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CHAPTER TWENTY-TWO
BOND PORTFOLIO
MANAGEMENT
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BOND PORTOLIOS
METHODS OF MANAGEMENT
Passive
rests on the belief that bond markets are semi-strong
efficient
current bond prices viewed as accurately reflecting
all publicly available information

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BOND PORTOLIOS
METHODS OF MANAGEMENT
Active
rests on the belief that the market is not so efficient
some investors have the opportunity to earn above-
average returns
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BOND PRICING THEOREMS
5 BOND PRICING THEOREMS
for a typical bond making periodic coupon
payments and a terminal principal payment
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BOND PRICING THEOREMS
5 BOND PRICING THEOREMS
THEOREM 1
If a bonds market price increases
then its yield must decrease
conversely if a bonds market price decreases
then its yield must increase
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BOND PRICING THEOREMS
5 BOND PRICING THEOREMS
THEOREM 2
If a bonds yield doesnt change over its life,
then the size of the discount or premium will
decrease as its life shortens
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BOND PRICING THEOREMS
5 BOND PRICING THEOREMS
THEOREM 3
If a bonds yield does not change over its life
then the size of its discount or premium will
decrease
at an increasing rate as its life shortens
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BOND PRICING THEOREMS
5 BOND PRICING THEOREMS
THEOREM 4
A decrease in a bonds yield will raise the bonds
price by an amount that is greater in size than the
corresponding fall in the bonds price that would
occur if there were an equal-sized increase in the
bonds yield
the price-yield relationship is convex
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BOND PRICING THEOREMS
5 BOND PRICING THEOREMS
THEOREM 5
the percentage change in a bonds price owing to a
change in its yield will be smaller if the coupon rate
is higher
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CONVEXITY
CONVEXITY DEFINITION:

a measure of the curvedness of the price-yield
relationship
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CONVEXITY
THE PRICE-YIELD RELATIONSHIP
YTM
Price
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CONVEXITY
THEOREM 1 TELLS US
price and yield are inversely related but not in a
linear fashion (see graph)
an increase in yield is associated with a drop in
bond price
but the size of the change in price when yield
rises is greater than the size of the price change
when yield falls
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DURATION
DEFINITION:
measures the average maturity of a stream of
bond payments
it is the weighted average time to full recovery
of the principal and interest payments
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DURATION
FORMULA


where P
0
= the current market price of
the bond
PV(C
t
)= the present value of the
coupon payments
t = time periods

=
(

=
T
t
t
t
P
C PV
D
1
0
) (
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DURATION
THE RELATION OF DURATION TO
PRICE CHANGES
THEOREM 5 implies
bonds with same maturity date but different coupon
rates may react differently to changes in the interest
rate
duration is a price-risk indicator
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DURATION
DURATION IS A PRICE-RISK
INDICATOR
FORMULA


rewritten

where y = the bonds yield to maturity
| | ) 1 ( ytm D
p
p
+ A ~
A
|
|
.
|

\
|
+
A
~
A
y
y
D
p
p
1
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DURATION
MODIFIED DURATION
FORMULA:


reflects the bonds % price change for a one
percent change in the yield
y
D
D
m
+
=
1
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DURATION
THE RELATIONSHIP BETWEEN
CONVEXITY AND DURATION
whereas duration would have us believe that the
relationship between yield and price change is
linear
convexity shows us otherwise
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DURATION
THE RELATIONSHIP BETWEEN CONVEXITY AND DURATION


YTM
P
C
0
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IMMUNIZATION
DEFINITION: a bond portfolio
management technique which allows the
manager to be relatively certain of a given
promised cash stream
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IMMUNIZATION
HOW TO ACCOMPLISH
IMMUNIZATION
Duration of a portfolio of bonds
equals the weighted average of the individual bond
durations in the portfolio
Immunization
calculate the duration of the promised outflows
invest in a portfolio of bonds with identical
durations
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IMMUNIZATION
PROBLEMS WITH IMMUNIZATION
default and call risk ignored
multiple nonparallel shifts in a nonhorizontal
yield curve
costly rebalancing ignored
choosing from a wide range of candidate bond
portfolios is not very easy
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ACTIVE MANAGEMENT
TYPES OF ACTIVE MANAGEMENT
Horizon Analysis
simple holding period selected for analysis
possible yield structures at the end of period are
considered
sensitivities to changes in key assumptions are
estimated
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ACTIVE MANAGEMENT
TYPES OF ACTIVE MANAGEMENT
Bond Swapping
exchanging bonds to take advantage of superior
ability to predict yields
Categories:
substitution swap
intermarket spread swap
rate anticipation swap
pure yield pickup swap
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ACTIVE MANAGEMENT
TYPES OF ACTIVE MANAGEMENT
Contingent Immunization
portfolio managed actively as long as favorable
results are obtained
if unfavorable, then immunize the portfolio
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PASSIVE MANAGEMENT
TYPES OF PASSIVE MANAGEMENT
INDEXATION
the portfolio is formed to track a chosen index