Bond Portfolio Mgt
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Transcript of 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
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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.
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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.
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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.
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� 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.
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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%.
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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%
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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.
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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%
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(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%
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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%
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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
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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.
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� 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%.
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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
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Rate at 7%
Payment Number Year remaining
until obligation
Accumulated Value Total
A. Rate remains at 8%
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
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Rate at 9%
Payment Number Year remaining
until obligation
Accumulated Value Total
A. Rate remains at 8%
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
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� 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.
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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
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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
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� 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.
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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.