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MANAGING BOND RISK

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									MANAGING BOND RISK ...



        DESIGNING
          BOND
        PORTFOLIO
       STRATEGIES...
HOW TO MANAGE BOND‟S RISK?
   To manage bond risk, one has to adopt an
    INVESTMENT STRATEGY depending upon the
    following factors:
         Objectives of investment strategy - maximising
          return/minimising risk/tax advantage/ hedging against inflation
       Risk bearing capacity
       Attitude towards risk

       Future requirement of funds and future expected inflow of
        cash
       Nature of the liabilities already incurred and that to be paid
        out of future receipts
       Transaction cost

       Marketability of securities
THEREFORE, WE MOVE TO…
ONE OF THE BASIC ISSUE BEHIND
INVESTMENT 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 objective of the investor is to maximise the income over a
    period through coupon and its reinvestment.
   This strategy ignores the risk of capital gains/losses arising due to
    changes in interest rate.
   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 out trading possibilities in an
    attempt to outperform the market.
 PASSIVE STRATEGY…???

 Some   of the passive strategies may be

    Bond Ladder Strategy

    Bond Barbell Strategy

    Bond Bullet Strategy

    Investment in Index Fund

    Riding the Yield Curve
SHOULD WE HAVE LONG-

TERM BONDS OR SHORT-

TERM BONDS IN OUR BOND

PORTFOLIO?
    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.
   Such a strategy is inflexible and if an investor seeks to take
    advantage of anticipated changes in interest rates then the whole
    portfolio is to be revised.
       LADDER STRATEGY
“INVEST EQUALLY IN ALL MATURITY”




               Time
BOND BARBELL STRATEGY
   In this strategy, an investor acquires portfolio consisting of
    very long and very short term maturity bonds.

   A fixed income strategy in which the maturity`s of the
    securities included in the Portfolio are concentrated at two
    extremes.

   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.

   This strategy as compared to LADDERED ONE is more risky if
    the anticipation about future interest rates go wrong.
  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.

    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.
   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 can’t beat the
    market, go along with it” - which is based on the notion of Efficient
    Financial Markets.
   The ides of such a strategy is to create a portfolio that mirrors the
    broad market and supposedly minimises systematic or market
    related risk.
   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.
INDICES REPORTED BY NSE…
SECOND……




           …Semi-Active Strategy
      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. That’s to say that
  when holding period is equal to duration, the change in price with
  respect to change in interest rate will be equal to change in
  reinvestment amount with respect to change in interest rate but in
  opposite direction.
     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
    reinvestment risk.
   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
THIRD……




          ……Active
          Strategy
ACTIVE INVESTMENT STRATEGY
 Activeinvestment strategy involves switching and
  swapping bonds as circumstances changes in the
  market for fixed income securities.
 Activeinvestment 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.
 Portfoliomanagers 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.
 It   is adopted by those who are having comparatively
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
       If it has a bad impact, revise it.
   Such strategy is highly risky and along with it, one should
ACTIVE INVESTMENT STRATEGY
(CONTINUED…)


 ActiveManagement Strategies are primarily bond swap
 strategies.
 These   Bond Swaps may be:
     Substitution Swap
     Quality Swap
     Inter-Market Spread Swap
     Rate Anticipation Swap
     Pure Yield Pickup Swap
     Tax Swap
     Liquidity Swap

  Besides swap strategies, one may have Contingent
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
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 case, they may
    swap high-quality bonds for low-quality bonds and thus, get
    higher yield.
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
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 following-
      Bond 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
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 loss and take the advantage
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.

   The basic thrust is - earn an expected term
    premium in higher - yield bonds.
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; thus get
   higher yield.
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 bonds with
    that of less liquid bonds and thus, get the advantage of
    higher yield.
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’.
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
That‟s what we want to

discuss about bonds‟

investment strategy.
                                DIFFERENT
INCOME OR LOSS SOURCES                                                          HOLDING PERIOD IN YEARS
                           REINVESTMENT RATES
                                                      1               3               5         6.79             7              9            10
COUPON INCOME                     5%            Rs.        90 Rs. 270           Rs. 450        Rs. 611     Rs. 630        Rs. 810         Rs. 900
CAPITAL GAIN/LOSS                               Rs.       287   Rs. 234         Rs. 175        Rs. 117     Rs. 110        Rs.       39 Rs.        -
INTEREST - ON - INTEREST                        Rs.        1    Rs.       17 Rs.          54   Rs. 106     Rs. 113        Rs. 197         Rs. 250
TOTAL RETURN                                    Rs.       378   Rs. 521         Rs. 679        Rs. 834     Rs. 854        Rs.1,046        Rs. 1,150


COUPON INCOME                     7%            Rs.        90 Rs. 270           Rs. 450        Rs. 611     Rs. 630        Rs. 810         Rs. 900
CAPITAL GAIN/LOSS                               Rs.       132   Rs. 109         Rs.       83   Rs.   57    Rs.       53   Rs.       19 Rs.        -
INTEREST - ON - INTEREST                        Rs.        2    Rs.       25 Rs.          78   Rs. 155     Rs. 165        Rs. 292         Rs. 373
TOTAL RETURN                                    Rs.       223   Rs. 404         Rs. 611        Rs. 822     Rs. 849        Rs.1,121        Rs. 1,273


COUPON INCOME                     9%            Rs.        90 Rs. 270           Rs. 450        Rs. 611     Rs. 630        Rs. 810         Rs. 900
CAPITAL GAIN/LOSS                               Rs.         -   Rs.         -   Rs.        -   Rs.     -   Rs.        -   Rs.         -   Rs.     -
INTEREST - ON - INTEREST                        Rs.        2    Rs.       32    Rs. 103        Rs. 207     Rs. 222        Rs. 398         Rs. 512
TOTAL RETURN                                    Rs.        92 Rs. 302           Rs. 553        Rs. 818     Rs. 852        Rs.1,208        Rs. 1,412


COUPON INCOME                     11%           Rs.        90 Rs. 270           Rs. 450        Rs. 611     Rs. 630        Rs. 810         Rs. 900
CAPITAL GAIN/LOSS                               Rs. (112) Rs.             (96) Rs. (75) Rs. (53) Rs. (50) Rs.                       (18) Rs.      -
INTEREST - ON - INTEREST                        Rs.        2    Rs.       40    Rs. 129        Rs. 264     Rs. 283        Rs. 517         Rs. 669
TOTAL RETURN                                    Rs.       (20) Rs. 214          Rs. 504        Rs. 822     Rs. 863        Rs.1,308        Rs. 1,569


COUPON INCOME                     13%           Rs.        90 Rs. 270           Rs. 450        Rs. 611     Rs. 630        Rs. 810         Rs. 900
CAPITAL GAIN/LOSS                               Rs. (209) Rs. (180) Rs. (144) Rs. (102) Rs. (97) Rs.                                (36) Rs.      -
INTEREST - ON - INTEREST                        Rs.        3    Rs.       48    Rs. 157        Rs. 325     Rs. 350        Rs. 648         Rs. 847
TOTAL RETURN                                    Rs. (116) Rs. 138               Rs. 463        Rs. 834     Rs. 883        Rs.1,422        Rs. 1,747
                              Interest Rates remain constant at 10%
                                   Reinvestment Rate at the end of Year
            10%              10%            10%           10%            10%                10%
Year         1                2              3              4             5                   6
        Rs.    88.00     Rs.    96.80 Rs.     106.48 Rs.    117.13 Rs.    128.84      Rs.     141.72
                         Rs.    88.00 Rs.      96.80 Rs.    106.48 Rs.    117.13      Rs.     128.84
                                        Rs.    88.00 Rs.      96.80 Rs.   106.48      Rs.     117.13
                                                      Rs.     88.00 Rs.     96.80     Rs.     106.48
                                                                     Rs.    88.00     Rs.       96.80
                                                                                      Rs.       88.00
Total   Rs.      88.00 Rs.     184.80 Rs.     291.28 Rs.      408.41 Rs.     537.25   Rs.     678.97
              + Bond Value at the end of year 6                                       Rs.     979.17
                             Total Value of the portfolio at the end of year 6        Rs.   1,658.15




                              Interest Rates falls to 9% After 3 Years
                                    Reinvestment Rate at the end of Year
            10%              10%            9%              9%             9%               9%
Year         1                 2              3              4              5                 6
        Rs.    88.00     Rs.     96.80 Rs.    106.48 Rs.      116.06 Rs.    126.51    Rs.     137.89
                         Rs.     88.00 Rs.      96.80 Rs.     105.51 Rs.    115.01    Rs.     125.36
                                        Rs.     88.00 Rs.      95.92 Rs.    104.55    Rs.     113.96
                                                        Rs.    88.00 Rs.      95.92   Rs.     104.55
                                                                       Rs.    88.00   Rs.       95.92
                                                                                      Rs.       88.00
Total   Rs.      88.00 Rs.     184.80 Rs.     291.28 Rs.      405.50 Rs.     529.99   Rs.     665.69
              + Bond Value at the end of year 6                                       Rs.     996.48
                             Total Value of the portfolio at the end of year 6        Rs.   1,662.17
                              Interest Rates rise to 11% After 3 Years
                                    Reinvestment Rate at the end of Year
            10%              10%            11%            11%             11%              11%
Year         1                 2              3              4              5                 6
        Rs.    88.00     Rs.     96.80 Rs.     106.48 Rs.    118.19 Rs.     131.19    Rs.     145.63
                         Rs.     88.00 Rs.      96.80 Rs.    107.45 Rs.     119.27    Rs.     132.39
                                        Rs.     88.00 Rs.      97.68 Rs.    108.42    Rs.     120.35
                                                       Rs.     88.00 Rs.      97.68   Rs.     108.42
                                                                       Rs.    88.00   Rs.       97.68
                                                                                      Rs.       88.00
Total   Rs.      88.00 Rs.     184.80 Rs.     291.28 Rs.      411.32 Rs.     544.57   Rs.     692.47
              + Bond Value at the end of year 6                                       Rs.     962.32
                             Total Value of the portfolio at the end of year 6        Rs.   1,654.79




                              Interest Rates rise to 13% After 3 Years
                                    Reinvestment Rate at the end of Year
            10%              10%            13%            13%             13%              13%
Year         1                 2              3              4              5                 6
        Rs.    88.00     Rs.     96.80 Rs.     106.48 Rs.    120.32 Rs.     135.96    Rs.     153.64
                         Rs.     88.00 Rs.      96.80 Rs.    109.38 Rs.     123.60    Rs.     139.67
                                        Rs.     88.00 Rs.      99.44 Rs.    112.37    Rs.     126.97
                                                       Rs.     88.00 Rs.      99.44   Rs.     112.37
                                                                       Rs.    88.00   Rs.       99.44
                                                                                      Rs.       88.00
Total   Rs.      88.00 Rs.     184.80 Rs.     291.28 Rs.      417.15 Rs.     559.38   Rs.     720.09
              + Bond Value at the end of year 6                                       Rs.     929.94
                             Total Value of the portfolio at the end of year 6        Rs.   1,650.03
                                            HORIZON RATE OF INTEREST AND INTEREST RATE
                         60%
                                               H=1

                         50%



                         40%         H=2
HORIZON RATE OF RETURN




                         30%



                         20%         H=4                                                      H = 300

                                                                                                        H = 20
                         10%
                                                                                                 H = Duration

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


                         -10%



                         -20%
                                                                  INTEREST RATE
     DO VISIT

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