Chapter 16 – Managing Bond Portfolios
16-1
CHAPTER SIXTEEN
MANAGING BOND PORTFOLIOS
CHAPTER OVERVIEW
This chapter discusses active and passive bond portfolio management strategies. The concept and use of
duration are explained, as are the various types of portfolio immunization strategies utilizing duration. In
addition, it describes various active strategies, or bond swaps.
LEARNING OBJECTIVES
After studying this chapter, the student should have a thorough understanding of duration and how to
PRESENTATION OF MATERIAL
16.1 Interest Rate Risk
The traditional bond pricing relationships and interest rate relationships are discussed in this section. The
relationships with respect to maturity are not exact. In discussing the pricing relationships, it is helpful to
discuss how maturity and cash flows as measured by coupon rates must be considered together to get
exact relationships.
This section continues with a detailed look at duration. The description of duration used here stresses the
concept of average life. Since the measurement of duration considers the timing and value of
16.2 Convexity
Calculating the second order price change, known as the bond’s convexity reduces pricing results in
Chapter 16 – Managing Bond Portfolios
16.3 Passive Bond Management
Major strategies for passive management are discussed here. Bond indexing is similar to stock indexing
except that it requires more rebalancing and is in many ways more difficult to implement. Many bonds
trade in relatively thin markets and indexing for fixed income instruments can be more costly. Figure
16.8 illustrates how stratification is used in bond indexing.
16.4 Active Bond Management
Bond swapping strategies are presented here. Swapping strategies are used when the fixed income
portfolio is actively managed. Substitution, intermarket and rate anticipation swaps require some level of
market disequilibrium. With a substitution swap, two bonds that are substitutes offer different rates of
return. The strategy involves purchase of the bond that is offering the higher rate of return and selling the
Excel Models
immunization. One is constructed to help students understand the concepts related to holding period
immunization. The spreadsheet is built with closed-end equations that make it easy to work with bonds
of any maturity. Students can compare return with different holding periods and understand how returns
are affected by interest rate change. The other spreadsheets calculate duration using 1) the individual
cash flows and 2) the closed-end equation. The models are also very useful in-class teaching tools.