Lecture 4 -

Bond Portfolio Management

2
Topics
Passive bond portfolio management.
What is portfolio immunization.
Facts about interest rate risk.
Duration.
Using duration for the purpose of immunization.
Active bond portfolio management.


3
Bond portfolio management
There are two types of bond portfolio management:
Passive:
following bond indexes such as Citigroup World
Government Bond Index
Value weighted index of fixed-rate gov bonds with maturity >
1 year
Immunization
To protect the net worth of financial institutions such as
banks against shocks due to interest rate fluctuations.
To ensure the ability of institutions such as pension funds to
fulfil their obligations.
Active: interest rate forecasting, search for mispriced
bonds.

4
Immunization
Constitutes a protection of the net worth from
interest rate fluctuations.

MV(equity) = f(MV(assets) - MV(debt))

Are the liabilities of banks long term or short term
liabilities? What about the banks assets?

How would a rise in the interest rates (for various
maturities) affect the market value of the banks
stocks?
5
Immunization
Example: 2003 was a good year for both stocks and bonds.
The S&P 500 increased by 25%.
The value of assets of the US pension funds increased by
more than 100 billion dollars!
But the PV of their obligations grew by much more, so that
they entered an actuary deficit.
The reason was a sharp decline in the interest rate
(Greenspan ear). Why?
The average obligation of the funds was for 15 years, whereas
the average life of the assets (mainly bonds but also stocks)
was 5 years. (why did they invest in stocks?).

6
Immunization
We can think of it as follows: After the decline in the
interest rate, in order to be able to fulfil their
obligations they had to invest more money relative to
before the interest rate decline.

In general a low interest rate environment is
problematic for pension funds since its more difficult
to finance future obligations.
Facts about interest rate risk
(price risk)
Recall that the price of a bond depends on the
various interest rates.

The bonds YTM is a weighted average of the various
interest rates for different maturities.
7
8
Facts about interest rate risk
(price risk)
There is a negative relation between bond prices and
the interest rates. Importantly, when we hear that
bond yields increased the meaning is that their
prices fell.

The relation between a bonds price to its YTM
(which is an average of the interest rates) is convex.
Facts about interest rate risk
(price risk)
The prices of long term bonds are more sensitive to
changes in the interest rates than the prices of short
term bonds.
To be more specific: the sensitivity of a bond to
changes in its YTM (which is an average of the
interest rates) is higher for long term bonds.
As time to maturity increases, that sensitivity rises
but at diminishing rates.
9
Facts about interest rate risk
(price risk)
The higher the coupon rate:



The higher the bonds YTM:
10
11
Facts about interest rate risk
(price risk)
We see that the the price sensitivity of bonds to
changes in the interest rates is affected by many
factors, all related to the effective time in which the
cash flows are received.

We need one measure which will summarize the
sensitivity of the bonds price to changes in its YTM
(i.e. the average interest rate).

This measure is called duration.
12
Duration

Duration is a measure for the effective time in which
the stream of cash flows is received.

It is a weighted average of the time of each payoff
where the weights are approximately the fraction of
the value of the payoff relative to the value of all the
payoffs (i.e. the bonds price).


13
Duration
The weight of time t is given by



And the duration is


This is called Macaulay duration.


t
t
t
w CF
y ice = + ( ) 1 Pr
t w t D
T
t

=
=
1
CF Cash Flow for period t t =
14
Duration
The Macauly duration:


For a zero coupon bond the duration equals the time to
maturity.
For a coupon bond the duration is shorter than the time to
maturity

PV
y
CF
t
D
T
t
t
t

=
+

=
1
]
) 1 (
[
15
Duration - example

Consider a 4 year bond, CR 10%, paid once a year, Par
1000 and YTM = 8.36%





501 . 3
0836 . 1
1100
0836 . 1
100
0836 . 1
100
0836 . 1
100
4
0836 . 1
1100
3
0836 . 1
100
2
0836 . 1
100
1
0836 . 1
100
4 3 2
4 3 2
=
+ + +
+ + +
= D
16
Duration
Duration has another meaning too: it is the elasticity
of the bonds price to changes in the average interest
rate.

That is, by what % (approximately) the bond price will
change when the YTM will change by 1% (say from
10% to 10.1% due to a change in the average interest
rate.
17
Duration as elasticity
Define y=YTM and Y=1+y
The YTM elasticity is:

18
Duration as elasticity
dY
dP
P
Y
Y
dY
P
dP
=
|
.
|

\
|
|
.
|

\
|
= =
Y in change %
P in change %
Elasticity

= =
+

= =

=
=
= |
.
|

\
|
= =
= =
(

=
=
(

= =
=
T
t
T
t
t
t
t
t
t
T
t
t
T
t
t
t
T
t
t
t
T
t
t
t
D P
Y
CF
t
Y
CF
t
P
Y
Y CF t
P
Y
dY Y CF d
P
Y
dY
Y
CF
d
P
Y
dY
dP
P
Y
Y
CF
P
1 1
1
1
1 1
1
1
/
/
/ Elasticity
: bond coupon a For
19
Is duration a good proxy for the change in the
bonds value in response to change in the
central bank rate?

The mathematical definition above shows us that duration is
the percentage change in the bond price in response to a
change in its YTM, i.e. the average interest rate.

This average of interest rates can change for example due to
changes in expected future interest rates.

The question is whether duration is a good enough proxy for
the percentage change in the bonds price in response to the
central bank interest rate?



20
Is duration a good enough proxy for the
percentage change in the bonds price in
response to the central bank interest rate?
If the central bank reduced the short term interest
rate by 0.25%, what will happen to the longer term
interest rates?
They will decline because the future short term
interest rates are expected to be lower (the interest
rate is very persistent statistically).
Moreover, portfolio managers will change the
composition of their portfolio into more long term
bonds, which will increase their prices and reduce
long term interest rates.
Is duration a good enough proxy for the
percentage change in the bonds price in
response to the central bank interest rate?

So all the yield curve will change in the same direction
and so the average interest rates.

Conclusion: duration is a good proxy to the percentage
change in the bond price in response to a change in the
central bank rate.
21
22
Duration and volatility

Note that long duration bonds have more volatile
returns (HPRs) not only due to a stronger response of
their prices to changes in the central bank rate but
also to changes in expectations for the future interest
rate and inflation.

Therefore when the macroeconomic uncertainty is
larger, the relative risk (price risk) of long duration
bonds is higher (relative to short duration bonds).
23
Duration rules
The duration of a zero coupon bond is equal
to its time to maturity.
The higher the coupon rate the duration__
The longer the time to maturity the longer
the duration.
The higher the YTM of a coupon bond the ___
the duration.
24
Low YTM and volatility
When yields are low as they are today (causing
duration to be higher) and high uncertainty, the
expected return (HPR) to volatility ratio is relatively
low.

Of course in equilibrium investors will not be willing
to hold bonds unless they offer a sufficiently
attractive expected return (the alternative asset
classes also offer low expected returns these days).
25
The effect of the coupon rate on
duration an example
Consider a 4-year coupon bond, CR 10% paid once a
year, par 1000 and YTM=8.36%



What will happen if the CR is 20%?
501 . 3
0836 . 1
1100
0836 . 1
100
0836 . 1
100
0836 . 1
100
4
0836 . 1
1100
3
0836 . 1
100
2
0836 . 1
100
1
0836 . 1
100
4 3 2
4 3 2
=
+ + +
+ + +
= D
501 . 3 24 . 3
0836 . 1
1200
0836 . 1
200
0836 . 1
200
0836 . 1
200
4
0836 . 1
1200
3
0836 . 1
200
2
0836 . 1
200
1
0836 . 1
200
4 3 2
4 3 2
< =
+ + +
+ + +
=
macaulay
D
26
The effect of the YTM on duration
an example
Suppose that the bond from the example above
had YTM=25%
501 . 3 35 . 3
25 . 1
1100
25 . 1
100
25 . 1
100
25 . 1
100
4
25 . 1
1100
3
25 . 1
100
2
25 . 1
100
1
25 . 1
100
4 3 2
4 3 2
< =
+ + +
+ + +
= D
27
Modified duration
Duration is the elasticity of the bond price with respect to its
YTM (average interest rates). It is the percentage change in the
price divided by the percentage change in the 1+YTM.
So, if for example the rate of change in the YTM (average of
interest rates) was 1%, say from 10% to 10.1% then the
duration tells us by what rate the bond price will change.
However, it is conventional to talk about changes in YTM and
changes in interest rates rather than about the % change in
these variables (so we will say that the YTM increased by 10bp
or 0.1 percentage point).
Therefore let us define the modified duration which will tell us
the % change in the bond price in response to a change (not
rate of change) in the YTM.
28
Modified duration
Recall that:



so


Define modified duration as
so
dY
dP
P
Y
Y
dY
P
dP
D =
|
.
|

\
|
|
.
|

\
|
= =
Y in change %
P in change %
YTM A =
A
*
D -
P
P
YTM
YTM
D
Y
Y
D
Y
Y
D
P
P
A
|
.
|

\
|
+
=
= A
|
.
|

\
|
=
|
.
|

\
|
A
=
|
.
|

\
|
A
1
|
.
|

\
|
+
=
YTM
D
D
1
*
29
Modified duration
So modified duration is the regular duration divided
by 1+YTM.
30
Modified duration - example
Consider a 4-year bond, par 1000, CR 4%, YTM 5%,
price 964.54. Assume that the yield curve is flat at 5%.
The duration of the bond is:


The modified duration is:
7704 . 3
54 . 964
05 . 1
1040
4
54 . 964
05 . 1
40
3
54 . 964
05 . 1
40
2
54 . 964
05 . 1
40
1
4 3 2
=
|
.
|

\
|
+
|
.
|

\
|
+
|
.
|

\
|
+
|
.
|

\
|
= D
591 . 3
05 . 1
7704 . 3
*
= = D
31
Suppose that the interest rate increased by 0.25%
(25 bp) and that the yield curve remained flat:



A direct calculation shows that the bond price will
decline by 0.892%:
% 898 . 0 00898 . 0 0025 . 0 591 . 3 % 25 . 0 591 . 3
*
= = = = A =
A
y D
P
P
93 . 955
0525 . 1
1000
0525 . 1 0525 . 0
1
0525 . 0
1
40
4
= +
(

= P
32
Yield
Price
Duration
Pricing Error
from convexity
Duration and Convexity
33
Correction for Convexity

=
(

+
+ +
=
n
t
t
t
t t
y
CF
y P
Convexity
1
2
2
) (
) 1 ( ) 1 (
1
Correction for Convexity:
] ) ( [
2
1
2 *
y Conveixity y D
P
P
A + A =
A
34
The duration of a portfolio



Note: PV1 is the value of our holdings of bond 1, not necessarily that bonds
price
923 . 7
1300
2 200 9 1100
=
+
=
p
D
For example, the duration of a portfolios which
consists of 2 bonds, one with D=9 and price 1100
and the other with D=2 and price 200 is:
Total
n n
p
PV
D PV D PV D PV
D
+ + +
=
...
2 2 1 1
35
The duration of a levered portfolio
Assume that a portfolio managers invested in the above
2 bonds but also took a loan (issued bonds) with D=5
and PV of 1000.
.
The net worth of the portfolio is 300.



Note that a liability is a negative asset.

If, for example, the bonds YTM is 5% then the modified
duration is 16.82%.
66 . 17
300
5 1000 2 200 9 1100
=
+
=
p
D
36
The duration of a levered portfolio
Notice that there is no meaning here for effective time
to maturity since the duration of the portfolio is larger
than any of the assets and liabilities.
The meaning: a rise of 1% (100 bp) in the interest rate
will case a decline of 16.28% in the portfolio value
(approximately).
If the liability had D=12 then


The meaning: due to the leverage a rise of 1% in the
interest rate will cause a rise of 5.39% in the portfolio
value.
% 39 . 5 , 66 . 5
300
12 1000 2 200 9 1100
*
= =
+
= D D
p
37
The duration of a bank

The issue of duration is highly important for financial
institutions which their net worth is sensitive to
interest rate fluctuations, and primarily for banks.

38
A banks duration example
Assume that bank Z has the following assets:
Loans with PV 100 million and D=5.
A daily credit line of 50 million and D=?
Mortgages of 250 million with D=15.

And the following liabilities:
Deposits by the public PV 150 million, D=2.
Current accounts of 10 million, D=?
Savings accounts, PV 200 million, D=10.

What is the banks duration?
39
A banks duration example
The net worth of the bank is 40 million, hence:
So if for some reason the interest rate will rise by
1%, the bank will lose approximately 48.75% of its
net worth (say that modified duration is close to
the duration).
A rise of 2-3% in the interest rate will almost
eliminate the net worth of the bank!
Precisely for this reason, banks make sure their
duration does not deviate by much from 0!
75 . 48
40
10 200 0 10 2 150 15 250 0 50 5 100
=
+ +
=
Equity
D
40
A banks duration example
Suppose that the bank wants to change its duration to
0 (i.e. to immunize itself). What should it do?
There are several possibilities, for example reducing
the mortgages by selling some of them to another
bank for cash (this will constitute a reduction in the
asset duration).
Start a marketing campaign for savings programs
(increasing the duration of liabilities).
Suppose it wants to act in the first way. How many
mortgages it will have to sell?
41
A banks duration example
Search for X such that:
M X
X X
D
Equity
130
0
40
10 200 0 10 2 150 15 ) 250 ( 0 ) 50 ( 5 100
=
=
+ + +
=
42
Immunization and rebalancing
Several factors can cause a change in duration and
undo the immunization of the bank:
Changes in the interest rate. E.g. a rise in the interest rate
will reduce the duration of the assets and liabilities but not
necessarily to the same extent.
The mere passage of time.
Right after a coupon payment what happens to duration?
Hence the portfolio needs to be rebalanced
occasionally (theoretically continuously) so that the
bank remains immunized.