Topic 6: Bonds – Part 2

FIN 3702B
Investment Analysis and Portfolio Management
Arkodipta Sarkar
 Outline
• Interest Rate Risk and Duration.
• Bond Investment
 Outline
• Interest Rate Risk and Duration
• Bond Investment
 Risk in Bonds
• Default risk (credit risk)
– Moody’s / S&P / Fitch ratings
– High Grade: AAA/AA – (extremely) strong capability to pay interest and principal
– Medium Grade: A/BBB – adequately strong capability to repay, but may be affected by adverse
economy condition
– Speculative Grade: (Junk bond) BB/B – You take the risk!
– Default: <CCC – Close to bankrupt, or already in.
• Interest rate risk / Inflation risk
• Reinvestment risk
• Call risk
• Exchange rate risk
• Liquidity risk
 Determinants of Bond Yields
𝒀𝐢𝐞𝐥𝐝 = 𝐫𝐞𝐚𝐥 𝐫𝐚𝐭𝐞 𝐨𝐟 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 + 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐩𝐫𝐞𝐦𝐢𝐮𝐦
Term Structure
+ 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞 𝐫𝐢𝐬𝐤 𝐩𝐫𝐞𝐦𝐢𝐮𝐦
+ 𝐎𝐭𝐡𝐞𝐫 𝐫𝐢𝐬𝐤 𝐩𝐫𝐞𝐦𝐢𝐮𝐦𝐬
• Term Structure (real rate + inflation premium + interest rate risk premium)
– Compensation for time
– Money demand, real growth of economy, fiscal policy
– Money supply, monetary policy, domestic and foreign savings
– US Treasury bills/notes/bonds
• Other risk premiums
– Default and Credit risk
– Liquidity risk
– Exchange rate, political risks
– Other bond features
 Determinants of Nominal Interest Rates
• Supply
– Households
• Timing preference for consumption

• Demand
– Businesses
• Investment Opportunities in the economy

• Government’s Net Supply and/or Demand

– Budget Deficit  increase in borrowing  shift demand to the
right
– Expansion in Monetary Policy (Federal Reserve actions)  shift
supply to the right

• Expected rate of inflation

1 + 𝑖 = 1 + 𝑟 1 + 𝜋 𝑜𝑟 𝑖 ≈ 𝑟 + 𝜋
Yield Spreads
 Interest Rate Risk
 Bond price percentage change
New Price
 = −1
Old Price

 When interest rate rises, bond price falls

 Long maturity bond experiences greater magnitude of price change than
short maturity bond when interest rate changes
 semiannual 12% coupon, interest rate 10%  14%
 30-year: $1189  $860, -28%
 10-year: $1125  $894, -21%

 Percentage change in bond price due to interest rate change increases

with maturity but at a decreasing rate
 20-year: $1172  $867, -26%
 Interest Rate Risk (cont’d…)
 A decrease in interest rate leads to a bigger change in bond price than the same magnitude of increase in
interest rate
 semiannual 12% coupon, interest rate 10%  6%
 20-year: $1172  $1693, +45%
 Convexity

 High coupon bond experiences smaller percentage change in price than low coupon bond when interest
rate changes
 20-year, interest rate 10%  14%
 semiannual 6% coupon: $657  $467, -29%
o long maturity, low coupon bonds have greater volatility
o short maturity, high coupon bonds have smaller volatility
Change in Bond Prices with Change in YTM
 Trading Strategies

 If expect fall in interest rate

 maximum bond price appreciation for long-maturity, low-coupon bonds

 If expect rise in interest rate

 maximum protection with short-term, high-coupon bonds
 A Metric for Interest Rate Risk
 Longer maturity, higher price sensitivity to interest rate change
 Higher coupon, lower price sensitivity to interest rate change
 Suppose you are managing a $1M bond portfolio and read from the
market that interest rate has climbed up by 0.1%. How can you quickly
figure out the change of your portfolio value?
 We need a composite metric of price sensitivity to interest rate change,
incorporating maturity and coupon:
 Duration
 Duration
 The weighted average of the times until each payment is received, with the weights proportional to the
present value of the payment.
 A measure of the effective maturity of a bond.
 Below is the definition of Macaulay’s Duration:

where
Excel spreadsheet for calculating Duration
 Rules for Duration
 Rule 1 The duration of a zero-coupon bond equals its time to maturity.
 Rule 2 Holding maturity constant, a bond’s duration is higher when the coupon rate
is lower.
 Rule 3 Holding the coupon rate constant, a bond’s duration generally increases
with its time to maturity#.
 Rule 4 Holding other factors constant, the duration of a coupon bond is higher
when the bond’s yield to maturity is lower. 𝑦
1 1+𝑚
 Rule 5 The duration of a perpetuity is equal to: 𝑦
𝑚
𝑚
 Portfolio duration = weighted average of component duration

# Not true for deep-discount bonds

D p   wi Di
i
 Example

 Compute the duration of the semi-annual 8% coupon bond with a semi-annual YTM of 5% and
maturity of 2 years
 Compute the duration of zero coupon bond with a semi-annual YTM of 5% and maturity of 2 years
Solution
Bond Duration vs Bond Maturity
 Duration/Price Relationship
∆𝐏
≈ −𝐃∗ × ∆𝐲
𝐏
D
where D* = Modified duration = y , where m is payment frequency
(1+m)

 % change in bond price  – modified duration × change in yield

 $ change in bond price  % change in bond price × old bond price

 Example: Duration Rule
 As the manager of a $1M (face value) bond portfolio with 8% semi-annual
coupon, 9% YTM, 5 years to maturity
 The modified duration is ?
 Portfolio value is ?

 According to duration rule, when y changes from 9% to 9.1% (dy = 0.1%)

 % change in bond price = ?
 $ change in bond value = ?
 approximate portfolio value after the change is now ?

• Actual new price of the bond portfolio:

– The actual portfolio value = ?
– The actual $ change in bond value = ?
 Example: Duration Rule
 As the manager of a $1M (face value) bond portfolio with 8% semi-annual
coupon, 9% YTM, 5 years to maturity
 The modified duration is 4.02 years.
 Portfolio value is $960,436

 According to duration rule, when y changes from 9% to 9.1% (dy = 0.1%)

 % change in bond price = ?
 $ change in bond value = ?
 approximate portfolio value after the change is now ?

• Actual new price of the bond portfolio:

– The actual portfolio value = ?
– The actual $ change in bond value = ?
 Example: Duration Rule
 As the manager of a $1M (face value) bond portfolio with 8% semi-annual
coupon, 9% YTM, 5 years to maturity
 The modified duration is 4.02 years.
 Portfolio value is $960,436

 According to duration rule, when y changes from 9% to 9.1% (dy = 0.1%)

 % change in bond price = – 4.02 × 0.1% = – 0.402%
 $ change in bond value = – 0.402% × $960,436 = – $3,861
 approximate portfolio value after the change is now $956,575

• Actual new price of the bond portfolio:

– The actual portfolio value =
– The actual $ change in bond value =
 Example: Duration Rule
 As the manager of a $1M (face value) bond portfolio with 8% semi-annual
coupon, 9% YTM, 5 years to maturity
 The modified duration is 4.02 years.
 Portfolio value is $960,436

 According to duration rule, when y changes from 9% to 9.1% (dy = 0.1%)

 % change in bond price = – 4.02 × 0.1% = – 0.402%
 $ change in bond value = – 0.402% × $960,436 = – $3,861
 approximate portfolio value after the change is now $956,575

• Actual new price of the bond portfolio:

– The actual portfolio value = $956,587
– The actual $ change in bond value = $956,587 - $960,436= –$3,849 (–
0.4008%)
 Example: Duration Rule (cont’d…)
• As the manager of a $1M (face value) bond portfolio with 8% semi-annual
coupon, 9% YTM, 5 years to maturity.
• According to duration rule, when y changes from 9% to 9.1% (dy = 0.1%).
– Approximate portfolio value after the change is now $956,575
– The actual portfolio value = $956,587

• This is a trivial question when you are managing $1M portfolio, with an
estimation error of only $12. But if you are managing $1Billion portfolio, the
estimation error will become about $12,000.
• Actual new price > approximate new price
 Duration Trading Strategy
 Expect y 
 Upside price volatility
 Buy long duration bonds to maximize price appreciation

 Expect y 
 Downside price volatility
 Buy short duration bonds to minimize price depreciation

DP
» -D *´Dy
P
Bond Price Convexity (30-Year Maturity, 8% Coupon;
Initial Yield to Maturity = 8%
DP
» -D *´Dy
P
If the % change in a bond’s
price were exactly
proportionate to the change in
its yield, then a graph that
plots % change in price as a
function of the change in yield
would plot as a straight line
with a slope equal to –D*.

Yet, we clearly know the

relationship between bond
prices and yields are not linear
 Duration rule is only a good
approximation for small
changes in yields.
 Bond Investment Strategies
 Passive Investment strategies
 Indexing
 Immunization
• Both strategies see market prices as being correct, but the strategies have very different risk
profiles.
• Index portfolio will have the same risk-reward profile as the market index while immunized
portfolio seeks to have a virtually zero-risk profile.

 Active Investment strategies

– Swapping strategies
 Bond Index Funds
 Bond market indexing is similar to stock market indexing – the idea is to create a portfolio that mirrors
the composition of the index.
 Common indices for US market are Barclays Capital US Aggregate Bond Index, the Citigroup US Broad
Investment Grade (USBIG) Index and the Bank of America Merrill Lynch Domestic Master Index.
 Additional Challenges compared to Stock indexing:
– Bond indices contain thousands of issues, many of which are infrequently traded  this creates greater
replication challenges.
– Bond indices turn over more than stock indices as the bonds mature  this create greater re-balancing
challenges.
– Bonds generate considerable interest income from coupon receipts  this creates reinvestment challenges.

• In practice, bond index funds hold only a representative sample of the bonds
in the actual index.
 Bond Index Funds
① The bond market is stratified into several sub-classes, e.g. maturity, issuer, coupon rates, credit
risk, etc.
② Next, percentages of the entire universe falling within each cell are computed and reported.
③ Finally, the portfolio manager establishes a bond portfolio with representation for each cell that
matches the weight of that cell in the bond universe.

The characteristics of the

portfolio in terms of maturity,
coupon rate, credit risk,
industrial representation, etc.,
will match the characteristics of
the index, and the performance
of the portfolio likewise should
match the index.
 Immunization
 Immunization is a way to control interest rate risk.

 Widely used by banks, pension funds and insurance companies.

– Banks are concerned with protecting net worth
– Insurance companies and pension funds are concerned with protecting future values of
their portfolios to pay off future obligations

 Immunize a portfolio by matching the interest rate exposure of assets and

liabilities.
 This means: Match the duration of the assets and liabilities.

 Result: Value of assets will track the value of liabilities whether rates rise or
fall.
 Terminal Value of a Bond Portfolio After 5 Years
Consider, for example, an insurance company that
issues a guaranteed investment contract, or GIC,
for $10,000. (Essentially, GICs are zero-coupon
bonds issued by the insurance company to its
customers. They are popular products for individuals’
retirement- savings accounts.)
If the GIC has a 5-year maturity and a guaranteed
interest rate of 8%, the insurance company promises
to pay $10,000*(1.08)5 = $14,693.28 in 5 years.
Suppose that the insurance company chooses to
fund its obligation with $10,000 of 8% annual coupon
bonds, selling at par value, with 6 years to maturity.
Growth of Invested Funds
 Duration matching balances the
difference between the accumulated
value of the coupon payments
(reinvestment rate risk) and the sale
value of the bond (price risk).
 That is, when interest rates fall, the
coupons grow less than in the base
case, but the higher value of the bond
offsets this.
 When interest rates rise, the value of
the bond falls, but the coupons more
than make up for this loss because
they are reinvested at the higher rate.
Figure 16.9 illustrates this case.
 For a horizon equal to the portfolio’s
duration, price risk and reinvestment
risk exactly cancel each other out.
 Active Bond Investment
 Basis: you can predict interest rate movement or identify mispricing between two bonds or
portfolios.

 Substitution swap: an exchange of one bond for a nearly identical substitute (with equal
coupon, maturity, quality, call features, sinking fund provision, etc.
 E.g. Sale of a 20-year maturity, 6% coupon Toyota bond that is priced to provide a yield to
maturity of 6.05%, coupled with a purchase of a 6% coupon Honda bond with the same
time to maturity that yields 6.15%. If the bonds have about the same credit rating, there is
no apparent reason for the Honda bonds to provide a higher yield. Therefore, the higher
yield actually available in the market makes the Honda bond seem relatively attractive.

• Intermarket swap: if you believe that the yield spread between two sectors of bond market is
temporarily out of line.
– E.g. If the yield spread between 10-year Treasury bonds and 10-year Baa-rated corporate
bonds is now 3%, and the historical spread has been only 2%, an investor might consider
selling holdings of Treasury bonds and replacing them with corporates. If the yield spread
eventually narrows, the Baa-rated corporate bonds will outperform the Treasuries.
 Active Bond Investment (cont’d)
 Rate anticipation swap: pegged to interest rate forecasting (if rates will fall, move into longer
duration bonds).
 E.g. Sell a 5-year maturity Treasury bond, replacing it with a 25-year maturity Treasury bond. The new bond
has the same lack of credit risk as the old one, but has longer duration.

• Pure yield pickup: not to exploit mispricing, but to increase return by holding higher-yield
bonds.
– When the yield curve is upward-sloping, the yield pickup swap entails moving into longer-term bonds.

 Tax swap: move into bonds with tax advantages.

 E.g. Swap from one bond that has decreased in price to another if realization of capital losses is advantageous
for tax purposes.
 Readings and Assignment
• Readings:
– BKMJ Chapter 14 (14.1, 14.2, 14.3, 14.5)
– BKMJ Chapter 15 (15.1 – 15.5)
– BKMJ Chapter 16