FNCE 30001 Week 9 Managing Fixed Income Portfolios

FNCE 30001 Investments 9.
0
FNCE 30001 Investments
Semester 2, 2011
5 & 7 October 2011
Week 9: Managing Fixed Income
Portfolios
Professor Rob Brown
FNCE 30001 Investments 9.1
Week 9: Managing Fixed Income
Portfolios
Overview of Lecture
1. Overview of Bond Portfolio Risks
2. Some Mathematical Properties of Bond Prices
3. Duration and Convexity
4. More Properties of Duration
5. How Duration is Used in Portfolio Management
6. Measuring Portfolio Yield
Reading: Bodie et al, Chapter 16.
How Duration Changes Over Time (available on the LMS)
1. Overview of Bond Portfolio Risks
Overview of Bond Portfolio Risks
There are four main risks in investing in bonds:
1. Interest rate risk
If interest rates decrease, bond prices rise, but
If interest rates increase, bond prices fall capital loss.
2. Inflation risk
Most bonds promise payments in nominal (rather than
real) terms.
If inflation is higher than expected lower real return
than expected.
In real terms, the return may even be negative.
Overview of Bond Portfolio Risks
3. Credit (or, default) risk
Applies only to non-government debt.
Occurs if the promised nominal payments are not made
in full and/or on time.
The loss may be small or large, depending on the case.
4. Exchange rate risk
Applies only if you invest in a bond that pays interest
and/or par value in a foreign currency.
If the home currency appreciates lower return in
home currency terms.
In this lecture our focus is on interest rate risk.
2. Some Mathematical Properties of
Bond Prices
Some Mathematical Properties of Bond Prices
Interest rate risk arises because interest rate changes affect the
bond price.
Hence, we first need to understand the detail of how interest
rates and bond prices are related.
This relationship has the following five features:
1. The bond price is inversely related to the required yield.
2. This relationship is convex.
3. All other things equal, the longer the term to maturity, the greater is the
volatility of the bond price.
4. All other things equal, the higher the coupon rate, the lower is the
volatility of the bond price.
5. All other things equal, the greater the convexity, the more attractive is
the bond to investors.
1, 2 and 3: Price change vs Yield for different terms to maturity
T = 30 years
T = 15 years
T = 5 years
4. Price change vs Yield for different coupons
c = 5%
c = 15%
c = 25%
Recall the pricing formula for a coupon bond:
To simplify the notation a little, I will use i instead of ytm and drop the
subscript 0 from P. The price, P, is a function of i.
We are interested in how P responds to changes in i.
That is, if i changes to i + i, then P changes to P + P and we want to
know how the change in the price (P) is related to the change in the
yield (i).
We are also interested in the proportionate change in price P/P,
because this tells us the percentage capital gain or loss on the bond.
( ) ( ) ( )
+
= + + + +
+
+ + +
2 3
( ) ...
1
1 1 1
T
C C C C Par
P i
i
i i i
( ) ( ) ( )
0
2 3
...
1
1 1 1
T
C C C C Par
P
ytm
ytm ytm ytm
+
= + + + +
+
+ + +
We now use a Taylors series expansion and get:
( ) ( ) ( )
( ) ( ) ( )
( )
+A = + A + A +
A = +A ~ A + A
A A
~ + A
2
2
2
2
2
2
2
2
2
1
higher-order terms
2
Therefore:
1
2
1
2
dP d P
P i i P i i i
di di
dP d P
P P i i P i i i
di di
P dP i d P
i
P di P P di
How can this term be
interpreted?
By definition, the yield elasticity () of the bond price is:
That is, the proportionate change in yield multiplied by the bonds yield
elasticity.
=
dP i
di P
= =

So,
dP i i dP i i
di P i di P i
From the last slide:
( )
A A
~ + A
2
2
2
1
2
P dP i d P
i
P di P P di
The %
capital gain
or loss
Proportionate
change in
yield xbonds
yield elasticity
2
nd
derivative
tells us about
convexity
Usually quite
small, but
measurable.
Recall:
( ) ( ) ( )
+
= + + + +
+
+ + +
2 3
( ) ...
1
1 1 1
T
C C C C Par
P i
i
i i i
( ) ( ) ( )
( )
( )
( ) ( )
( )
( )
+
+
=
+ + + +
(
+
= + + + +
(
+ +
+ + +
(

2 3 4 1
2 3
Therefore:
2 3
...
1 1 1 1
1 2 3
...
1 1
1 1 1
T
T
T C Par
dP C C C
di
i i i i
T C Par
C C C
i i
i i i
( ) ( ) ( )
( )
( )
( ) ( ) ( )
( )( )
( )
( ) ( ) ( )
( )( )
( )
+
+
+
=
+ + + +
+ +
= + + + +
+ + + +
(
+ +
= + + + +
(
+
+ + + +
(

2 3 4 1
2
2 3 4 5 2
2 2 3
Because:
2 3
... ,
1 1 1 1
therefore:
1
2 6 12
...
1 1 1 1
1
1 2 6 12
...
1
1 1 1 1
T
T
T
T C Par
dP C C C
di
i i i i
T T C Par
d P C C C
di
i i i i
T T C Par
C C C
i
i i i i
Lets go back to the term
We now know that:
The big term in square brackets looks like a big mess!!
But actually it has a very simple and intuitive meaning.
It is called duration (D).
( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( )
(
+ + + + + + + + + A A
=
(
+
(

(
+ + + + + A
= + + + +
(
+
(

2 3
2 3
/ 1 2 / 1 3 / 1 ... / 1
So
1
/ 1 / 1 / 1 / 1
2 3 ...
1
T
T
C i C i C i T C Par i dP i i
di P i P
C i C i C i C Par i i
T
i P P P P
( ) ( )
( )
( )
+
(
+
= + + + +
(
+ +
+ + +
(

2 3 1
1 2 3
...
1 1
1 1 1
T
T C Par dP C C C
di i i
i i i
A
.
d P i
d i P
Duration (D) is defined to be:
Note it also follows that
( ) ( ) ( ) ( ) ( )
2 3
/ 1 / 1 / 1 / 1
2 3 ...
T
C i C i C i C Par i
D T
P P P P
+ + + + +
= + + + +
1
1
So
dP i i
D
di P i
i dP
D
P di
A A
=
+
+
| |
=
|
\ .
3. Duration and Convexity
Duration and Convexity
Consider the following bond:
Today is a coupon payment date (coupon has been paid)
Term = 5 years
Coupon rate = 8.5% pa
Par value = $100
Yield = 10% pa
What is its duration?
Time
(t)
Cash
flow ($)
PV of cash
flow ($)
PV of cash flow
/Price
(PV of cash
flow/Price) Time
1 $8.50 $7.727272 0.081931
0.081931 years
2 $8.50 $7.024793 0.074483
0.148966 years
3 $8.50 $6.386176 0.067712 0.203136 years
4 $8.50 $5.805614 0.061556
0.246224 years
5 $108.50 $67.369963 0.714318 3.571590 years
Total $94.313818 1.000000 4.251847 years
( ) ( ) ( ) ( ) ( ) + + + + +
= + + + +
2 3
/ 1 / 1 / 1 / 1
1 2 3 ...
T
C i C i C i C Par i
D T
P P P P
Duration (D)
Duration is the bonds weighted average term to maturity.
The formula takes the dates on which cash flows will occur (1, 2, 3, 4 and
5), then weights each of these dates by the percentage contribution of the
present value of that cash flow to the price of the bond.
In the example, the first coupon ($8.50) occurs at t = 1. The present value
of this coupon is $7.727272, which represents 8.1931% of the price of the
bond ($94.313818).
So, although this is a 5-year bond, in a sense the average wait for the cash
flows is 4.251847 years.
This measure (4.251847) is called the Macaulay duration of the bond, or
just duration for short.
Some simple algebra shows that the duration formula can also be written
this way:
And also this way:
( )
=
+
=

1
1
where means the cash flow at time .
T
t
t
t
t
t CF
i
D
P
CF t
( )
( )
=
=
+
=
+
1
1
1
1
T
t
t
t
T
t
t
t
t CF
i
D
CF
i
Duration recognises that term to maturity is an inadequate
measure of the time period of an investment
we also need to take into account the pattern of cash flows
within the term to maturity.
Extreme example:
Suppose we invented a new security called a 30001 special
bond.
A 50-year 30001 special bond pays $100 after 1 year and $1
after 50 years.
The term to maturity of this 30001 special bond is indeed
50 years, but would you really think of it as a 50-year
investment?
The duration of this 30001 special bond would be slightly
more than 1 year.
We now go back to our approximation for bond price sensitivity:
( )
A A
~ + A
2
2
2
1
2
P d P i d P
i
P d i P P d i
The %
capital gain
or loss
Proportionate
change in
yield xbonds
yield elasticity
2
nd
derivative
tells us about
convexity
Usually quite
small, but
measurable.
A
=
+ 1
i
D
i
We will call this term the
convexity adjustment,
denoted by X.
So, to a first approximation, the percentage capital gain or loss on a bond,
when the yield changes, is:
where D is the Macaulay duration of the bond.
To a second (more accurate) approximation, we add in the convexity
adjustment (X).
see next slide.
A A
=
+ 1
P i
D
P i
If we wanted to be more accurate, we could add in the convexity
adjustment, X:
( )
( ) ( ) ( )
( )( )
( )
A A
= + A
+
=
(
+ +
= + + + +
(
+
+ + + +
(

2
2
2
2 2 3
,
1
1
where
2
1
1 2 6 12
...
1
2 1 1 1 1
T
P i
D X i
P i
d P
X
P di
T T C Par
C C C
i
P i i i i
Example
Consider the 5-year 8.5% coupon bond (annual coupons) priced to yield
10% pa, with a par value of $100. We found that D = 4.251847 years.
If the yield were to change to 10.5% pa, to a first approximation, what is the
estimated percentage capital loss?
Answer
We know to a first approximation that
Here, i = 10% and i = +0.5%.
A A
=
+
.
1
P i
D
P i
A
~
A
~
0.005
So 4.251847
1.1
1.93266%
P
P
P
ie
P
Example (contd.)
If we wanted to be more accurate we could use the convexity adjustment:
( ) ( ) ( )
( )( )
( )
2 2 3
1
1 2 6 12
...
1
2 1 1 1 1
T
T T C Par
C C C
X
i
P i i i i
(
+ +
= + + + + (
+
( + + + +

Time
(t)
Cash
flow ($)
Cash flow
multiplier
Cash flow cash
flow multiplier
PV of (cash flow cash
flow multiplier)
1 $8.50 1 2 = 2 $17 $15.454545
2 $8.50 2 3 = 6 $51 $42.148760
3 $8.50 3 4 = 12 $102 $76.634110
4 $8.50 4 5 = 20 $170 $116.112287
5 $108.50 5 6 = 30 $3255 $2021.098907
Total $2271.448609*
*This is the value of the term in square brackets.
Example (contd.)
So the adjustment to be made is:
( ) ( ) ( )
( )( )
( )
( )
( )
( )
(
+ +
+ + + + A
(
+
+ + + +
(

=

=
=
2
2 2 3
2
2
1 1 2 6 12
...
1
2 1 1 1 1
1
$2271.448609 0.005
2 $94.313818 1.1
0.0002488
0.02488%
T
T T C Par C C C
i
i
P i i i i
Example (contd.)
So the more accurate approximation for the percentage capital
loss is:
A
~ + = 1.93266% 0.02488% 1.90778%
P
P
Example (contd.)
How good are these approximations?
Using the bond price formula we can work out the exact
answer.
When the yield increases from 10.0% to 10.5%, the bond price
falls from $94.313818 to $92.514284.
Thus the exact capital loss is $1.799534 and
the exact percentage capital loss is 1.90803%.
Our approximations were:
first approximation: a loss of 1.93266%
second approximation: a loss of 1.90778%
4. More Properties of Duration
More Properties of Duration
How Duration Behaves
All other things being equal, duration is higher if:
The coupon rate is lower (why?)
The yield is lower (why?)
(Usually) the term to maturity is longer (why?)
The duration of a zero-coupon bond is equal to the bonds
term to maturity.
The duration of a coupon bond is always less than the bonds
term to maturity.
+ 1
The duration of a perpetuity is .
i
i
Between coupon dates, the duration of a bond decreases in
line with the change in maturity;
ie duration decreases by one day, every day.
But on a coupon payment date, the duration of a bond
increases discretely.
In the next three slides we show this for a specific case, but it
holds in all cases.
Consider again the 5-year 8.5% coupon bond (annual coupons)
priced to yield 10% pa, with a par value of $100
This bonds has a duration of 4.25 years.
After three months (0.25 years), all times in the duration formula
have decreased by 0.25 years.
We now recalculate the duration (next slide).
Time
(t)
Cash
flow ($)
PV of cash
flow ($)
PV of cash flow
/Price
(PV of cash
flow/Price) Time
0.75 $8.50 $7.913606 0.081931
0.061449 years
1.75 $8.50 $7.194187 0.074483
0.130346 years
2.75 $8.50 $6.540170 0.067712 0.186208 years
3.75 $8.50 $5.945609 0.061556
0.230836 years
4.75 $108.50 $68.994500 0.714318 3.393006 years
Total $96.588070 1.000000 4.001845 years
( ) ( ) ( ) ( ) ( ) + + + + +
= + + + +
0.75 1.75 2.75
/ 1 / 1 / 1 / 1
0.75 1.75 2.75 ...
T
C i C i C i C Par i
D T
P P P P
Duration (D)
Ignoring a small rounding error, the duration has decreased by
exactly 0.25 years.
That is, duration has fallen by one day, every day.
It can be proved that this will always happen.
Now consider what happens when a coupon is paid.
The numerator of duration is now hardly affected by
tomorrows coupon, since the time attached to it is only
1/365
th
of a year.
But the denominator of duration (which is the bond price)
includes tomorrows coupon payment in full.
So, when the coupon is paid, the numerator will hardly change
at all, but the bond price will drop instantly by the amount of
the first coupon.
Hence, with almost the same numerator but a smaller
denominator, the duration instantly increases when the
coupon is paid.
The Duration of a Bond Portfolio
If the yield curve is flat, the duration of a bond portfolio is the
weighted average of the durations of the bonds that comprise
the portfolio, where the weights are the portfolio (value) weights.
Example
Recall the 5-year 8.5% coupon bond (annual coupons) priced to
yield 10% pa, with a par value of $100. Its price was $94.313818
and its duration was 4.251847 years. Call this Bond A.
Consider buying one Bond A and one Bond B, which is a 2-year
6.5% coupon bond priced to yield 10% pa.
Example (contd.)
We need to calculate the duration of Bond B:
The duration of Bond B is 1.937088 years.
Time
(t)
Cash
flow ($)
PV of cash
flow ($)
PV of cash flow
/Price
(PV of cash
flow/Price) Time
1 $6.50 $5.909090 0.062912
0.062912 years
2 $106.50 $88.016529 0.937088
1.874176 years
Total $93.925619 1.000000
1.937088 years
Example (contd.)
Total invested = $94.313818 + $93.925619 = $188.239437.
We first calculate the weighted average of the durations of Bond A and
Bond B.
Investment in A Investment in B
Wtd ave +
Total invested Total invested
$94.313818 $93.925619
4.251847 1.937088
$188.239437 $188.239437
0.50103 4.251847 0.49897 1.937088
3.09685 years
A B
D D D =
= +
= +
=
Example (contd.)
If we calculate the duration of the cash flows in the portfolio, we should
find that the portfolio duration is 3.09685 years.
The portfolio cash flows are:
Time (t)
Bond A cash
flows
Bond B cash
flows
Portfolio
cash flows
1 $8.50 $6.50 $15.00
2 $8.50 $106.50 $115.00
3 $8.50 $8.50
4 $8.50 $8.50
5 $108.50 $108.50
Example (contd.)
The calculation of portfolio duration is:
Time
(t)
Cash flow
($)
PV of cash
flow ($)
PV of cash flow
/Price
(PV of cash
flow/Price) Time
1 $15.00 $13.636364 0.072442 0.072442 years
2 $115.00 $95.041322 0.504896 1.009792 years
3 $8.50 $6.386176 0.033926 0.101778 years
4 $8.50 $5.805614 0.030842 0.123368 years
5 $108.50 $67.369963 0.357894 1.789470 years
Total $188.239439 1.000000 3.096850 years
This gives the same result: D = 3.09685.
This property is often used to design a portfolio that has the
duration we require (say, D*).
For example, suppose we wished to invest $1 million in Bond
A and Bond B and achieve a duration of 2.5 years.
We use w
A
D
A
+ w
B
D
B
= D*, where:
D
A
= 4.251847
D
B
= 1.937088
D* = 2.5
w
A
+ w
B
= 1, which implies w
B
= 1 w
A
.
So we need to solve:
4.251847 w
A
+ 1.937088 (1 w
A
) = 2.5
which solves to give w
A
= 0.24318
and therefore w
B
= 0.75682.
So the solution is that we invest:
$243,180 in Bond A and
$756,820 in Bond B.
This portfolio of bonds will have a duration of 2.5 years.
5. How Duration is Used in
Portfolio Management
How Duration is Used in Portfolio
Management
Duration is used for three main purposes:
1. As a summary measure of a bonds sensitivity to changes in
yield (interest rates).
2. As a guide to act on expectations.
3. As a tool to immunise a bond portfolio.
We will now work through each of these uses.
Management
1. Duration as a summary measure of bond price sensitivity
Recall our first approximation:
For given i and i, the percentage capital gain or loss is directly
related to duration (D).
So high-duration bonds respond more to changes in interest
rates (yields).
And low-duration bonds respond less to changes in interest
rates (yields).
A A
=
+ 1
P i
D
P i
Management
2. Duration as a guide to act on expectations
If you expect interest rates to fall, then you:
foresee capital gains
want bonds with high price sensitivity
want high-duration bonds
- eg long-term bonds with low coupons.
If you expect interest rates to rise, then you:
foresee capital losses
want bonds with low price sensitivity
want low-duration bonds
- eg short-term bonds with high coupons.
Management
3. Duration as a tool to immunise a bond portfolio
Immunise means to ensure that a bond portfolio achieves a
target rate of return even if yields change.
Suppose you need to invest today to be certain of having $1
million in five years time: how would you do that?
Simple answer: buy a five-year zero coupon bond. (Why?)
Problem: In practice, there are very few five-year zeros to buy!
So, in practice, many investors have to invest in coupon
bonds but then they face the problem of changes in yield.
It turns out that the way to do it is to invest in a bond (or a
portfolio of bonds) whose duration is five years.
Management
Why does this work?
When yields decrease, there is good news and bad news for
the investor:
Good news: capital gain
Bad news: expect a lower reinvestment rate
When yields increase, there is good news and bad news for
the investor:
Good news: expect a higher reinvestment rate
Bad news: capital loss
The duration-matching strategy exactly balances the good
news and the bad news, so it doesnt matter if yields increase
or decrease.
Management
Is it as simple as that?
Unfortunately, no.
Unlike buying a zero, duration-matching with coupon bonds
isnt a set and forget strategy:
When a coupon is paid, the portfolios duration no longer
matches the time horizon, so the portfolio has to be
rebalanced.
When yields change, duration changes, so the portfolio has
to be rebalanced.
Technically, it only works if the yield curve is flat (so that
all zero rates equal the yield) and is sure to stay flat.
Management
Example
(This example is based on Peirson et al, Business Finance,
McGraw-Hill, 10
th
edn., 2009, pp. 103-105).
The current yield curve is flat at 10% pa. An investor needs to
invest today to achieve a target value of $1.275 million in 3
years time.
There is a bond with a term of 3.4 years, paying annual
coupons of 7%.
We will show that by investing in this bond, the investor will
achieve the target even if yields decrease to 8% pa, or increase
to 12 % pa.
Management
Example (contd.)
( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
= = + + +
=

= + + +
=
=
=
0.4 1.4 2.4 3.4
0.4 1.4 2.4 3.4
$7 $7 $7 $107
1.1 1.1 1.1 1.1
$95.816022
0.4 $7 1.4 $7 2.4 $7 3.4 $107
1.1 1.1 1.1 1.1
$287.740099
$287.740099
$95.816022
3.0030 years
denom
num
D P
D
D
Management
Example (contd.)
If the investor buys one such bond with a par value of $1
million, it will cost $958,160.
If its yield of 10% pa can be locked in (immunised) then in
three years time the value of the investment will be:
$958,160 x (1.1)
3
= $1,275,311.
If duration matching works, a yield of 10% pa will be achieved,
even if yields decrease to 8% pa or increase to 12% pa.
Management
Example (contd.)
Next we look at what happens if yields decrease (increase) to
8% pa (12% pa) immediately after the investment is made and
stay at the new level for the next 3 years.
If yields immediately decrease to 8% pa, the bond price
increases from $958,160 to $1,012,573.
If yields immediately increase to 12% pa, the bond price
decreases from $958,160 to $907,809.
Management
Management
1. Because the bond
price is lower .
2. . more bonds
can be bought .
3. . so more coupon
interest is received.
Management
If yields increase, there is an immediate capital loss, but
reinvestment earnings are high.
But if yields decrease, there is an immediate capital gain, but
reinvestment earnings are low.
The next slide shows these effects diagrammatically.
Management
6. Measuring Portfolio Yield
Measuring Portfolio Yield
Many institutions (banks, insurance companies etc) calculate an
average portfolio yield.
For example, if $100m is invested in a 3-year 8% bond yielding
10% and $150m is invested in a 10-year 11% bond yielding 13%,
the temptation is to say that the portfolio yield is:
This isnt correct. Yields dont just average.
To work out the correct yield we need to calculate every cash
flow of the portfolio.
+
= +
=
$100 $150
10% 13%
$250 $250
0.4 10% 0.6 13%
11.80%
m m
m m
We first have to calculate the bond prices.
The bond prices are:
and
( ) ( )
(
= +
(
(

=
3 3
$8 1 $100
1
0.1
1.1 1.1
$95.02629602
P
( ) ( )
(
= +
(
(

=
10 10
$11 1 $100
1
0.13
1.13 1.13
$89.14751305
P
So, with $100m invested in the 3-year bond, the number of 3-year bonds
held is:
and with $150m invested in the 10-year bonds, the number of 10-year bonds
held is:
Therefore, the par values of the bond holdings are:
3-year bonds: $105,234,000
10-year bonds: $168,260,400
=
$100
1, 052, 340
$95.02629602
m
=
$150
1, 682, 604
$89.14751305
m
So the annual coupons are:
3-year bonds: 8% $105,234,000 = $8,418,720
10-year bonds: 11% $168,260,400 = $18,508,644
We can now set out the future portfolio cash flows and then
find the yield-to-maturity (internal rate of return).
Calculation of portfolio cash flows
Year 3-year bond 10-year bond Portfolio
1 $8,418,720 $18,508,644 $26,927,364
2 $8,418,720 $18,508,644 $26,927,364
3 $113,652,720 $18,508,644 $132,161,364
4 9 $18,508,644 pa $18,508,644 pa
10 $186,769,044 $186,769,044
The yield on the portfolio cash flows is 12.34% pa, which is
considerably more than the simple average of 11.80% pa.

FNCE 30001 Week 9 Managing Fixed Income Portfolios

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FNCE 30001 Week 9 Managing Fixed Income Portfolios

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