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Managing Bond Portfolios

Learn about active and passive strategies in managing fixed income securities, including bond-index funds, immunization techniques, active bond management, bond swaps, yield curve analysis, and contingent immunization.

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Managing Bond Portfolios

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  1. Managing Bond Portfolios

  2. Managing Fixed Income Securities: Basic Strategies • Active strategy • Trade on fundamentals • Trade on market inefficiencies • Passive strategy • Control risk • Balance risk and return

  3. Passive Management • Buy and hold • Bond-Index Funds: Salomon Smith Barney Broad Investment Grade index, the Lehman Brothers Aggregate Bond Index, and the Merrill Lynch Domestic Master Index: maturities > 1 yr • Performance is judged by tracking error • Cellular approach • Immunization of interest rate risk: • Net worth immunization: price risk and reinvestment risk cancel out Duration of assets = Duration of liabilities • Target date immunization: portfolio rebalancing Holding Period matches Duration • Cash flow matching and dedication

  4. Example on rebalancing • Suppose a manager hold 3-year zero-coupon bond and perpetuities paying annual coupon with yield at 10%. To match the 7-year duration obligation, this year, the manager needs to: • w*3+(1-w)*1.1/0.1=7, so w = 0.5 • Next year: w*2+(1-w)*1.1/0.1=6, so w = 5/9

  5. Active Bond Management • Interest-rate anticipation • Risky strategy relying on uncertain forecasts • Valuation analysis • The portfolio manager attempts to select bonds based on their intrinsic value • Credit analysis • Involves detailed analysis of the bond issuer to determine expected changes in its default risk • For example, credit analysis on high yield bonds, Z-score models • Yield spread • Bond swaps

  6. Bond Swaps Continued • Substitution swap: exchange of one bond for a nearly identical substitute to take advantage of temporary market anomalies in yield spreads between equivalent issues • Inter-market swap: if yield spread b/n two sectors of the bond mkt is temporarily out of line, LTCM • Pure yield pickup, get out of low-coupon bond, invest in high-coupon, similar bonds • Tax swap: try to offset capital gains in other securities through the sale of a bond currently held and selling at a discount from the price paid a purchase, and swapping into a similar bond to hold the position

  7. Horizon Analysis: Yield Curve Ride Yield to Maturity % 1.5 1.25 .75 Maturity 3 mon 6 mon 9 mon

  8. Example on yield curve ride • 9-month bill yield is 1.5% per quarter Selling at 100/1.015^3 = 95.63 • If 1.5% remains the same after 3 month, the new price is 100/1.015^2 = 97.07, return is 1.5% • But with only 6 month remaining yield becomes 1.25%, therefore Price is 100/1.0125^2 = 97.55, holding period is 2%

  9. Contingent Immunization • A combination of active and passive management • The strategy involves active management with a floor rate of return. • As long as the rate earned exceeds the floor, the portfolio is actively managed. • Once the floor rate or trigger rate is reached, the portfolio is immunized.

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