds or ETFs • Particularly as long-term investment • Can be part of Markowitz portfolio selection • Immunize bond portfolio from interest rate risk

2. Immunization • Immunize bond portfolio from interest rate risk • Net worth immunization • Duration of assets = Duration of liabilities • Very important for financial institutions • FINE4700 • Target date immunization • Investment horizon = Duration of portfolio • FINE3200

3. How Does Immunization Work? • For net worth immunization, if • Duration of assets = Duration of liabilities • Then both sides of the balance sheet have the same sensitivity to interest rate changes

4. How Does Immunization Work? • Target date immunization • Suppose you have to make a single payment in 2 years. Put aside money in a bond portfolio for this purpose • If set duration of bond portfolio equal to investment horizon (2 years), then bond price risk offsets reinvestment risk • Do question posted on the course website

5. Duration of a portfolio • May need more than one bond in portfolio to match duration to horizon • How do we calculate the duration of a bond portfolio? • Portfolio duration has a nice property: Duration of a bond portfolio = weighted average of the individual bond durations

6. Target Date Immunization • What if you match term to maturity instead of duration? • Consider a 5-year investment horizon and an investment in a 5-year coupon bond • If interest rates fall, say after 2 years, coupons will be reinvested at a lower rate • Need bond price increase to offset lower reinvestment rate. • However, bond is maturing in year 5 – price movement is limited, restricted by par value • Not sufficient to offset the decline in the reinvestment rate

7. Target Date Immunization • If match duration, change in bond price will offset change in reinvestment rate • For coupon bonds, maturity > duration • Will need a coupon bond (or a bond portfolio) with maturity longer than 5 years • If interest rates fall, bond price can go up by an amount that is sufficient to offset the lower reinvestment rate

8. Immunization: Problems • Immunization based on duration matching will only work well for small interest rate changes • Because of convexity • Is your bond portfolio (asset) more convex or your obligation (liability)? • If bond portfolio is more convex, then duration matching will lead to surpluses • Example in ch.13

9. Immunization: Problems • Portfolio duration does not decrease linearly with the passage of time • Duration of coupon bonds decreases less rapidly than maturity  leads to mismatch over time • Portfolios need to be rebalanced periodically to maintain immunization

10. Immunization: Problems • Analysis more complicated if shift in the yield curve is nonparallel • One solution: manage each segment of the yield curve separately, i.e., hedge against an interest rate movement in each segment • Multifactor duration models – advanced quantitative models

11. D. Active Bond Management Traditional strategies • Bond swapping • Substitution swap • Pure yield pickup swap • Intermarket swap • Rate anticipation swap • Interest rate swaps

12. Bond Swapping Strategies • Substitution swap • Look for mispricing. Two close substitutes (maturity, credit quality, coupon, marketability and call provisions), but selling at different prices • Take advantage of a temporary mis-alignment in prices • Pure yield pickup swap • Look for yield improvement over the long term - not concerned with interim bond price fluctuations. Given two close substitutes, pick higher yielding one

13. Bond Swapping Strategies (cont’d) • Intermarket spread swap • If the yield spread between two bond markets (e.g., government and corporate) is too wide and is expected to narrow, then switch into the higher-yielding market • Rate anticipation swap • Swapping for higher (lower) duration bonds when interest rates are expected to fall (rise) • http://www.addenda-capital.com/publications/SCU%20123107(5).pdf

14. Interest Rate Swaps • First introduced in early 1980s (period of high volatility in interest rates) • Contract between two parties to exchange a stream of cash flow. Swap a floating-rate cash flow for a fixed-rate cash flow or vice versa • Rate based on a “notional principal”. No exchange of underlying assets required • Financial institutions act as swap dealers. May also take the other side of the contract

15. Interest Rate Swaps • Most commonly used short-term floating rate is the LIBOR (London Interbank Offered Rate) • Rate at which banks borrow from each other in the Eurodollar market • Why use these swaps? • Match cash outflow and inflow, e.g., if one is fixed-rate and the other is floating-rate • Swaps provide a cheaper and more flexible option than changing portfolios

16. Interest Rate Swap Example 7.05% 6.95% Firm A Firm B Swap Dealer 7% coupon obligation LIBOR obligation LIBOR LIBOR • Bid-ask spread: 7.05% - 6.95% = 0.10% or 10 basis pts • Firm A pays the dealer LIBOR in return for a fixed rate (6.95%) • transforms fixed rate debt into floating debt • now pays 7% + LIBOR – 6.95% = LIBOR + 0.05% • Firm B pays the dealer a fixed rate (7.05%) in return for LIBOR

17. Asset-Liability Management • Defined benefit (DB) pension plan • Liability/obligation: monthly pension payments to retirees (cash outflow) • Investment of assets to generate income (cash inflow) to match obligation • Liability matching (see Addenda immunization products) • Hot topic (see Boots example)