Bodie, Kane and Marcus, Investments, Eighth Edition (2009), Chapter Summaries, Ravi Shukla

Chapter 16 Managing Bond Portfolios Overview

An unanticipated change in interest rates is the most important source of uncertainty (risk) for bonds. Eect of interest rate changes Bond prices move inversely with interest rates. Future values investments in bonds are aected by interest rate changes in less clear way. Prices of long-term bonds are more sensitive to interest rate changes than the prices of short-term bonds. The relationship, however, is complicated by the bonds coupon rate and yield to maturity. This Chapter denes duration, a measure of bonds length, that incorporates the eect of coupon rate and yield to maturity. Key conclusions: Sensitivity of a bond price is directly proportional to its duration. The future value of the investment in a bond is unaected by small changes in interest rates if the anticipated holding period equals duration. A bond portfolio can be immunized to interest rate changes by making its duration equal to the anticipated holding period.

16.1 Bond Price Sensitivity

The relationship between bond price (P ) and yield to maturity (y) is: P = =
t=1 T

C C C + FV C + + + + 1 + y (1 + y)2 (1 + y)T 1 (1 + y)T

T

CFt (1 + y)t PV(CFt )

=
t=1

PV(CFt ) is the present value of cash ow CFt that occurs at t. Inverse relationship between bond price and yield is obvious. Investors know that longer term bonds are more sensitive to interest rate changes. The relationship is complicated, as indicated by the properties described on page 514 of the BKM.

Example
Consider a $1,000 face value bond maturing in 20 periods with coupon rate of 4.00% per period. The yield to maturity of the bond is 6.00% per period. The price of the bond is $1,040 $40 $40 + + + 1 + 6.00% (1 + 6.00%)2 (1 + 6.00%)20 1 $1,000 1 = $40 + 1 20 6.00% (1 + 6.00%) (1 + 6.00%)20 = = $770.60 You can think of it as a 4% coupon bond with coupon paid annually. Yield to maturity is equal to the market interest rate, the discount rate the market uses to calculate the bonds value. If the bonds yield to maturity were to go to 6.01%, its price would become: $40 $1,040 $40 + + + 1 + 6.01% (1 + 6.01%)2 (1 + 6.01%)20 1 $1,000 1 1 + = $40 6.01% (1 + 6.01%)20 (1 + 6.01%)20 = = $769.64 which represents a change of $769.64 $770.60 = 0.12% $770.60 The following table shows the change in the prices of bonds of various lengths as the bonds yield to maturity goes from 6.00% to 6.01%:
Yield to Maturity 6.00% 6.01% $915.75 $915.35 $852.80 $852.13 $805.76 $804.91 $770.60 $769.64 $744.33 $743.30 $724.70 $723.62

5 10 15 20 25 30

Chg. -0.04% -0.08% -0.10% -0.12% -0.14% -0.15%

This table conrms the intuition that the longer the bonds maturity, the greater the sensitivity of its price to interest rate change. The relationship, however is complicated by other bond characteristics. The following table shows the eect of coupon rate.
Coupon Rate 4.00% 6.00% -0.04% -0.04% -0.08% -0.07% -0.10% -0.10% -0.12% -0.11% -0.14% -0.13% -0.15% -0.14%

5 10 15 20 25 30

0.00% -0.05% -0.09% -0.14% -0.19% -0.24% -0.28%

Maturity

2.00% -0.05% -0.08% -0.12% -0.14% -0.16% -0.17%

8.00% -0.04% -0.07% -0.09% -0.11% -0.12% -0.13%

10.00% -0.04% -0.07% -0.09% -0.10% -0.12% -0.13%

Maturity

 Other things being the same, a higher coupon rate bond has a lower interest rate sensitivity. The following table shows the eect of the bonds yield to maturity.
0.00% -0.05% -0.09% -0.12% -0.16% -0.19% -0.22% 2.00% -0.05% -0.08% -0.12% -0.15% -0.17% -0.20% Yield to Maturity 4.00% 6.00% -0.04% -0.04% -0.08% -0.08% -0.11% -0.10% -0.14% -0.12% -0.16% -0.14% -0.17% -0.15% 8.00% -0.04% -0.08% -0.10% -0.11% -0.12% -0.13% 10.00% -0.04% -0.07% -0.09% -0.10% -0.11% -0.11%

5 10 15 20 25 30

Other things being the same, bonds with higher yield to maturity have a lower interest rate sensitivity.

Exercise 16.1.1
9% coupon bond, annual coupons, 4 years to maturity, face value of $1,000, yield to maturity = 12%. Calculate the bond price. Calculate the bond price for y = 12.1%. Calculate P/P for y = 0.1%.

Duration
To get a closed form expression of a bond prices sensitivity to interest rate changes, take the rst derivative of P with respect to y, rearrange and use nite dierences () as approximations of innitesimal dierences (): P 1 P 1+y
T

Maturity

t
t=1

PV(CFt ) y P

This relationship gives the % change in the bond price in response to a y change in the yield to maturity. The smaller the change in the yield (y), the better the approximation. The expression in the square brackets is known as bonds duration, denoted by D:
T

D= = With this denition, we can write:

t
t=1 T t=1

PV(CFt ) P

t PV(CFt ) P

1 P Dy P 1+y D = y 1+y D y where D = D/(1 + y) is known as the bonds modied duration. 3

 Here is the derivation of the duration formula: P C C C C + FV = 2 (T 1) T y (1 + y)2 (1 + y)3 (1 + y)T (1 + y)T +1 C C C C + FV 1 +2 + + (T 1) +T = 1+y 1+y (1 + y)2 (1 + y)T 1 (1 + y)T = 1 1+y 1 1+y
T

t PV(CFt )
t=1 T

t
t=1 T

PV(CFt ) P P PV(CFt ) y P

P 1 = P 1+y

t
t=1

The derivative utilizes the following relationships: z =1+y 1 = z k zk F G H [F + G + H] = + + y y y y F F z = y z y k z = kz k1 z

Duration combines the bonds coupon rate, length (time to maturity), and yield to maturity to provide a single metric that measures the bond prices interest rate sensitivity. The duration is a weighted average of the times (t) at which the bond cash ows are paid. The weights are proportional to the present values of the cash ows:
T

D=
t=1 T

PV(CFt ) P PV(CFt )
T t=1

=
t=1 T

PV(CFt )

=
t=1

t wt

Exercise 16.1.2
9% coupon bond, annual coupons, 4 years to maturity, face value of $1,000, yield to maturity = 12%. Calculate the bonds duration. Calculate P/P for y = 0.1% using duration.

Observations about Duration

Duration of a zero-coupon bond is equal to its time to maturity. Duration of a console (perpetual) bond = 1+y y .

The higher the coupon rate, the lower the duration. For bonds priced at or above par, the longer the maturity, the higher the duration. The lower the yield to maturity, the higher the duration.

16.2 Convexity
The relationship between P and y is nonlinear. Because of the nonlinearity, the sensitivity of P to y calculated using the duration is an approximation. Duration is based on innitesimal changes in y (y 0) and measures the tangency of the curve describing the relationship between P and y at the current value of y. The degree of approximation depends on the nonlinearity of the relationship. The shape of the curve describing the relationship between P and y is convex (look at the shape standing at the origin of the graph) The nonlinearity, in this case, is the convexity.
$1,400 Actual $1,200 Duration Approximation

$1,000

$800 P $600

$400

$200

$0 0% 2% 4% 6% y 8% 10% 12%

Convexity is related to the second derivative of P to y: Convexity = 5 1 2P P y 2

 The expression for convexity of a bond turns out to be: Convexity = 1 P (1 + y)2
T

PV(CFt )(t2 + t)
t=1

A better approximation for interest rate sensitivity, utilizing its convexity, is P 1 D y + Convexity(y)2 P 2 Note that even this relationship is an approximation, though a better approximation than the one based on the duration alone.

Exercise 16.2.1
9% coupon bond, annual coupons, 4 years to maturity, face value of $1,000, yield to maturity = 12%. Calculate the bonds convexity. Calculate P/P for y = 0.1% using duration and convexity.

Question?
Why are we messing around with duration and convexity? Why not just calculate price of a bond at y and then at y + y, and calculate the percent change in the bond price?

16.3 Passive Bond Management

Biggest investors in bonds Bond mutual funds Pension funds Insurance companies Strategies Indexing Immunize portfolio value from interest rate changes

Indexing
Create a bond portfolio that mimics the returns of a bond index Challenges: Large number of bonds in the indexes Heavy turnover due to the changes in the index composition Unlike stocks, bonds have nite lives Reinvestment of coupon income

Immunization
Denition: Making the future value a bond portfolio insensitive to interest rate changes Suppose you have a liability of X, h years from now Numerical example: You have to pay $3 million 7.5 years from now. To meet the liability, you buy a coupon bond with yield to maturity of y, maturing in T years, T > h. Numerical example: An 8% coupon bond with 12 years to maturity, and yield to maturity = 10% ($1,000 face value bond is priced at $863.73). You buy sucient number of bonds, reinvest coupon income until the date the liability is due, and sell the bond at t = h. Assumption: Term structure is at. So, all interest rates related to the bond cash ows are equal to the bonds yield to maturity, y. We avoid mathematical complexity by assuming a at term structure. Intuitions developed with this assumption are valid for the real world where the shape of the term structure is much more complex. Time line showing the cash ows. h and h+ are integers around h:

C ...

C ...

C + FV

1 Numerical example:

h+

T 1

$80

$80 ...

$80

$80 ...

$80

$1,080

7.5

11

12

Cash ow from reinvested coupons: Vt=h [CFt ] = C(1 + y)h1 + C(1 + y)h2 +
t<h

Vt=h [CFt ] is the value (compounded value in this case) of CFt at t = h. Numerical example: = $80(1 + 10%)6.5 + $80(1 + 10%)5.5 + + $80(1 + 10%)0.5 = $796.02 Cash ow from the sale of the bond: Ph =
t>h

Vt=h [CFt ] = + C(1 + y)(T 1h) + (C + F V )(1 + y)(T h)

Vt=h [CFt ] is the value (discounted value in this case) of CFt at t = h.

 Numerical example: = $80(1 + 10%)0.5 + + $80(1 + 10%)3.5 + $1,080(1 + 10%)4.5 = $969.29 Total cash ow from the bond at the end of the holding period: $796.02 + $969.29 = $1,765.31 Verify that $1,765.31 = (1 + 10%)7.5 $863.73 Algebraically, the sum of reinvested coupons and sale price adds up to: =
t<h T

Vt=h [CFt ] +
t>h T

Vt=h [CFt ] (1 + y)h Vt=0 [CFt ]

t=1

=
t=1

Vt=h [CFt ] =
T

= (1 + y)h
t=1

Vt=0 [CFt ] = (1 + y)h P

where P is the bond price today. Consider a shift in the term structure of y immediately after the purchase of the bond. Shift: All interest rates change by y, regardless of the length of the bond. Normally the changes in the interest rates a much more complex. Two possible cases: y > 0: Value of reinvested coupons goes up. Value of future price of the bond goes down. y < 0: Value of reinvested coupons goes down. Value of future price of the bond goes up. Net impact on the future payo: Depends on the length of the holding period. Spreadsheet: Immunization What holding period h immunizes the future payo to changes in interest rates? Mathematically: h? such that Vh =0 y

Answer: h = D, where D is the duration of the bond. Here is the proof that h = D immunizes the bond: Vh y (1 + y)h P y h (1 + y) P P + (1 + y)h y y P h(1 + y)h1 P + (1 + y)h y 8 =0 =0 =0 =0

From the derivation of bond price sensitivity, we know that 1 P = DP y 1+y Substituting this above, we get h(1 + y)h1 P + (1 + y)h 1 DP = 0 1+y h=D

h(1 + y)h1 P D(1 + y)h1 P = 0

The payo from liquidating a bond in D years is unaected by changes in interest rates. D is the bonds duration. You cant choose your h, but you can choose your bond such that its D = h. Eect of Holding Period on Ending Value and Return

Nochangeininterestrates Realized Compound Return 10.0000% 10.0000% 10 0000% 10.0000% 10.0000% 10.0000% 10.0000%

Holding Reinvested BondSale Period Coupon Price Total 6.50 $647.38 $957.45 $1,604.83 7.00 7 00 $758.97 $924.18 $1,683.16 $758 97 $924 18 $1 683 16 7.50 $796.02 $969.29 $1,765.31 7.83 $821.25 $1,000.02 $1,821.27 8.00 $914.87 $936.60 $1,851.47 8.50 $959.52 $982.32 $1,941.84

Eect of Holding Period on Ending Value and Return

0.10%changeininterestrates Realized Compound Return 10.0206% 10.0119% 10.0045% 10.0001% 9.9979% 9.9922%

Holding Reinvested BondSale Period Coupon Price Total 6.50 $645.45 $961.33 $1,606.78 7.00 $756.65 $927.79 $1,684.44 7.50 $793.22 $972.63 $1,765.85 7.83 $818.12 $1,003.17 $1,821.28 8.00 $911.55 $939.64 $1,851.20 8.50 $955.61 $985.06 $1,940.67
9

 Compare this table with the previous table and note that if the holding period is 7.83 years, the bonds duration, the change of 0.1% in the yield to maturity has almost no eect on the ending value of the bond and the realized compound return.

Finding Bonds of Desired Duration

The message from the preceding analysis is that we should nd a bond whose duration is equal to the require holding period. It may be dicult to nd a particular bond whose duration matches the holding period exactly. However, one can create a portfolio of bonds such that the duration of the portfolio is equal to the required holding period. Under the assumption of at term structure, the duration of a portfolio of bonds is equal to the weighted average of durations of bonds in the portfolio. DP = wi Di

In general, one should calculate the duration of a portfolio of bonds using the portfolio cash ows as shown in the example next. Spreadsheet: Immunization

Example: Duration of a Bond Portfolio

Bond 1: Coupon rate = 7.00%, years to maturity = 3, yield to maturity = 5.00%. Bond 2: Coupon rate = 6.00%, years to maturity = 5, yield to maturity = 8.00%. Both bonds have face values of $1,000 and pay coupons at an annual frequency. The following time lines show the cash ows of the two bonds: $70 0 1 $60 0 You can verify that: The prices of the two bonds are $1,054.46 and $920.15, respectively. The durations of the two bonds are 2.81 and 4.44 years, respectively. Now consider a portfolio that invests 60% of its money in bonds 1 and 40% in bond 2. Suppose the total value of the portfolio is $100,000: $60,000 invested in bond 1 and $40,000 in bond 2. At the prices listed above, the portfolio will have 56.90 units of bond 1 and 43.47 units of bond 2. The combined cash ows of the portfolio are: 1 $70 2 $60 2 $1,070 3 $60 3 $60 4 $1,060 5

10

$100,000 0

$6,591.34 1

$6,591.34 2

$63,492.24 3

$2,608.28 4

$46,079.65 5

Now we can calculate the yield to maturity of the portfolio by solving for y below: $100,000 = which gives y = 6.57%. Finally, we calculate the duration of the portfolio: 1 $63,492.24 $6,591.34 $6,591.34 +3 1 +2 2 $100,000 1 + 6.57% (1 + 6.57%) (1 + 6.57%)3 $46,079.65 $2,608.28 +5 +4 4 (1 + 6.57%) (1 + 6.57%)5 which turns out to be 3.51. By choosing appropriate portfolio weights, we can design the bond portfolio to have any duration between 2.81 and 4.44 years. As a comparison, the weighted average yield to maturity and duration are: YTM : Duration : 60% 5.00% + 40% 8.00% = 6.20% 60% 2.81 + 40% 4.44 = 3.46 $6,591.34 $6,591.34 $63,492.24 $2,608.28 $46,079.65 + + + + 1+y (1 + y)2 (1 + y)3 (1 + y)4 (1 + y)5

Needless to say, weighted average YTM and duration are not a very good approximation in this case.

Duration Matching
A nancial institution may be holding a portfolio of bonds to meet a series of obligations, rather than a single liability. Changes in interest rates will aect the value of the bond portfolio as well as the present value of obligations. The nancial institution will be unaected by the changes in the interest rates as long as the change in the value of the portfolio matches the change in the value of the obligations. This will happen if the duration of the portfolio matches the duration of the obligations.

Bond Portfolio Rebalancing

Durations of bonds change with changes in yield to maturity and passage of time. Consider an 8% coupon bond with 12 years to maturity with YTM = 10%. The bonds price is $863.73 and duration is 7.83 years. If the bonds YTM changes to 11% the duration becomes 7.67 years. If the bonds time to maturity changes to 11 years, the bonds duration changes to 7.46 years. Note: Except for zero coupon bonds, duration decreases by an amount less than the passage of time. Bond portfolios need to be rebalanced periodically to ensure that their duration matches the target investment horizon. 11