Material based on Douglas Hearth and Janis K.
Zaima, Contemporary Investments Security and
Portfolio Analysis, Fourth Edition, Thomson
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
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
• 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
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
Immunization – reduce the bond portfolio’s risk
with respect to fluctuations in interest rates
Indexing reduces transaction costs and
management expenses compared with actively
Points to remember:
An investor who wants to eliminate any exposure to
credit risk should avoid indexes that include corporate
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
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
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
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