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Indexing
Match performance of a selected bond index Performance analysis involves examining tracking error
Indexing methodologies
Duration
Since price volatility of a bond varies inversely with its coupon and directly with its term to maturity, it is necessary to determine the best combination of these two variables to achieve your objective A composite measure considering both coupon and maturity would be beneficial
Duration
C t (t ) (1 i) t t 1 D n Ct (1 i) t t 1
Where: t = time period in which the coupon or principal payment occurs Ct = interest or principal payment that occurs in period t i = yield to maturity on the bond
t PV (C )
t 1 t
price
Characteristics of Duration
Duration of a bond with coupons is always less than its term to maturity because duration gives weight to these interim payments A zero-coupon bonds duration equals its maturity An inverse relation between duration and coupon A positive relation between term to maturity and duration, but duration increases at a decreasing rate with maturity An inverse relation between YTM and duration Sinking funds and call provisions can have a dramatic effect on a bonds duration
Bond price movements will vary proportionally with modified duration for small changes in yields An estimate of the percentage change in bond prices equals the change in yield time modified duration
Source: L. Fisher and R. L. Weil, "Coping with the Risk of Interest Rate Fluctuations: Returns to Bondholders from Nave and Optimal Strategies," Journal of Business 44, no. 4 (October 1971): 418. Copyright 1971, University of Chicago Press.
Longest duration security gives maximum price variation Active manager wants to adjust portfolio duration to take advantage of anticipated yield changes
Expect rate declines (parallel shift in YC), increase average modified duration to experience maximum price volatility Expect rate increases (parallel shift in YC), decrease average modified duration to minimize price decline
Convexity
Modified duration approximates price change for small changes in yield Accuracy of approximation gets worse as size of yield change increases
WHY? Modified duration assumes price-yield relationship of bond is linear when in actuality it is convex. Result MD overestimates price declines and underestimates price increases So convexity adjustment should be made to estimate of % price change using MD
Convexity
Convexity of bonds also affects rate at which prices change when yields change Not symmetrical change
As yields increase, the rate at which prices fall becomes slower As yields decrease, the rate at which prices increase is faster Result convexity is an attractive feature of a bond in some cases
Convexity
The measure of the curvature of the priceyield relationship Second derivative of the price function with respect to yield Tells us how much the price-yield curve deviates from the linear approximation we get using MD
Coupon income Capital gain Reinvestment income Changes in level of interest rates Changes in shape of yield curve Changes in spreads among sectors Changes in risk premium for one type of bond
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Swapping or exchanging bonds in portfolio for new bonds to achieve target duration (rate anticipation swaps) Interest rate futures buying futures increases duration and selling futures decreases duration
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Ladder strategies Riding the YC Strategies result in different performance depending on size and type of shift hard to generalize which gives optimal strategy Identification of misvalued securities
Valuation analysis
Credit analysis
High-Yield Bonds
Bond swaps
Pure yield pickup swap Substitution swap Intermarket spread swap Tax swap
Classical immunization
Price risk
Immunization
Immunization
Pension funds, insurance companies Immunize future value of fund at some target date to protect against rate changes
Immunization Strategies
Rebalancing is necessary as duration declines more slowly than term to maturity MD changes when market interest rates change YC shifts
Matched-Funding Techniques
Dedicated portfolio
Exact cash match Optimal match with reinvestment Combination of immunization strategy and dedicated portfolio
Horizon matching
Contingent Immunization
Manager follows active strategy to point where trigger point is reached Switch made to passive strategy to meet minimum acceptable return Cushion spread Safety margin