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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 www.projectbaba.com