Investments, 8

th
edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 16
Managing Bond
Portfolios
16-2
Inverse relationship between price and yield
An increase in a bonds yield to maturity
results in a smaller price decline than the
gain associated with a decrease in yield
Long-term bonds tend to be more price
sensitive than short-term bonds
Bond Pricing Relationships
16-3
Figure 16.1 Change in Bond Price as a
Function of Change in Yield to Maturity
16-4
As maturity increases, price sensitivity
increases at a decreasing rate
Price sensitivity is inversely related to a
bonds coupon rate
Price sensitivity is inversely related to the
yield to maturity at which the bond is selling
Bond Pricing Relationships Continued
16-5
Table 16.1 Prices of 8% Coupon Bond
(Coupons Paid Semiannually)
16-6
Table 16.2 Prices of Zero-Coupon Bond
(Semiannually Compounding)
16-7
A measure of the effective maturity of a
bond
The weighted average of the times until
each payment is received, with the
weights proportional to the present value
of the payment
Duration is shorter than maturity for all
bonds except zero coupon bonds
Duration is equal to maturity for zero
coupon bonds
Duration
16-8
t
t
t
w CF
y ice = + ( ) 1 Pr
t w t D
T
t

=
=
1
CF Cash Flow for period t t =
Duration: Calculation
16-9
Spreadsheet 16.1 Calculating the
Duration of Two Bonds
16-10
Price change is proportional to duration and not
to maturity


D
*
= modified duration

Duration/Price Relationship
(1 )
1
P y
Dx
P y
( A A +
=
(
+

*
P
D y
P
A
= A
16-11
Rules for Duration
Rule 1 The duration of a zero-coupon bond
equals its time to maturity
Rule 2 Holding maturity constant, a bonds
duration is higher when the coupon rate is
lower
Rule 3 Holding the coupon rate constant, a
bonds duration generally increases with its
time to maturity
Rule 4 Holding other factors constant, the
duration of a coupon bond is higher when the
bonds yield to maturity is lower
Rules 5 The duration of a level perpetuity is
equal to: (1+y) / y


16-12
Figure 16.2 Bond Duration versus
Bond Maturity
16-13
Table 16.3 Bond Durations (Yield to
Maturity = 8% APR; Semiannual
Coupons)
16-14
Convexity
The relationship between bond prices and
yields is not linear
Duration rule is a good approximation for only
small changes in bond yields
16-15
Figure 16.3 Bond Price Convexity: 30-
Year Maturity, 8% Coupon; Initial Yield to
Maturity = 8%
16-16
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
P
D y Convexity y
P
A
= -A + A
16-17
Figure 16.4 Convexity of Two Bonds
16-18
Callable Bonds
As rates fall, there is a ceiling on possible
prices
The bond cannot be worth more than its
call price
Negative convexity
Use effective duration:

/
Effective Duration =
P P
r
A
A
16-19
Figure 16.5 Price Yield Curve for a
Callable Bond
16-20
Mortgage-Backed Securities
Among the most successful examples of
financial engineering
Subject to negative convexity
Often sell for more than their principal
balance
Homeowners do not refinance their loans
as soon as interest rates drop
16-21
Figure 16.6 Price -Yield Curve for a
Mortgage-Backed Security
16-22
Mortgage-Backed Securities Continued
They have given rise to many derivatives
including the CMO (collateralized mortgage
obligation)
Use of tranches

16-23
Figure 16.7 Panel A: Cash Flows to Whole
Mortgage Pool; Panels BD Cash Flows to
Three Tranches
16-24
Bond-Index Funds
Immunization of interest rate risk:
Net worth immunization
Duration of assets = Duration of liabilities
Target date immunization
Holding Period matches Duration
Passive Management
16-25
Figure 16.8 Stratification of Bonds into
Cells
16-26
Table 16.4 Terminal value of a Bond Portfolio
After 5 Years (All Proceeds Reinvested)
16-27
Figure 16.9 Growth of Invested Funds
16-28
Figure 16.10 Immunization
16-29
Table 16.5 Market Value Balance Sheet
16-30
Cash Flow Matching and Dedication
Automatically immunize the portfolio from
interest rate movement
Cash flow and obligation exactly offset each
other
i.e. Zero-coupon bond
Not widely used because of constraints
associated with bond choices
Sometimes it simply is not possible to do
16-31
Substitution swap
Intermarket swap
Rate anticipation swap
Pure yield pickup
Tax swap
Active Management: Swapping
Strategies
16-32
Horizon Analysis
Select a particular holding period and predict
the yield curve at end of period
Given a bonds time to maturity at the end of
the holding period
Its yield can be read from the predicted
yield curve and the end-of-period price can
be calculated
16-33
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
16-34
Figure 16.11 Contingent Immunization