bond portfolio mgt

8/4/2019 Bond Portfolio Mgt

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Bond Portfolio Management Strategy

1. Passive Strategy:� Buy-and-hold strategy.

� Indexing.

2. Active strategy:

� Rate anticipation� Yield spread analysis

� Bond swap

� Credit analysis

3. Matched Funding Technique:

� Dedication.

� Immunization



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 iseliminated.

� 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 futureinterest rate.

� The idea is to preserve capital when an increase ininterest rates is anticipated & achieve attractivecapital gains when interest rates are expected todecline.

� Usually attained by altering maturity structure of

bond portfolio.� Expect an increase in interest rate & want to

preserve capitalHow?

� 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 Bond 2

Investment 1000 984.08

Coupon 120 120

Int. on Coupon 3.60 3.60

Principal Value at the end

of the year

1000 1000

Total Accrue 1123.60 1123.60

Total gain 123.60 139.52

Realized Yield 12% 13,71%



Matched Funding Techniques

� Objective is to build wealth through investment

so as to provide money for retirement, highereducation of children etc.

a. Dedication: Create and maintain bond portfoliothat has a cash inflow structure closely matchesthe 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 thetime when money would be needed.



Year Liabilities Maturity value

CurrentPurchaseprice

Currentannual YTM

1 5,00,000 5,00,000 4,62,963 8.00%

2 10,00,000 10,00,000 8,49,455 8.50%

3 15,00,00 15,00,00 11,58,278 9.00%

4 20,00,000 20,00,000 13,91,140 9.50%

5 25,00,000 25,00,000 15,52,303 10.00%



(ii) Cash matching with reinvestment: Construct aportfolio 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 apotential shortfall.

Example:

The conservative reinvestment rate is 5%.

The fund manager would like to invest in bonds withYTM not less than 9%



Year Liabilities Bonds Maturity Cash matching

bond portfolio

Coupon

rate

1 10,00,000 A 1 8.00%2 10,00,000 B 2 8.50%

3 15,00,000 C 3 5,00,000 9.00%

4 20,00,000 D 4 7,00,000 9.50%

5 25,00,000 E 5 11,00,000 10.00%

6 30,00,000 F 6 15,00,000 10.50%

7 35,00,000 G 7 22,00,000 10.75%

8 40,00,000 H 8 25,00,000 11.00%

9 45,00,000 I 9 30,00,000 11.25%

10 50,00,000 J 10 32,00,000 11.50%



Y Liabilities Cash

balance

at begin

Int. on

Cash

balance

Coupon

received

Redemp

tion

Total

cash avl

Surplus

1 10,00,000 0 0 15,96,000 0 15,96,000 5,96,000

2 10,00,000 5,96,000 29,800 15,96,000 0 22,21,800 12,21,800

3 15,00,000 12,21,800 61,090 15,96,000 5,00,000 33,78,890 18,78,890

4 20,00,000 18,78,890 93,945 15,51,000 7,00,000 42,23,835 22,23,835

5 25,00,000 22,23,835 1,11,192 14,84,500 11,00,000 49,19,526 24,19,526

6 30,00,000 24,19,526 1,20,976 13,74,500 15,00,000 54,15,003 24,15,003

7 35,00,000 24,15,003 1,20,750 12,17,000 22,00,000 59,52,753 24,52,753

8 40,00,000 24,52,753 1,22,638 9,80,500 25,00,000 60,55,890 20,55,890

9 45,00,000 20,55,890 1,02,795 7,05,500 30,00,000 58,64,185 13,64,185

10 50,00,000 13,64,185 68,209 3,68,000 32,00,000 50,00,394 394



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. interestrates.

� Banks are concerned with protecting the current net worth andpension funds may face an obligation to make promised paymentafter some years.

� The zero coupon bond is the simple solution to immunization butthe difficult part is to find out zero coupon bond whose maturityexactly matches with the duration time.



� Consider an insurance company offered aGuaranteed Investment Contract (GIC) havinga 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% annualcoupon paying bond with maturity 6 years.The market yield is 8%.



Rate at 8%

Payment Number Year remaining

until obligation

Accumulated Value Total

A. Rate remains at 8%

1 4 800×(1.08)4 1088.39

2 3 800×(1.08)3 1007.77

3 2 800×(1.08)2 933.12

4 1 800×(1.08)1 864.00

5 0 800×(1.08)0 800.00

Sell of Bond 0 10800/(1.08) 10,000

14693.28



Rate at 7%


until obligation



1 4 800×(1.07)4 1048.64

2 3 800×(1.07)3 980.03

3 2 800×(1.07)2 915.92

4 1 800×(1.07)1 856.00

5 0 800×(1.07)0 800.00

Sell of Bond 0 10800/(1.07) 10,093

14693



Rate at 9%


until obligation



1 4 800×(1.09)4 1129.27

2 3 800×(1.09)3 1036.02

3 2 800×(1.09)2 950.48

4 1 800×(1.09)1 872.00

5 0 800×(1.09)0 800.00

Sell of Bond 0 10800/(1.09) 9908.26

14696.02



� e.g.: Pension plan of ICICI Pru. States that a client Mr.X will receive Rs.10,000 for 15 years. The firstpayment is likely to be received by him at the end of 6th year.

� Mr. Y who is managing the fund, wants to immunizethis liability by investing in 10 years zero couponbonds 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 zerocoupon bond?

(ii) How much he has to invest in each bonds.



Year Cash Flows PVIF @ 8% PV of CF N×PVCF

1

2

3

4

5

6 10,000 0.630 6300 37800

7 10,000 0.583 5830 408108 10,000 0.54 5400 43240

9 10,000 0.50 5000 45000

10 10,000 0.463 4630 46300



11 10,000 0.429 4290 47190

12 10,000 0.397 3970 4764

13 10,000 0.368 3680 47840

14 10,000 0.340 3400 47600

15 10,000 0.315 3150 47250

16 10,000 0.292 2920 46720

17 10,000 0.270 2700 45900

18 10,000 0.250 2500 4500019 10,000 0.232 2320 44080

20 10,000 0.215 2150 43000

Total 58,240 6,75,3



� 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 ×R

s.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 =R

s.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.

bond portfolio mgt

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