BKM Chapter 16 - Managing Bond Portfolios

Question 1

What are the six general properties of bond prices?

Answer 1

1. Bond prices and yields are inversely related: as yields increase, bond prices fall; as yields fall, bond prices increase.
2. An increase in a bond’s yield to maturity results in a smaller price change than a decrease in yield of equal magnitude.
3. Prices of long-term bonds tend to be more sensitive to interest rate changes than prices of short-term bonds.
4. The sensitivity of bond prices to changes in yields increases at a decreasing rate as maturity increases.
5. Interest rate risk is inversely related to the bond’s coupon rate. Prices of low-coupon bonds are more sensitive to changes in interest rates.
6. The sensitivity of a bond’s price to a change in its yield is inversely related to the yield to maturity at which the bond is currently selling. (Higher yield to maturity => less sensitive)

Question 2

What are the three reasons that Duration is a key concept in fixed-income portfolio management?

Answer 2

1. It is a simple summary statistic of the effective average maturity of the portfolio. 2. An essential tool in immunizing portfolios from interest rate risk. 3. It is a measure of the interest rate sensitivity of a portfolio.

Question 3

What is the duration of a zero-coupon bond?

Answer 3

Its time to maturity

Question 4

What’s the relationship between a bond’s duration and it’s coupon rate?

Answer 4

Holding maturity constant, a bond’s duration is lower when the coupon rate is higher.

Question 5

What’s the relationship between a bond’s duration and time to maturity?

Answer 5

Holding the coupon rate constant, a bond’s duration generally increases with its time to maturity. Duration always increases with maturity for bonds selling at par or at a premium. Duration need not always increase with time to maturity (for some deep-discount bond, duration may eventually fall with increases with maturity).

Question 6

What’s the relationship between a bond’s duration and its yield to maturity?

Answer 6

Holding other factors constant, the duration of a coupon bond is higher when the bond’s yield to maturity is lower.

Question 7

What is the duration of a level perpetuity?

Answer 7

Duration of perpetuity = (1+y)/y

Question 8

Why is convexity considered a desirable trait?

Answer 8

Bonds with greater curvature gain more in price when yields fall than they lose when yields rise.

Question 9

What are the two broad classes of passive management pursued in the fixed-income market.

Answer 9

1. Indexing strategy: it attempts to replicate the performance of a given bond index. => same risk-reward profile as the bond market index to which it is tied.
2. Immunization: Designed to minimize the exposure to interest rate fluctuations (used by insurance companies and pension funds). Seek to establish a zero-risk profile.

Question 10

Why are modifications required for bond-index funds compared to stock market indexing?

Answer 10

1. Bond indexes include thousands of securities, making it difficult to purchase each security in the index in proportion to its market value.
2. Many bonds are very thinly traded. It’s difficult to identify their owners and purchasing at a fair market price.
3. Bonds are continually dropped from the index as their maturities fall below 1 year. Newly issued bonds are added to the index. => The securities used to compute bond indexes constantly change.

Question 11

Why is rebalancing impoartant?

Answer 11

1. As interest rates change, duration changes.
2. Asset duration will change due to the passage of time, even if interest rates do not change.

Question 12

Advantage and Disadvantages of Cash Flow matching

Answer 12

Advantage: It is a once-and-for-all approach to eliminating interest rate risk

Disadvantage:

1. Limit portfolio choice
2. May not be possible. if liabilities durations are very long you may not be able to find any assets with matching cash flow.

Question 13

List three reasons why the basic immunization approach described is unrealistic

Answer 13

1. It assumes that interest rates only change by small amounts,
2. it assumes parallel shifts in the term structure and
3. it ignores inflation.

Question 14

What are the two sources of potential value in active bond management?

Answer 14

1. Interest are forecasting, which tries to anticipate movements across the entire spectrum of the fixed-income market.
2. Identification of relative mispricing.

Question 15

What are the four types of bond swaps?

Answer 15

1. Substitution Swap: an exchange of one bond for a nearly identical substitute. This swap would be motivated by a belief that the market has temporarily mispriced two bonds. e.g. Toyota bond with 6% coupon that is price with a yield to maturity of 6.05% vs. Honda bond with 6% coupon that is priced with a yield to maturity of 6.15%. If the bonds have about the same credit rating, Honda bond is attractive
2. Intermarket spread swap: yield spread between two sectors is temporarily out of line. e.g. spread between corporate and government bond
3. Rate anticipation swap: if investors believe that rates will fall, they will swap into bonds of longer duration and vise versa.
4. Pure yield pickup swap: When the yield curve is upward-sloping, the yield pickup swap entails moving into longer-term bonds.

Question 16

Cite and explain two examples of how interest rate swaps could be used by a fixed-income portfolio manger to control risk or improve return

Answer 16

1. A portfolio manager who is holding a portfolio of long-term bonds, but is worried that interest rates might increase, causing a capital loss on the portfolio, can enter into a swap to pay fixed rate and receive a floating rate. The portfolio thereby converts the holding into a synthetic floating rate portfolio.
2. A pension fund manager might identify money market securities that are paying excellent yields compared to other ST securities. However, the manger might believe that such short term assets are inappropriate for the portfolio. The fund can hold these securities and enter a swap in which the fund receives a fixed rate and pays a floating rate. Thus, the fund captures the benefit of advantageous relative yields.

Question 17

Example of an negative duration bond

Answer 17

A mortgage-backed security interest only tranche.

When interest rates fall, the underlying mortgage in the pool will tend to be prepaid early and cash flow from the interest payments will decline. This causes the PV of the cash flows fall, rather than to rise. This is the opposite effect for a fixed-coupon bond and so the duration is negative.