Managing bond protfolio

Investment Analysis
Report

Managing Bond Portfolio

Corentin Tarlier (S00404537)
Santiago Berisso (S00304739)

Lecturer: Dr. Pedro Gurrolla Date: December 2010
Table of contents
Introduction3

Tools for portfolio manager3

Malkie´s Bond-pricing relationships 3
Duration6
Convexity9
Convexity example10

Passive bond management:11

Immunization strategy11
Immunizationexample11
Immunization example (2)13
Bond indexing 14
Indexing example 14
Buy and hold strategy15

ACTive bond management:15

Interest rate anticipation 15
Rate anticipation swap16
Pure yield swap16
Horizon analysis16
Mispricing in the fix income market16
Substitution swap17
Inter market spread swap17
Tax swap18
Ladders, Barbells and Bullets strategies18
Ladders strategies18
Barbellsstrategies19
Bullets strategies19
Contingent immunization19
Simulation of an active bond portfolio19

CONCLUSION22

References23

Introduction:

In the 1950s the bond market was considered a safe, conservative investment. At that time a buy-and-hold strategy was sufficient. However, times changed, in the 1960s inflation increased, and interest rates became more volatile. Thus, with morevolatile interest rates, there was a great amount of profit potential with bonds. Also, in the 1970s the Macaulay duration measure was re-discovered. Stock investors have different levels of risk/return requirements; bond investors will do the same thing. A young, aggressive bond investor may choose a high-risk bond and is willing to risk his principal investment. A retiree may not be willing totake a risky bond investment and may, instead invest in conservative bonds. We assume in this report that we are a bond portfolio manager who presenting how manage a bond portfolio. First we will describe the different tools used for manage a bond portfolio then we will present the two family of strategies used by a bond portfolio manager, passive and active strategies.

Tools for portfoliomanager:

A bond portfolio manager needs some tools in order to manage efficiently the different portfolio with different strategies. Because interest rate risk is crucial to formulating both active and passive strategies, we begin our discussion with an analysis of the sensitivity of bond prices to interest rate fluctuation. This sensitivity is measured by the duration and the convexity of thebond, and we devote considerable attention to what determines bond duration and convexity.

Malkie´s Bond-pricing relationships:

In order to illustrate these relationships, we use the example following:

Table A.

Bond | Coupon | Maturity | Initial YTM |
A | 12% | 5 years | 10% |
B | 12% | 30 years | 10% |
C | 3% | 30 years | 10% |
D | 3% | 30 years | 6% |

We know that an inverserelationship exists between bond prices and yields. It’s because coupon amount have to be all the time the same, so if the yield increase, price have to decrease in order to keep the same coupon. But a question here is, how changing price corresponding to change in yield to maturity. It’s very important to understand that if for an investor or manager in bond portfolio
An increase in bond’syield maturity results in smaller price change, than a decrease in yield of equal change. We can see it well on the graph with the bond D, for instance while the yield decrease of 5%, bond’s price increase around 150% but while the yield increase to 5%, bond’s price decrease only around 50%. Because here the curve is convex, which mean decreases in yields have bigger impact on price than increases inyield of same range.
Price of long-term bonds is more sensitive to interest rate than price of short-term bond. It’s normal because the impact of higher discount rate will be greater if this rate is applied to more distant cash flow, and with a long-term bond we have more distant cash flow.
Interest rate risk is less than proportional to bond maturity. In the table A. if we compare bond A and…