Managing Bond Portfolios

							                     A Primer
Material based on Douglas Hearth and Janis K.
Zaima, Contemporary Investments Security and
Portfolio Analysis, Fourth Edition, Thomson
South-Western
   Bond market can be volatile.
   To take advantage of anticipated changes in
    interest rates to boost returns.
   To protect the value of the portfolio from
    adverse changes in interest rates.
   Remember that bond prices and interest rates
    are inversely related.
•   The yield curve provides an indication of the
    future levels of interest rates.
    –   (Pure Expectations Theory of the Yield Curve)
•   Keeping all else equal, investors prefer shorter
    term commitments than longer term ones.
    –   (Liquidity Preference Theory of the Yield Curve)
•   We need to remember that investors invest to
    maximize their expected utility.
    –   (Market Segmentation Theory of the Yield Curve)
   Interest rate expectations strategies
   Yield curve strategies
   Yield spread strategies
   Foreign exchange strategies
   Individual bond selection strategies
   If interest rates are expected to fall, then invest
    long-term now
   If interest rates are expected to rise, then invest
    short-term for now such that you can reinvest
    at higher rates in the future
   Click on attached excel file
•   A yield spread measures the difference in
    yields between bonds of different qualities.
•   Yield spreads tend to increase (decrease) when
    interest rates are rising (falling).
•   Yield spreads tend to be at their maximum
    (minimum) when interest rates are historically
    high (low).
•   Pure Yield Pickup Swap – Short 10 year T-Bond
    to buy a 10 year AA-Corporate Bond
•   See attached Excel File for an example
   Consider Country A and Country B.
   Both issues government bonds with 1-year to
    maturity. The YTM on both bonds is 5%.
   The current exchange rate is 1 A$ for 2 B€.
   You forecast that in 1 year the exchange rate
    will be 2 A$ for 3 B€.
   Strategy: Invest in Country B government
    bond.
   If you believe a company’s fortune will
    improve and that its current bond rating is too
    low, then buy the bond now.
   If your expectation is correct, then the bond’s
    price will appreciate.
   Passive bond management strategies fall into
    two broad categories:
       Indexing Strategies – replicate the performance of a
        bond index
       Immunization – reduce the bond portfolio’s risk
        with respect to fluctuations in interest rates
   Indexing reduces transaction costs and
    management expenses compared with actively
    managed portfolios.
   Points to remember:
     An investor who wants to eliminate any exposure to
      credit risk should avoid indexes that include corporate
      bonds
     An investor that cannot tolerate interest rate risk should
      avoid indexes that are long in long-term bonds only.
     Due to regulatory constraints, some institutional investors
      cannot invest in indexes that include bonds that are rated
      below investment-grade.
   https://personal.vanguard.com/us/funds/va
    nguard/bytype#hist::upperTB=perfTBI|lower
    TB=avgAnnTBI
   Tracking Error is one way of assessing how
    well an index fund replicates the performance
    of its benchmark index.
   It is the difference between the total return of
    the portfolio and that of the index.
   You would like this error to be as small as
    possible.
   Immunization is an attempt by a bond investor
    to reduce a portfolio’s exposure to the risks
    associated with changing interest rates.
   Target date immunization – see Excel sheet
   Cash Flow Matching and Multi-period
    Immunization – see Excel Sheet
   Net Worth Immunization – Match the
    durations of assets and liabilities
   Two parties agree to exchange a series of
    interest payments
   A third party, a large bank or investment
    banking firm, usually acts as an intermediary
    between the two parties
   See Excel Sheet for an example