Bond Portfolio Management Strategy

1. Passive Strategy:
Buy-and-hold strategy. Indexing. Rate anticipation Yield spread analysis Bond swap Credit analysis Dedication. Immunization

2. Active strategy:

3. Matched Funding Technique:

Buy-&-hold Strategy
Identify the bond with desired characteristics and hold it till maturity. These investors do not actively traded with the objective of enhancing return. When a bond is hold till maturity price risk is eliminated. To eliminate the price risk the investor has to choose carefully the quality bond. Therefore this strategy will suits the investors with the objective of minimization of risk with moderate income.

Indexing Strategy
A bond portfolio is formed with the objective of replicating the performance of a selected index. If the investors risk tolerance is low then select an index which includes more Govt. bonds than corporate. Another important consideration for choosing an index is the regulation imposed by the regulator. Construction methods (i) Full replication. (High Tracking Error) (ii) Sampling.

Active Management
Interest Rate Anticipation: Involves relying on uncertain forecast of future interest rate. The idea is to preserve capital when an increase in interest rates is anticipated & achieve attractive capital gains when interest rates are expected to decline. Usually attained by altering maturity structure of bond portfolio. Expect an increase in interest rate & want to preserve capital How? Use of Cushion Bond to shorten the maturity.

 Yield Spread Analysis: Spread between high grade & low grade bonds. The spread widen during the period of economic recession & uncertainty. The spread will decline during the period of economic confidence & expansion.

Bond Swap: Substitution Swap

Short term and relies heavily on interest rate expectations. The procedure assumes a short term imbalance in yield spread between issues that are perfect substitute. Bond 1: 30 year, Aa, 12% coupon, YTM 12% Bond 2: 30 year, Aa, 12% coupon, YTM 12.2%, Price 984.08. Assume: Work out period 1 year & Reinvestment at 12%.

Bond 1 Investment Coupon Int. on Coupon Principal Value at the end of the year Total Accrue Total gain Realized Yield 1000 120 3.60 1000 1123.60 123.60 12%

Bond 2 984.08 120 3.60 1000 1123.60 139.52 13,71%

Matched Funding Techniques

Objective is to build wealth through investment so as to provide money for retirement, higher education of children etc. a. Dedication: Create and maintain bond portfolio that has a cash inflow structure closely matches the cash outflow structure of future liabilities. (i) Pure cash Matching: The cash inflows (coupon & principal) exactly match the required payments for a stream of liabilities. The easiest way to implement this is to purchase zero coupon bonds whose maturity coincide with the time when money would be needed.

Year

Liabilities Maturity value 5,00,000 5,00,000

1 2 3 4 5

Current Purchase price 4,62,963

Current annual YTM 8.00% 8.50%

10,00,000 10,00,000 8,49,455 15,00,00 15,00,00

11,58,278 9.00%

20,00,000 20,00,000 13,91,140 9.50% 25,00,000 25,00,000 15,52,303 10.00%

(ii) Cash matching with reinvestment: Construct a portfolio such that the cash inflows (coupon & Principal) & the expected reinvestment income provides a similar funds at the time of repayment. Here the fund manager faces the reinvestment risk, as a result a conservative estimate of future reinvestment rate is taken to protect against a potential shortfall. Example: The conservative reinvestment rate is 5%. The fund manager would like to invest in bonds with YTM not less than 9%

Year

Liabilities

Bonds

Maturity

Cash matching bond portfolio

Coupon rate

1 2 3 4 5 6 7 8 9 10

10,00,000 10,00,000 15,00,000 20,00,000 25,00,000 30,00,000 35,00,000 40,00,000 45,00,000 50,00,000

A B C D E F G H I J

1 2 3 4 5 6 7 8 9 10

5,00,000 7,00,000 11,00,000 15,00,000 22,00,000 25,00,000 30,00,000 32,00,000

8.00% 8.50% 9.00% 9.50% 10.00% 10.50% 10.75% 11.00% 11.25% 11.50%

Int. on Coupon Redemp Total Liabilities Cash Surplus balance Cash received tion cash avl at begin balance
10,00,000 10,00,000 15,00,000 20,00,000 25,00,000 30,00,000 35,00,000 40,00,000 45,00,000 50,00,000 0 5,96,000 0 29,800 15,96,000 15,96,000 15,96,000 15,51,000 14,84,500 13,74,500 12,17,000 9,80,500 7,05,500 3,68,000 0 0 5,00,000 7,00,000 11,00,000 15,00,000 22,00,000 25,00,000 30,00,000 32,00,000 15,96,000 5,96,000 22,21,800 12,21,800 33,78,890 18,78,890 42,23,835 22,23,835 49,19,526 24,19,526 54,15,003 24,15,003 59,52,753 24,52,753 60,55,890 20,55,890 58,64,185 13,64,185 50,00,394 394

1 2 3 4 5 6 7 8 9 10

12,21,800 61,090 18,78,890 93,945 22,23,835 1,11,192 24,19,526 1,20,976 24,15,003 1,20,750 24,52,753 1,22,638 20,55,890 1,02,795 13,64,185 68,209

Immunization
In maturity matching price risk is eliminated but not the reinvestment risk. Using the concept of duration we can immunization the portfolio from changing interest rate. The immunization technique attempts to derive a specified rate of return (generally quite close to market rate) during a given investment horizon regardless of what happen to mkt. interest rates. Banks are concerned with protecting the current net worth and pension funds may face an obligation to make promised payment after some years. The zero coupon bond is the simple solution to immunization but the difficult part is to find out zero coupon bond whose maturity exactly matches with the duration time.

 Consider an insurance company offered a Guaranteed Investment Contract (GIC) having a face value of 10,000, maturity 5 years & guaranteed interest rate at 8%. The obligation of the company would be 10,000(1.08)5=14693.28 Suppose the company choose 8% annual coupon paying bond with maturity 6 years. The market yield is 8%.

Rate at 8%
Payment Number A. Rate remains at 8% 1 2 3 4 5 Sell of Bond 4 3 2 1 0 0 800(1.08)4 800(1.08)3 800(1.08)2 800(1.08)1 800(1.08)0 10800/(1.08) 1088.39 1007.77 933.12 864.00 800.00 10,000 14693.28 Year remaining until obligation Accumulated Value Total

Rate at 7%
Payment Number A. Rate remains at 8% 1 2 3 4 5 Sell of Bond 4 3 2 1 0 0 800(1.07)4 800(1.07)3 800(1.07)2 800(1.07)1 800(1.07)0 10800/(1.07) 1048.64 980.03 915.92 856.00 800.00 10,093 14693 Year remaining until obligation Accumulated Value Total

Rate at 9%
Payment Number A. Rate remains at 8% 1 2 3 4 5 Sell of Bond 4 3 2 1 0 0 800(1.09)4 800(1.09)3 800(1.09)2 800(1.09)1 800(1.09)0 10800/(1.09) 1129.27 1036.02 950.48 872.00 800.00 9908.26 14696.02 Year remaining until obligation Accumulated Value Total

e.g.: Pension plan of ICICI Pru. States that a client Mr. X will receive Rs.10,000 for 15 years. The first payment is likely to be received by him at the end of 6th year. Mr. Y who is managing the fund, wants to immunize this liability by investing in 10 years zero coupon bonds whose maturity value is Rs.1000 per bond & 7% perpetual bond. If the current interest rate is 8% p.a. you are required to calculate (i) How much money should he invest in each zero coupon bond? (ii) How much he has to invest in each bonds.

Year 1 2 3 4 5 6 7 8 9 10

Cash Flows PVIF @ 8%

PV of CF

NPVCF

10,000 10,000 10,000 10,000 10,000

0.630 0.583 0.54 0.50 0.463

6300 5830 5400 5000 4630

37800 40810 43240 45000 46300

11 12 13 14 15 16 17 18 19 20 Total

10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000

0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

4290 3970 3680 3400 3150 2920 2700 2500 2320 2150 58,240

47190 4764 47840 47600 47250 46720 45900 45000 44080 43000 6,75,300

 Duration= 6,75,300/58,240 = 11.60 years. Present value of deferred payments = Rs.58,240 If W is the weight of 10 years coupon bond in the portfolio 10W +15(1-W) = 11.60 W = 68% So investment in 10years bond is 68% i.e. 0.68 Rs.58,240 = Rs.39,603 So investment in 15years bond is 32% i.e. 0.32 Rs.58,240 = Rs.18,637. (ii) Investment in bonds: Redemption value of 10 years bond = 39,603 (1.08)10 = Rs.85,500. Redemption value of 15 years bond = 18,637 (1.08)15 = Rs.59,120.

Limitations
Except zero coupon bond, an immunized portfolio requires frequent rebalancing because the modified duration of the portfolio should always equal to the remaining time horizon. In case of non-parallal shift in the yield curve . In case of high inflationary situation .