Interesting!! !!!!!!!!!

Lets try to understand a story of a young dynamic manager

We started in the last class MANAGING BOND RISK ...

One of the Investment

basic issue behind Strategy in bonds is...

How to ensure a balance between risk and return while making a suitable portfolio of bonds so as to satisfy the risk-return appetite of an investor?

INVESTMENT STRATEGIES for bonds

Investment strategies are broadly classified into the following categories:
Passive or Buy - and - Hold Strategy Semi-Active Strategy Active Strategy

First

Passive or Buy-and-Hold Strategy

PASSIVE STRATEGY
A buy-and-hold strategy is one whereby an investor buys and holds bonds till the maturity or redemption. In it, the primary objective of the investor is to maximise the income over a period through coupon and its reinvestment. Passive Strategies are the strategies that once they are formed do not require active management or changes.

PASSIVE STRATEGY

(continued)

A passive strategy requires no economic forecasting or on going asset allocation decisions. In it, once a portfolio is established, one simply waits until the term of bond expires. If bonds market is efficient, then such a strategy would be very useful strategy. The investor does not actively seek

PASSIVE STRATEGY???
Some of the passive strategies may be
Bond Ladder Strategy Bond Barbell Strategy Bond Bullet Strategy Investment in Index Fund

BOND LADDER STRATEGY

Bond value changes daily and an investor can avoid losses arising due to these fluctuations by acquiring short-term bonds. They usually have higher transaction cost and lower yields. On the other side, the opposite strategy is to buy long term bond but they are having high interest rate risk. But, if a portfolio of bonds is constructed with maturities distributed over a period of time, then it can have the advantages of short-term bonds as well as long term bonds. A bond portfolio construction strategy that invests approximately equal amounts in every maturity within a given range.

BOND LADDER STRATEGY

(continued)

The most important advantage of such a strategy is that all the bonds would not mature in the same interest rate environment; as a consequenceIf rates rise the value of our portfolio may fall, but we do not need to sell bonds that havent matured and whatever bonds are matured that would be sold at the redemption value. If cash is needed, the maturing bonds offer a ready source of cash.

Such a strategy is inflexible and if an investor seeks to take advantage of anticipated changes in interest rates

LADDER STRATEGY INVEST EQUALLY IN ALL MATURITY

Amount Invested

Time

BOND BARBELL STRATEGY

In this strategy, an investor acquires portfolio consisting of very long and very short term maturity bonds.

The Bond Barbell Strategy places heavy weights on very long and very short maturities, with no position in intermediate term securities
A fixed income securities strategy in which the maturities of the securities included in the Portfolio are concentrated at two extremes.

BOND BARBELL STRATEGY

(continued)

The advantage of this is - an investor needs to revise only half of his/her portfolio depending upon the expectation of changes in interest rates. If interest rates are expected to rise, then he/she should sell the long-term bonds and invest in short term and do the opposite if the interest rates are expected to fall.

Following this strategy may mean that the investor is unable to match maturities with cash needs as effectively as he/she could do with that of the Ladder Strategy.
This strategy as compared to LADDERED ONE is more risky if the anticipation about future interest rates go

Amount Invested

BARBELL STRATEGY INVESTMENT CONCENTRATED AT TWO EXTREMES OF MATURITY

Time

BOND BULLET STRATEGY

A single maturity is at the heart of the bullet strategy. However, the essence is that the maturities of the bonds in the portfolio are concentrating towards one maturity time. Under Bond Bullet Strategy, the maturities are concentrated towards one end of the yield curve. It can be best used when investor has a strong sense of the when money will be needed. Another reason to have such a strategy could be to position a portfolio in response to strong anticipated change in interest rates in one direction.

BOND BULLET STRATEGY

(continued)

One of the advantages of the Bullet Strategy is to focus cash flows to meet expected future expenditures such as buying a business in future. Zero-coupon bonds could be appropriate in these situations because they eliminate reinvestment risk and provide a known amount of cash at maturity. Another reason to have such a strategy could be to position a portfolio in response to strong anticipated change in interest rates in one direction.

Amount Invested

BULLET STRATEGY INVESTMENT CONCENTRATING TOWARDS ONE MATURITY

Time

INVESTMENT IN INDEX FUND

In this strategy, an investor selects an appropriate index of bond market and invest in it! The basic philosophy of the Index Fund is - if you cant beat the market, go along with it - which is based on the notion of Efficient Financial Markets. It is usually adopted by those funds who strongly believe that they can not outperform the market. The idea of such a strategy is to create a portfolio that mirrors the broad market and supposedly minimizes systematic or market related risk.

INVESTMENT IN INDEX FUND

(continued)

Bond Index funds are having lot of practical problems as bonds are continually dropped from the index as the mature and that requires a revision. Also, if the index is consisting of large number of securities, then it will be very costly to create and maintain such a portfolio. Generally, funds uses the publicly available indices but they may use their own customized index specifically designed to meet certain investment objectives.

INVESTMENT IN INDEX FUND

(continued)

There are three ways that are widely used in the industry to replicate a particular index Purchase all the bonds in an index in a proportion that appear in the Index. Such an approach is called PURE BOND INDEXING. An alternative to selecting all bonds is to use only a sample. Another approach which is known as CELL MATCHING approach involves decomposing the index into cells based on some feature like credit rating, sector, duration etc. and then, select a sample of bonds from each cell.

Indices reported by NSE

NSE G-Sec Index for the day As on 3-July-2007
Index Total Returns Index Principal Avg. Coupon Avg. Returns Residual index Maturity Portfolio YTM Portfolio Duration Portfolio Modified Duration Portfolio Convexity
As on 03-July-2007

ALL 1-3 3-8 8+ TB GS

248.43 211.31 246.35 294.71 227.34 250.99

118.3 90.91 106.55 131.42 227.34 109.06

8.350 8.641 8.929 7.988 0.000 8.350

9.228 2.162 5.365 14.927 0.322 10.415

8.577 8.713 8.465 8.606 7.443 8.585

5.406 1.966 4.261 8.135 0.317 6.069

5.184 1.884 4.088 7.799 0.306 5.820

55.636 4.433 21.902 98.799 0.164 62.842

Second

Semi-Active

SEMI - ACTIVE INVESTMENT STRATEGY INTEREST IMMUNIZATION STRATEGIES

An investment strategy that immunizes a bond portfolio from interest rate fluctuations is called IMMUNIZATION STRATEGY. An immunization strategy refers to that strategy adopted by investors to shield their overall financial status from exposure to interest rate fluctuations. A portfolio of bond is said to be immunized if the value of the portfolio at the end of a holding period is insensitive to interest rate changes. OR, IMMUNIZATION said to exist if the total value of a portfolio of bonds at the end of a holding period is equal to the value of the portfolio based on the YTMs that existed when purchased.

SEMI - ACTIVE INVESTMENT STRATEGY - INTEREST IMMUNIZATION STRATEGIES (continued)

MATCH THE MATURITY is a crude way to achieve some degree of immunization. However, DURATION is an important and a better tool for immunizing a bond portfolio and therefore, we should use it for immunization. Under the assumption that a yield curve is flat or there are parallel shifts in it, it can be shown that a bond portfolio will be immunized completely if holding period is exactly equal to duration. In doing so, one ensures a balance between price risk and reinvestment risk. Thats to say that when holding period is equal to duration, the change in price with respect to change in interest rate

SEMI - ACTIVE INVESTMENT STRATEGY - INTEREST IMMUNIZATION STRATEGIES (continued)

If an investor buys a bond whose duration is equal to holding period, then any parallel shift in the yield curve in near future would have price and interest rate effects that exactly offset each other. To achieve immunization, the duration of the bond must be equal to the remaining time in the horizon period. Hence, immunization called requires active management,

SEMI - ACTIVE INVESTMENT STRATEGY - INTEREST IMMUNIZATION STRATEGIES (continued)

If Holding period/Horizon Period is same as DURATION then the IMMUNIZATION STRATEGY adopted is called HOLDING PERIOD IMMUNIZATION. In this case, changes in the interest rate do not change the HOLDING PERIOD RATE OF RETURN or HORIZON RATE OF RETURN.

SEMI - ACTIVE INVESTMENT STRATEGY INTEREST IMMUNIZATION STRATEGIES

(continued)

Immunization, that is ensuring equality between the portfolio duration and the holding period, can be achieved using either of the following Ladder Barbell Bullet

SEMI - ACTIVE INVESTMENT STRATEGY DEDICATION

DEDICATION(also known as CASH FLOW MATCHING) is concerned with financing a stream of liabilities over a period of time; match the receipt of cash flows from bonds to the liabilities payment over a period of time. A dedicated portfolio of bonds seeks to match the receipt of cash flows with the need for the funds so that the interest and the principal amounts are matched with the payment schedule of the investor. No reinvestment is done here. Therefore, it has no

SEMI - ACTIVE INVESTMENT STRATEGY DEDICATION

In it, if structured properly, the portfolio of bonds will cash itself out in the sense that between every two successive liability payments, the cash flow from the principal payment and coupon receipts would be sufficient to cover the next liability payment. The biggest risk with cash-flow matching strategies is that the bonds selected to match forecasted liabilities may be called, if they have a call option, forcing the investment manager

Third

Active Strategy

ACTIVE INVESTMENT STRATEGY

Active investment strategy involves switching and swapping bonds as circumstances changes in the market for fixed income securities. Active investment strategies are based on the assumption that the bond market is not so efficient, thereby giving some investors the opportunity to earn above average-profits. Portfolio managers with the ability to identify mispriced bonds or to time the bond market by accurately predicting interest rates can make use of the active investment strategy.

ACTIVE INVESTMENT STRATEGY

(continued)

Active Investment Management Strategy involves security selection,where attempts are made at identifying mispriced bonds and involves market timing, where attempts are made at forecasting general movements in interest rates and take the advantage of turnings. It involves the following steps:
Determine the proper pricing of bonds under consideration and try to identify over-and under-priced bonds. Forecast the level and change in the yield curve Given the forecast determine the impact of change on the current portfolio

ACTIVE INVESTMENT STRATEGY

(continued)
Active Management Strategies are of two type
One, Bond Swap Strategies; and Second, Yield Curve Shift Strategies.

Some of the Bond Swap Strategies may be: Substitution Swap Quality Swap Inter-Market Spread Swap Rate Anticipation Swap Pure Yield Pickup Swap Tax Swap Liquidity Swap Besides these, one may have Contingent Immunization-as Active Investment Strategy.

Substitution Swap
Substitution Swap Strategy is based on the concept of temporary mis-pricing which is arising due to an imbalance in the relative supply and demand conditions in the market. It is an exchange of one bond for a nearly identical substitute but with a belief that the market has temporarily mispriced the two bonds and that the discrepancy between the prices of bonds represents a profit opportunity.

Substitution Swap-Example
EXAMPLE:
Consider the following two bonds Bond A yielding 7.5% and it is a AA bond. (presently held bond) Bond B yielding 7.85% and it is also AA bond.

Here, Substitution Swap will mean sell Bond A and Buy B; thus get higher yield.

Quality Swap
Quality Swap Strategy is based on the concept of yield spread which is arising due to differences in yields between bonds of different qualities. (we all know that bonds of different risk quality has different yield) If it is believed strongly that an economy is improving and becoming strong, then investors may see less credit risk in low quality(but, higher return). In such a

Quality Swap-Example
EXAMPLE:
Consider the following two bonds Bond A yielding 7.5% and it is a AA bond. (presently held bond) Bond B yielding 7.95% and it is also A bond.

Here, Quality Swap will mean sell Bond A and

Buy B; thus get higher yield if we are expecting no default in near future due to better economic conditions.

Inter-Market Spread Swap

The Inter-market Spread Swap is pursued when an investor believes that the yield spread between two sectors/segments of the bond market is temporarily out of line.

Inter-Market Spread Swap -Example

EXAMPLE:
Consider the followingBond A is trading in BSE Debt Segment at a price yielding 7.5% and it is a AA bond. The same Bond A is trading at a price in NSE debt segment yielding 7.75%.

Here, Inter-Market Spread Swap will mean sell Bond A at BSE and Buy the same

Rate Anticipation Swap

Such a swap are geared toward profiting from an anticipated movement in the overall market prices. It is pegged to interest rate forecasting. In case, if investors believe that rates will fall, then they will swap bonds of longer duration. Conversely, if rates are expected to increase, they will swap to shorter duration bonds. Rate Anticipation Swap means that depending upon the anticipation about future interest rates, one can swap bonds with different durations. For

Rate Anticipation Swap-Example

EXAMPLE:
Consider the following two bonds Bond A is Zero-Coupon yielding 8% with maturity of 20 years. (presently held bond) Bond B is 10% Coupon yielding 6.25% with a maturity of 5 years.

If an investor is expecting the interest rate to rise in future, then Rate Anticipation Swap will mean sell Bond A and Buy B; thus get minimum capital

Pure Yield Pickup Swaps

These swaps are oriented toward yield improvements over the long-term, with little heed being paid to interim price movements in the market. The basic idea of this swap strategy is to increase return by holding higher-yield bonds. When the yield curve is upward sloping, the pure yield pickup swap entails moving into longer - term higher-yield bonds. In this case, the investor is willing to accept higher interest rate risk.

Pure Yield Pickup Swap-Example

EXAMPLE:
Consider the following two bonds Bond A yielding 8% and it is having 5-year maturity. (presently held bond) Bond B yielding 8.85% and it is having a 10-year maturity. If the investor is concerned only with the PURE YIELD, then Pure Yield Pickup Swap will mean sell Bond A and Buy B;

Tax Swaps
Sometimes, bonds with same quality have different yields and one of cause of differences is tax. If such a difference is not exactly off-set the advantages of tax benefits, there is a possibility of some swap strategy for obtaining higher rate of return after tax. Then, investors may adopt tax-swap strategies.

Tax Swaps-Example
EXAMPLE: Consider the following two bonds Bond A yielding 8% and it is a taxable bond. (presently held bond) Bond B yielding 5.75% and it is a tax-free bond.

If the investor is paying 30% tax, then Tax Swap will mean sell Bond A and Buy B; thus get higher yield(after tax).

Liquidity Swap
Sometimes, bonds with same quality may have different yield or price because of differences in liquidity of bonds. If an investor is not concerned about the liquidity of a bond as he has no intention of trading in that, then he can take advantage of higher yield of a less liquid bond. That is to say, an investors may swap higher liquidity

Liquidity Swap-Example
EXAMPLE:

Consider the following two bonds Bond A yielding 8% and it is a bond having very good liquidity in the market. (presently held bond) Bond B yielding 8.75% and it is a comparatively less liquid bond but is of same quality as that of Bond A. If the investor is very keen in possessing highly liquid bonds, then Liquidity Swap will mean sell Bond A and Buy B; thus get higher yield. It is because of the fact that the investor is willing to take

liquidity

premium.

Yield Curve Shifts and Bond Strategies

Yield Curve Shift Strategies make forecasts about likely shifts in yield curve and then devise an appropriate bond investment strategy to profit from such forecasts.

Three types of yield curve shifts occur with some regularity:

1. 2. 3. Parallel Shifts Shifts with Twists Shifts with Humpedness

Yield Curve Shifts: Parallel

Parallel Shifts: It takes place when rates on all maturities change by the same number of basis points.
YTM

Shifts with a Twist: A twist is a non-parallel shift, it takes place when rates are changing differently with either a flattening or steepening of the yield curve.

Yield Curve Shifts: Twist

Flattening: The spread between longterm and short-term rates decreases. Steepening: The spread between longterm and short-term rates increases.

Yield Curve Shifts: Twist

Shifts with a Twist:
Flattening:
YTM

LT

(YTM LT YTM ST )
M

Steepening:
YTM

ST

ST

LT

(YTM LT YTM ST )
M

Yield Curve Shifts: Humpedness

Shifts with Humpedness: A shift with humpedness is a non-parallel shift in which short-term and long-term rates change by greater magnitudes than intermediate rates.

Positive Butterfly: There is an increase in both short and long-term rates relative to intermediate rates. Negative Butterfly: There is a decrease in both short and long-term rates relative to intermediate rates.

Yield Curve Shifts: Humpedness

Positive Butterfly: ST and LT rates change more than intermediate:
YTM

ST

LT

Negative Butterfly: Intermediate rates change YTM more than ST and LT:

ST

LT

When the view about yield curve is -

Yield Curve Shift Strategies

Negative Butterfly
1.

The bullet strategy is formed by constructing a portfolio concentrated in one maturity area. The barbell strategy is formed with investments concentrated in both short-term and long-term bonds. The ladder strategy is formed with equally allocated investments in each maturity group.

1.

1.

Yield Curve Shift Strategies

When the view about yield curve is

Negative Butterfly

In such a case, the investor should go for the barbell strategy which will be formed with investments concentrated in both short-term and long-term bonds as rates of intermediaries maturity are going to increase.

5 5

5 5

Yield Curve Shift Strategies

When the view about yield curve is -

Positive Butterfly

In such a case, the investor may go for the Bullet Strategy which will be formed by constructing a portfolio concentrated in one maturity area as rates of short-term as well as long term maturity are going to increase.

5 5

5 5

Yield Curve Strategies

Yield Curve Shift Strategies

If investors expected a simple downward parallel shift in the yield curve, a bullet strategy with longer duration bonds would yield greater returns than an investment strategy in intermediate or short-term bonds if the expectation turns out to be correct. The barbell strategy could be profitable for an investor who is forecasting an upward negative butterfly yield curve shift. Yield Curve Shift Strategies If investors expected a simple downward parallel shift in the yield curve, a bullet strategy with longer duration bonds would yield greater returns than an investment strategy in intermediate or short-term bonds if the expectation turns out to be correct.

CONTINGENT IMMUNIZATION
Such a strategy has a combination of Immunization Strategy and Active Investment Strategy. In this strategy, the investor prescribes the minimum acceptable target yield and accordingly it is worked out how much can be devoted to active bond investment strategy. In case, the investment amount falls below that which will give minimum acceptable target yield, then the accepted investment strategy becomes that of immunization. Thus, contingent immunization strategy means

Thats what we want to discuss about

bonds strategy.

investment

INCOME OR LOSS SOURCES COUPON INCOME CAPITAL GAIN/LOSS INTEREST - ON - INTEREST TOTAL RETURN

DIFFERENT REINVESTMENT RATES 1 5% Rs. Rs. Rs. Rs. 90 287 1 378 3 Rs. 270 Rs. 234 Rs. 17

HOLDING PERIOD IN YEARS 5 Rs. 450 Rs. 175 Rs. 54 6.79 Rs. 611 Rs. 117 Rs. 106 Rs. 834 7 Rs. 630 Rs. 110 Rs. 113 Rs. 854 Rs. 9 Rs. 810 39 10 Rs. 900 Rs. -

Rs. 197 Rs.1,046

Rs. 250 Rs. 1,150

Rs. 521

Rs. 679

COUPON INCOME CAPITAL GAIN/LOSS INTEREST - ON - INTEREST TOTAL RETURN

7%

Rs. Rs. Rs. Rs.

90 132 2 223

Rs. 270 Rs. 109 Rs. 25

Rs. 450 Rs. Rs. 83 78

Rs. 611 Rs. 57

Rs. 630 Rs. 53

Rs. 810 Rs. 19

Rs. 900 Rs. -

Rs. 155 Rs. 822

Rs. 165 Rs. 849

Rs. 292 Rs.1,121

Rs. 373 Rs. 1,273

Rs. 404

Rs. 611

COUPON INCOME CAPITAL GAIN/LOSS INTEREST - ON - INTEREST TOTAL RETURN

9%

Rs. Rs. Rs. Rs.

90 2 92

Rs. 270 Rs. Rs. 32

Rs. 450 Rs. -

Rs. 611 Rs. -

Rs. 630 Rs. -

Rs. 810 Rs. -

Rs. 900 Rs. -

Rs. 103 Rs. 553

Rs. 207 Rs. 818

Rs. 222 Rs. 852

Rs. 398 Rs.1,208

Rs. 512 Rs. 1,412

Rs. 302

COUPON INCOME CAPITAL GAIN/LOSS INTEREST - ON - INTEREST TOTAL RETURN

11%

Rs.

90

Rs. 270

Rs. 450

Rs. 611

Rs. 630

Rs. 810

Rs. 900 -

Rs. (112) Rs. Rs. Rs. 2 Rs.

(96) Rs. (75) Rs. (53) Rs. (50) Rs. 40 Rs. 129 Rs. 504 Rs. 264 Rs. 822 Rs. 283 Rs. 863

(18) Rs.

Rs. 517 Rs.1,308

Rs. 669 Rs. 1,569

(20) Rs. 214

COUPON INCOME CAPITAL GAIN/LOSS INTEREST - ON - INTEREST TOTAL RETURN

13%

Rs.

90

Rs. 270

Rs. 450

Rs. 611

Rs. 630

Rs. 810

Rs. 900 -

Rs. (209) Rs. (180) Rs. (144) Rs. (102) Rs. (97) Rs. Rs. 3 Rs. 48 Rs. 157 Rs. 463 Rs. 325 Rs. 834 Rs. 350 Rs. 883

(36) Rs.

Rs. 648 Rs.1,422

Rs. 847 Rs. 1,747

Rs. (116) Rs. 138

Y ear

10% 1 R s. 88.00

Interest Rates rem constant at 10% ain Reinvestment Rate at the end of Year 10% 10% 10% 2 3 4 R s. 96.80 Rs. 106.48 R s. 117.13 R s. 88.00 Rs. 96.80 R s. 106.48 Rs. 88.00 R s. 96.80 R s. 88.00

R s. R s. R s. R s. R s.

10% 5 128.84 117.13 106.48 96.80 88.00 537.25

Total

R s.

88.00 R s. 184.80 Rs. 291.28 R s. 408.41 R s. + Bond Value at the end of year 6 Total Value of the portfolio at the end of year 6

R s. R s. R s. R s. R s. R s. R s. R s. Rs.

10% 6 141.72 128.84 117.13 106.48 96.80 88.00 678.97 979.17 1,658.15

Y ear

10% 1 R s. 88.00

Interest Rates falls to 9%After 3 Years Reinvestment Rate at the end of Year 10% 9% 9% 2 3 4 R s. 96.80 Rs. 106.48 R s. 116.06 R s. 88.00 Rs. 96.80 R s. 105.51 Rs. 88.00 R s. 95.92 R s. 88.00

R s. R s. R s. R s. R s.

9% 5 126.51 115.01 104.55 95.92 88.00 529.99

Total

R s.

88.00 R s. 184.80 Rs. 291.28 R s. 405.50 R s. + Bond Value at the end of year 6 Total Value of the portfolio at the end of year 6

R s. R s. R s. R s. R s. R s. R s. R s. Rs.

9% 6 137.89 125.36 113.96 104.55 95.92 88.00 665.69 996.48 1,662.17

Y ear

10% 1 R s. 88.00

Interest Rates rise to 11% After 3 Years Reinvestment Rate at the end of Year 10% 11% 11% 2 3 4 Rs. 96.80 Rs. 106.48 R s. 118.19 Rs. 88.00 Rs. 96.80 R s. 107.45 Rs. 88.00 R s. 97.68 R s. 88.00

Rs. Rs. Rs. Rs. Rs.

11% 5 131.19 119.27 108.42 97.68 88.00 544.57

Total

R s.

88.00 Rs. 184.80 Rs. 291.28 R s. 411.32 Rs. + Bond Value at the end of year 6 Total Value of the portfolio at the end of year 6

Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.

11% 6 145.63 132.39 120.35 108.42 97.68 88.00 692.47 962.32 1,654.79

Y ear

10% 1 R s. 88.00

Interest Rates rise to 13% After 3 Years Reinvestment Rate at the end of Year 10% 13% 13% 2 3 4 Rs. 96.80 Rs. 106.48 R s. 120.32 Rs. 88.00 Rs. 96.80 R s. 109.38 Rs. 88.00 R s. 99.44 R s. 88.00

Rs. Rs. Rs. Rs. Rs.

13% 5 135.96 123.60 112.37 99.44 88.00 559.38

Total

R s.

88.00 Rs. 184.80 Rs. 291.28 R s. 417.15 Rs. + Bond Value at the end of year 6 Total Value of the portfolio at the end of year 6

Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.

13% 6 153.64 139.67 126.97 112.37 99.44 88.00 720.09 929.94 1,650.03

HORIZON RAT E OF INT EREST AND INT EREST RAT E

60%

H=1

50%

40%

H=2

HORIZON RATE OF RETURN

30%

20%

H=4

H = 300 H = 20

10%

H = Duration

0% 1% -10% 3% 5% 7% 9% 11% 13% 15% 17% 19%

-20% INTEREST RATE