Bond Management

Strategies
Prof Hitesh Punjabi
Portfolio objectives and strategies
• Before investors construct a bond portfolio, they must answer two
critical questions:
1. What is the objective of the portfolio?
2. What is the appropriate strategy, to meet the objective, given the
current market conditions?
• Portfolio objective depends on:
1. Investor’s future cash requirement.
2. Investor’s risk tolerance.
• 30 year old-Maximize Capital Gain.60 year old-Maximize current
income.
Strategies
1. Passive Strategies with Immunization.
Investors want normal returns for given risk levels and also seek to
minimize transaction costs. Immunization is a way to achieve this objective.
(risk reduction/vaccination).
2.Active Bond Portfolio Management.
Managers try to achieve abnormal returns by actively trading bonds on the
basis of interest rate forecasts. They are given powers to select and remove
products(bonds) , from the portfolio.
Immunization

• A bond portfolio is said to be immunized if it is not very much affected by

changes in interest rates.
• The process for constructing a bond portfolio so that the realized return
will always at least equal the promised return because of the relationship
between the portfolio’s duration and holding period.
• Used to minimize reinvestment risk over a specified investment horizon.
• Investment strategy for protecting a bond portfolio against the risk of
changing interest rates.
• Possible because of the twin effects of changing interest rates.
• Rising interest rates depress prices but future income is reinvested at
higher rates. Opposite effect when interest rates fall.
Classical Immunization
• The process by which a bond portfolio is created to have an assured return
for a specific time period irrespective of interest rate charges.
• Fundamental principle underlying immunization- structure a portfolio, that
balances change in portfolio value with returns on reinvestment i.e offsets
interest rate risk and reinvestment risk.
• Requires controlling portfolio duration, by setting portfolio duration equal to
desired portfolio time horizon.
General Principles of Classical Immunization
Assumptions of Classical Immunization
• The sufficient condition for classical immunization is that the duration of the
portfolio ,match the duration of the liability. It is based on the following
assumptions:
1. Any changes in the yield curve are parallel changes,(i.e. interest rates move
up or down by the same amount for all maturities.
2. The portfolio is valued at a fixed horizon date and there are no cash inflows
or outflows during the time horizon except for coupon income and
reinvestment income.
3. The target value of the investment is defined as the portfolio at the horizon
date if the interest rate structure does not change in future.
Example of immunization
Contingent immunization.
• A method where portfolio managers are granted significant powers over
selection of products to be included or excluded from the portfolio, as
long as the products remain profitable.

• If these products become unprofitable beyond a threshold (safety

limit/minimum), then the manager must start classical immunization
procedures.-powers given to the managers are reduced. (Student failing).

• A way to continue active management until ,until an adverse investment

experience, drives down the potential return to the safety level.
Contingent Immunization-Key considerations

1. Establish a well defined ‘immunizable’ lower safety level of return, which

is lower than the achievable return.
2. Implement an effective monitoring procedure to ensure safety net is not
violated.
3. Constantly measure how much leeway (safety margin) is there at any
particular point.
Parallel shift in yield curve
Parallel and non parallel shifts
Convexity
Steepening & Flattening Curves
Flattening yield curve
• The term “flattening yield curve” sounds very technical, but the concept is
straightforward.
• When the yield curve flattens, it means that the gap between the yields on
short-term bonds and long-term bonds decreases, making the curve appear
less steep.
• The narrowing of the gap indicates that yields on long-term bonds are
falling faster than yields on short-term or, occasionally, that short-term bond
yields are rising even as longer-term yields are falling.
Why does a yield curve flatten

• A flattening yield curve can indicate that expectations for future inflation are
falling. (Since inflation reduces the future value of an investment, investors
demand higher long-term rates to make up for the lost value. When inflation
is less of a concern, this premium shrinks.)
• A flattening also can occur in anticipation of slower economic growth.
• Sometimes, the curve flattens when short-term rates rise on the expectation
that the Central Bank will raise interest rates.
What is steepening Yield curve?
• When the yield curve steepens, the gap between the yields on short-term
bonds and long-term bonds increases, making the curve appear "steeper".
• The increase in this gap indicates that yields on long-term bonds are rising
faster than yields on short-term bonds.
• Occasionally, that short-term bond yields are falling even as longer-term yields
are rising.
Why does the yield curve steepen

• A steepening yield curve typically indicates investor expectations for 1) rising

inflation 2) stronger economic growth (since improving growth causes the
demand for longer-term capital to increase even as the Central bank
maintains a low-rate policy).
Three common bond portfolio structures:

1. Barbell portfolios contain a relatively large percentage of long

and short maturity bonds.

2. Ladder portfolios contain bonds that are evenly distributed

throughout the maturity spectrum.

3. Bullet portfolios typically have a relatively high concentration of

bonds at long maturity.
Laddered,Barbell,Bullet structures-Principal Maturity
Ladder Strategy
• Enables staggering bond investments over time with different maturity.
• A way to diversify a bond portfolio and not get tied down into any one bond over a long
period.
• Gain more flexibility by spreading out investment capital over a number of different bonds
at different times and interest rates.
• Prevents a single sum of money being stuck in a bond for a long period, not allowing an
investor to take advantage of rise in interest rates.
• If rates are rising, than maturing principal can be invested at higher rates. If falling,
portfolio is still earning higher interest on the longer-term holdings.
• The ladder strategy also increases liquidity of bond investments because at least one bond
is relatively close to maturity.
 Barbell Strategy
• The barbell strategy is used to take advantage of the best aspects of short-
term and long-term bonds. In this strategy only very short-term and
extremely long-term bonds are purchased. Longer dated bonds typically
offer higher interest yields, while short-term bonds provide more flexibility.

• The short-term bonds give an investor the liquidity to adjust potential

investments every few months or years. If interest rates start to rise, the
shorter maturities allow an investor to reinvest principal in bonds that will
realize higher returns than if that money was tied up in a long-term bond.

• The long-term bonds give an investor a steady flow of higher-yield income

over the term on the bond. It also limits the downside effects if interest
rates were to rise in that bond period.
 Bullet Strategy

• If an investor knows that he or she will need a certain amount of capital at a

given point in time in the future, then a bullet investment strategy might be
the best way to go. This strategy suggests that an investor stagger purchase
dates on bonds that all mature at the same time.

• By staggering the purchase of bonds, investors can more efficiently seek out
securities that have more attractive interest rates. And since all of the bonds
have the same maturity date, investors are able to receive a potentially more
attractive inflow. However, because the investor is staggering the purchase
of the bonds, it can lead to a risk that interest rates will fall over the bond
purchasing period. Keeping a close eye on the interest rate environment is
key to successfully following this strategy.
The bottom line
• Regardless of which one an investor decides to follow, each strategy has its
drawbacks and benefits. For one, purchasing multiple bonds is significantly
more costly than purchasing a single bond. However, the potential returns
that are generated by these strategies may certainly be worth the extra cost.

• It is important to note, however, that the benefits of these strategies are

typically not seen in the short term; patience and commitment are key. For
those willing to put in the time and effort, taking an extra step in protecting
your portfolio from interest rate risk could certainly be worthwhile.