Managing fixed income portfolios

Kristien Smedts

KU Leuven
Readings

BKM - Chapter 15: The term structure of interest rates

BKM - Chapter 16: Managing bond portfolios

Kristien Smedts (KU Leuven) Managing fixed income portfolios 2 / 68

Roadmap

1 The yield curve

2 Interest rate risk

3 Passive bond management

4 Active bond management

Kristien Smedts (KU Leuven) Managing fixed income portfolios 3 / 68

The yield curve

The yield curve or term structure of interest rates is the set of

YTMs, at a given moment, on (Z)CB issued by the government of
varying maturities
This yield curve is a key concern for a fixed income investor
it is central to bond pricing as it gives the discount rates for various
future cash flows
it allows the investors to assess their expectations about future rates as
compared to the market
There exist two types of yield curves
the pure yield curve uses stripped or ZC treasuries
the on-the-run yield curve uses recently-issued coupon bonds selling at
or near par

Kristien Smedts (KU Leuven) Managing fixed income portfolios 4 / 68

The yield curve

Source: BKM (2021) p.468

Figure 15.1 Treasury yield curves

Kristien Smedts (KU Leuven) Managing fixed income portfolios 5 / 68

The yield curve: the US yield curve over time

Source: The New York Times (2015)

Kristien Smedts (KU Leuven) Managing fixed income portfolios 6 / 68

The yield curve: the German yield curve over time

Source: The New York Times (2015)

Kristien Smedts (KU Leuven) Managing fixed income portfolios 7 / 68

The yield curve: the Japanese yield curve over time

Source: The New York Times (2015)

Kristien Smedts (KU Leuven) Managing fixed income portfolios 8 / 68

The yield curve: explaining the yield curve

How can we explain the yield curve’s behaviour?

To study the behaviour of the yield curve we analyse:

1 The yield curve under certainty

2 The yield curve under uncertainty

Kristien Smedts (KU Leuven) Managing fixed income portfolios 9 / 68

The yield curve: explaining the yield curve under certainty

Yield curve under certainty

Assume the 1-year yield Y0,1 (= R0,1 ) is 5% and the 2-year yield Y0,2 is
6%. There is no uncertainty about future interest rates. You have the
choice between following 2-year bond investments:
1 Today you invest in a 2-year bond that you keep until maturity
2 Today you invest in a 1 year bond; in one year you invest in a 1-year
bond

What will be the future 1-year rate R1,1 ?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 10 / 68

The yield curve: explaining the yield curve under certainty
Yield curve under certainty

Source: BKM (2021) p.471

Figure 15.2 Two 2-year investment programs
Kristien Smedts (KU Leuven) Managing fixed income portfolios 11 / 68
The yield curve: explaining the yield curve under certainty

Yield curve under certainty

In a world without risk, bond investments with identical overall
maturity, must offer identical returns. If not, there are arbitrage
opportunities:

(1 + Y0,2 )2 = (1 + R0,1 ) (1 + R1,1 )

R1,1 = 7.01%

Next year’s 1-year rate will be just enough to make rolling over a series of
1-year bonds equal to investing in the 2-year bond.

The short rate is the rate for a given short maturity at different
points in time
The spot rate is the rate the prevails today for a given maturity → a
spot rate is the geometric average of its component short rates

Kristien Smedts (KU Leuven) Managing fixed income portfolios 12 / 68

The yield curve: explaining the yield curve under certainty

Source: BKM (2021) p.473

Figure 15.3 Short rates versus spot rates

Kristien Smedts (KU Leuven) Managing fixed income portfolios 13 / 68

The yield curve: explaining the yield curve under certainty

When the term structure is upward sloping

long spot rates are higher than short spot rates
it therefore implies that future short rates are expected to rise

When the term structure is downward sloping

long spot rates are lower than short spot rates
it therefore implies that future short rates are expected to decrease

Kristien Smedts (KU Leuven) Managing fixed income portfolios 14 / 68

The yield curve: explaining the yield curve under certainty

More generally, we can write:

(1 + Y0,T +1 )T +1 = (1 + Y0,T )T (1 + RT ,1 )

with Y0,T the YTM of a ZCB with a maturity T

with RT ,1 the short rate earned on an investment starting at T

This allows us to solve for the short rate RT ,1 in the future period
starting at T , based on the observed yield curve:

(1 + Y0,T +1 )T +1
(1 + RT ,1 ) =
(1 + Y0,T )T

the short rate RT ,1 makes up for the difference between the total
return on a (T+1)-period ZCB and the total return on a T-period ZCB
the short rate is therefore a break-even interest rate
Kristien Smedts (KU Leuven) Managing fixed income portfolios 15 / 68
The yield curve: forward rates as forward contracts

What is the meaning of this future rate under certainty?

In general, we do not know what the future rates will, be as the world is
uncertain
Of course, if we contractually agree today about a future interest rate, we
take away uncertainty
To account for this, we call the future interest rate, in the absence of
uncertainty, a forward rate

(1 + Y0,T +1 )T +1
(1 + FT ,1 ) =
(1 + Y0,T )T

Kristien Smedts (KU Leuven) Managing fixed income portfolios 16 / 68

The yield curve: forward rates as forward contracts

A forward rate is thus a guaranteed rate, that allows to lock in a forward

loan
Proof:

This strategy effectively engineers a synthetic forward loan

Kristien Smedts (KU Leuven) Managing fixed income portfolios 17 / 68

The yield curve: forward rates as forward contracts

To determine the corresponding rate of return on this loan:

P0,T +1 (1 + Y0,T )T
=
P0,T (1 + Y0,T +1 )T +1
1
=
(1 + FT ,1 )
P
The loan granted at T (− P0,T0,T+1 ), which is repaid at T+1 (1), thus yields a
return of FT ,1 !

Kristien Smedts (KU Leuven) Managing fixed income portfolios 18 / 68

The yield curve: forward rates as forward contracts

Important: Note that these forward rates are not (necessarily) the rates
that will prevail in the future

Even more: Forward rates are not (necessarily) the expected value of the
future rates!

What can we say about futures rates in the presence of uncertainty?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 19 / 68

The yield curve: the expectations hypothesis

Assume that investors only care about the expected value of the
interest rate
Forward rates will then be equal to expected rates:

FT ,1 = E (RT ,1 )

(1 + Y0,T +1 )T +1
(1 + E (RT ,1 )) =
(1 + Y0,T )T
This is the key result of the expectations hypothesis
In this view, an upward sloping curve is evidence of expected increases
in interest rates

Kristien Smedts (KU Leuven) Managing fixed income portfolios 20 / 68

The yield curve: the liquidity preference theory
Assume that investors not only care about expectations, but also
about risk
For a long term investor: a long-term bond that is held until maturity
is risk free, while rolling over short term bond is risky
For a short term investor: a short term bond held until maturity is risk
free, while selling a long-term bond before maturity is not
Given the different risk-profiles of the different investments the
forward rate differs from the expected future rate by a risk premium:

FT ,1 = E (RT ,1 ) + risk premium

(1 + Y0,T +1 )T +1
(1 + E (RT ,1 ) + risk premium) =
(1 + Y0,T )T

Is this risk premium positive or negative?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 21 / 68
The yield curve: the liquidity preference theory

The sign of the risk premium, for the market as a whole, depends on
the proportions of short-term versus long term investors.
Both short term and long term investors demand a risk premium
for a short term investor FT ,1 > E (RT ,1 ): the forward rate embodies a
positive risk premium as compared to the future short rate
for a long term investor FT ,1 < E (RT ,1 ): the forward rate embodies a
negative risk premium as compared to the future short rate

According to the liquidity preference theory, short term investors

dominate the market: the liquidity premium is positive and thus
FT ,1 > E (RT ,1 )

Kristien Smedts (KU Leuven) Managing fixed income portfolios 22 / 68

The yield curve: the liquidity preference theory
The term structure thus reflects expected future rates, but the forecasts
are clouded by a risk premium

Source: BKM (2021) p.479

Figure 15.4 Yield curves. Panel A: Constant expected short rates. Liquidity premium of
1%. Result: a rising yield curve. Panel B: Declining expected short rates. Increasing
liquidity premiums. Result: a rising yield curve despite falling expected interest rates.
Kristien Smedts (KU Leuven) Managing fixed income portfolios 23 / 68
The yield curve: the liquidity preference theory

Source: BKM (2021) p.480

Figure 15.4 (concluded) Panel C: Declining expected short rates. Constant liquidity
premiums. Result: a hump-shaped yield curve. Panel D: Increasing expected short
rates. Increasing liquidity premiums. Result: a sharply rising yield curve.
Kristien Smedts (KU Leuven) Managing fixed income portfolios 24 / 68
Roadmap

1 The yield curve

2 Interest rate risk

3 Passive bond management

4 Active bond management

Kristien Smedts (KU Leuven) Managing fixed income portfolios 25 / 68

Interest rate risk

TS graphs have shown that interest rates fluctuate substantially over

time
The basic bond pricing equation shows that bond prices depend on
current market rates
whenever market interest rates change, the price of an outstanding
bond will adjust
the price adjustment sets off any arbitrage opportunities between bonds
outstanding and newly issued bonds
Given the inverse relation between bond prices and interest rates
an increase in interest rates decreases bond prices and results in a
capital loss
a decrease in interest rates increases bond prices and results in a
capital gain

Can we say anything about the size of these bond price changes?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 26 / 68

Interest rate risk: bond pricing relationships

Source: BKM (2021) p.496

Figure 16.1 Change in bond price as a function of change in yield to maturity.

Kristien Smedts (KU Leuven) Managing fixed income portfolios 27 / 68

Interest rate risk: bond price relationships

1 Bond prices and yields are inversely related: as yields increase, bond
prices fall
2 An increase in a bond’s YTM results in a smaller price change than a
decrease of equal magnitude
3 Long term bonds tend to be more price sensitive as compared to short
term bonds
4 As the maturity increases, the price sensitivity increases at a
decreasing rate
5 Interest rate risk and coupon rates are inversely related: as coupons
increase, interest rate sensitivity decreases
6 Price sensitivity and YTM are inversely related: a bond selling at a
higher YTM, is less sensitive to changes in yields

Kristien Smedts (KU Leuven) Managing fixed income portfolios 28 / 68

Interest rate risk: bond price relationships

Maturity seems to be a major determinant of bond price sensitivity

To see how the maturity impacts bond price sensitivity to interest

changes, we start with a numerical example of ZCBs

Source: BKM (2021) p.498

Table 16.2 Prices of zero-coupon bond (semi-annual compounding).
For a ZCB the bond price changes almost 1 to 1 with maturity: a 1%
change in YTM changes the bond price by T%

Kristien Smedts (KU Leuven) Managing fixed income portfolios 29 / 68

Interest rate risk: bond price sensitivity to interest rates

To formalize this relation between maturity and bond price sensitivity

we take the first derivative of the ZCB price wrt the YTM (for ease of
notation we leave out time and maturity subscripts):

1 dP
P= T
→ = − T (1 + Y ) −T −1
(1 + Y ) dY

 
dP dY
= −T (1)
P 1+Y

For a ZCB, the sensitivity of price to a small change in the YTM is

proportional to maturity

Important: by taking the first derivative we are focusing on the linear

effect of a change in interest rates!

Kristien Smedts (KU Leuven) Managing fixed income portfolios 30 / 68

Interest rate risk: bond price sensitivity to interest rates
Can we generalize this sensitivity analysis to coupon bonds?

Source: BKM (2021) p.498

Table 16.1 Prices of 8% coupon bond (coupons paid semi-annually).

For a CB the sensitivity of price to a 1% change in the YTM is smaller

than its maturity

Do coupons reduce maturity?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 31 / 68
Interest rate risk: bond price sensitivity to interest rates

Characteristic to a coupon bond is that cash flows arrive at many

different times: each of the cash flows has its own ’maturity’

To deal with the ambiguity of a bond making many payments, we

need to measure the effective maturity

Such effective maturity should be an average of the maturity of the

cash flows of a coupon bond

Macaulay’s duration (D) is a measure of effective maturity of a bond. It

is the weighted average of the times to payment, where the weights are the
present value of each payment divided by the price of the bond

Kristien Smedts (KU Leuven) Managing fixed income portfolios 32 / 68

Interest rate risk: Macaulay’s duration

Formally:

Consider a coupon bond with a maturity of T

Coupon payments are made in periods t = {1, ..., T }
The weight wt associated with the payment Ct made at t equals:
present value of Ct
z }| {
Ct / ( 1 + Y ) t
wt =
P
The duration of the bond is then:

T
D= ∑ t × wt (2)
t =1

Kristien Smedts (KU Leuven) Managing fixed income portfolios 33 / 68

Interest rate risk: Macaulay’s duration

Macaulay duration
Consider a 4% coupon bond with a face value of 1000 and a maturity of 9
years (coupons paid on an annual basis). The YTM on this bond equals
5%. What is its duration? Consider also a zero coupon bond with a face
value of 1000 and a maturity of 9 years. The YTM on this bond equals
5%. What is its duration?

Macaulay duration
Assume now that the YTM declines to 4%. What happens to the price of
these bonds? What happens to its durations?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 34 / 68

Interest rate risk: Macaulay’s duration

Macaulay duration

Source: own calculations

Durations and bond price change for a 4% coupon bond

Kristien Smedts (KU Leuven) Managing fixed income portfolios 35 / 68

Interest rate risk: Macaulay’s duration

Macaulay duration

Source: own calculations

Durations and bond price change for a zero coupon bond

Kristien Smedts (KU Leuven) Managing fixed income portfolios 36 / 68

Interest rate risk: properties of Macaulay’s duration

The duration of a ZCB equals its time to maturity

Holding maturity constant, a bond’s duration is lower when the
coupon rate is higher
when coupon rate is higher relatively larger payments are received early
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/at a premium.
since duration is a weighted average of the maturity of all payments,
longer term bonds will most often have longer durations
Holding other factors constant, the duration of a coupon bond is
higher when the bond’s yield to maturity is lower
a lower YTM increases the present value of all payments, but more so
of the more distant ones.
at lower yields a larger fraction of the bond’s payments is thus later
The duration of a perpetuity can be explicitly solved as (1 + Y ) /Y

Kristien Smedts (KU Leuven) Managing fixed income portfolios 37 / 68

Interest rate risk: Macaulay’s duration as interest rate
sensitivity

Remember the price-sensitivity equation for a ZCB, this equation now

generalizes to coupon bonds, once we replace maturity with
Macaulay’s duration:
 
dP dY
= −D × (3)
P 1+Y

Duration (D) thus measures the sensitivity of the bond price to changes
in the YTM. It is important as it captures the bond’s risk associated with
changes in interest rates and is therefore a measure of interest rate risk.

Remark: this assumes a parallel shift in the term structure!

Kristien Smedts (KU Leuven) Managing fixed income portfolios 38 / 68

Interest rate risk: Macaulay’s duration as interest rate
sensitivity
Proof:
Consider a C% coupon bond with a maturity of T years, a yield Y
and a par value of M:
T
C M
P= ∑ (1 + Y )t + (1 + Y )T
t =1

To determine the approximate change in the bond price for a small

change in the YTM, we compute the first derivative wrt YTM:
dP (−1) C (−2) C (−T ) (C + M )
= 2
+ 3
+ ... +
dY (1 + Y ) (1 + Y ) (1 + Y )T +1

! !
T
t ×C
 
1 TM
=−
1+Y ∑ (1 + Y )t +
(1 + Y )T
t =1

Kristien Smedts (KU Leuven) Managing fixed income portfolios 39 / 68

Interest rate risk: Macaulay’s duration as interest rate
sensitivity
Proof:
Dividing both sides of the above equation by the bond’s price gives:
! !
T
t ×C
 
dP 1 1 TM 1
dY P
=−
1+Y ∑ t + T P
t =1 (1 + Y ) (1 + Y )

!
  T
1
=−
1+Y ∑ t × wt
t =1
| {z }
Macaulay duration

Rearranging gives us:

 
dP dY
= −D
P 1+Y
which completes our proof.
Kristien Smedts (KU Leuven) Managing fixed income portfolios 40 / 68
Interest rate risk: Modified duration as interest rate
sensitivity
Practitioners often find it useful to work with modified duration:
D
D∗ =
1+Y
In this case, equation (3) is further simplified to:

dP
= −D ∗ dY
P

Modified duration (D* ) is a measure of the proportional change in the

bond price caused by a given small change in the YTM.
Modified duration
If D ∗ = 10, then a 1% increase in the yield (e.g. from 3% to 4%) causes
the bond price to drop by 10%
Kristien Smedts (KU Leuven) Managing fixed income portfolios 41 / 68
Interest rate risk: calculating the impact of an interest rate
change

Macaulay duration
Retake the 4% coupon bond with a face value of 1000 and a maturity of 9
years (coupons paid on an annual basis). The initial YTM on this bond
equals 5%. What is the impact on the price of the bond when the YTM
decreases to 4%?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 42 / 68

Interest rate risk: Macaulay’s duration

Macaulay duration

Source: own calculations

Duration as a measure of interest rate sensitivity for a 4% coupon bond

Kristien Smedts (KU Leuven) Managing fixed income portfolios 43 / 68

Interest rate risk: grahical representation of modified
duration

Source: BKM (2021) p.506

Figure 16.3 Bond price convexity: 30-year maturity, 8% coupon bond; initial yield to
maturity = 8%.

The straight line is the % price change predicted by the duration rule
The slope of the straight line is the modified duration of the bond at
its initial YTM

Is duration an accurate proxy of interest rate risk?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 44 / 68
Interest rate risk: convexity
Modified duration is just a linear approximation to the actual curved
relation between prices and yield:
∂P 1 ∂2 P
dY +
dP = (dY )2 + h.o.t.
∂Y 2 ∂Y 2
dP 1 1 ∂2 P
= −D ∗ × dY + (dY )2 + h.o.t.
P 2 P ∂2
Only for small changes in yields the proxy is accurate:
as yields decrease, modified duration rises so the curve gets steeper on
the left
as yields increase, modified duration falls so the curve gets flatter on
the right
This property of bonds is known as convexity
the bond’s price after a change in yields is always higher than predicted
by duration
accounting for convexity thus increases the accuracy of interest rate
risk measurement
Kristien Smedts (KU Leuven) Managing fixed income portfolios 45 / 68
Interest rate risk: convexity

Formally, we can quantify convexity as the second derivative of the

price yield curve, expressed as a fraction of the bond price
It is thus the rate of change of the slope of the price-yield curve,
expressed as a fraction of the bond price:

1 ∂2 P
Convexity =
P ∂Y 2
Consider a T maturity coupon bond, convexity can then be calculated
as:
! !
T
1 t × (t + 1) × C T × (T + 1) × M
Convexity =
P ∑ (1 + Y )t +2 +
(1 + Y )T +2
t =1

Kristien Smedts (KU Leuven) Managing fixed income portfolios 46 / 68

Interest rate risk: improved measure of interest rate
sensitivity

Combining the duration (first order effect) with the convexity (second
order effect) allows us to obtain a more accurate measure of interest
rate sensitivity:
dP 1
= −D ∗ × dY + × Convexity × (dY )2
P 2

Duration-convexity effects
Retake the 4% coupon bond with a face value of 1000 and a maturity of 9
years (coupons paid on an annual basis). The initial YTM on this bond
equals 5%. What is the impact on the price of the bond when the YTM
decreases to 4%, accounting for convexity?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 47 / 68

Interest rate risk: improved measure of interest rate
sensitivity
Duration-convexity effects

Source: own calculations

Duration and convexity as a measure of interest rate sensitivity for a 4% coupon bond
Kristien Smedts (KU Leuven) Managing fixed income portfolios 48 / 68
Interest rate risk: attractiveness of convexity
Convexity is generally considered as attractive due to its asymmetric
effect on gains and losses:
a % decrease in yields has a greater effect (in absolute terms) on bond
prices, than an equal % increase in yields.
for a % change in yields we gain more than we loose
Bonds with higher curvature will therefore be more expensive than
bonds with less curvature

Source: BKM (2021) p.508

Figure 16.4 Convexity of two bonds

Kristien Smedts (KU Leuven) Managing fixed income portfolios 49 / 68

Interest rate risk: effective duration and effective convexity
Practitioners will often use the concept of effective duration (effective
convexity) instead of modified duration (and convexity)
Such effective measures allow to incorporate changes in cash flows
due to changes in interest rates
this is clearly of interest when intermediate cash flows depend on the
general level of interest rates or when options are embedded
Effective duration is measured as:
P− − P+
2PdR

with P− the price of the bond when interest rates decrease by dR

with P+ the price of the bond when interest rates increases by dR
Effective convexity is measured as:
P+ + P− − 2P
2P (dR )2
Kristien Smedts (KU Leuven) Managing fixed income portfolios 50 / 68
Roadmap

1 The yield curve

2 Interest rate risk

3 Passive bond management

4 Active bond management

Kristien Smedts (KU Leuven) Managing fixed income portfolios 51 / 68

Passive bond management

Passive bond management strategies take price largely as given, and focus
on controlling for the risk in the bond portfolio.

Two main passive bond management strategies can be distinguished:

1 An indexing strategy aims at replicating the performance of a given
bond index: it targets a risk profile in line with the risk profile of the
tracked bond index
2 An immunization strategy aims at shielding the portfolio from
exposure to interest rate fluctuations: it targets a very low, or even
zero-risk profile

Kristien Smedts (KU Leuven) Managing fixed income portfolios 52 / 68

Passive bond management: bond index funds

Bond index funds track the composition of a broad market bond index
It is a similar strategy as used in equity index funds, but with specific
problems
bond indices often include thousands of issues, many of which are
infrequently traded
bond indices turn over a lot due to bonds maturing; this requires a lot
of rebalancing
bonds generate considerable intermediate income which requires
reinvestment; this complicates the job of the index fund manager

These problems require modifications to traditional tracking

a bond index fund will restrict its portfolio to a smaller set of
representative bonds, matching the characteristics (e.g. maturity,
coupon rates, credit risk) of the bond index
this is achieved via stratified sampling or a cellular approach

Kristien Smedts (KU Leuven) Managing fixed income portfolios 53 / 68

Passive bond management: bond index funds
Example of bond stratification

Source: BKM (2021) p.514

Figure 16.8 Stratification of bonds into cells

By stratifying the broad universe of bonds into a limited set of key

characteristics, bonds having identical key characteristics are
considered homogeneous/identical
The bond manager then composes a portfolio according to the
portfolio weights in the different representative cells, by investing in
an instrument that matches the cell’s characteristics
Kristien Smedts (KU Leuven) Managing fixed income portfolios 54 / 68
Passive bond management: immunization

Immunization strategies insulate the portfolio from interest rate

risk

It is a typical strategy used by banks and LT investors (e.g. pension

funds) to protect their market value from interest rate volatility
The basic principle of immunization is the matching of interest rate
risk of assets and liabilities
by matching the duration of the assets and liabilities in a portfolio,
price risk and reinvestment risk exactly cancel out
the value of the assets will then track the value of liabilities when
interest rates change

Kristien Smedts (KU Leuven) Managing fixed income portfolios 55 / 68

Passive bond management: need for immunization

need for immunization

Assume an insurance company markets a guaranteed investment contract
for $10,000, with a 5 year to maturity and guaranteed interest rate of 8%.
The insurance company funds this liability with a $10,000 investment in
8% coupon bonds with a maturity of 7 years that sells at par. What is the
final net worth of the insurance company when the interest rate stays
unchanged at 8%. What happens when interest rates decrease to 7%, or
increase to 9%?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 56 / 68

Passive bond management: need for immunization

need for immunization

Source: own calculations based on BKM (2021) p.516

Terminal value of an asset & liability portfolio after five years (all proceeds reinvested)

Kristien Smedts (KU Leuven) Managing fixed income portfolios 57 / 68

Passive bond management: need for immunization

need for immunization

Source: own calculations based on BKM (2021) p.516

Terminal value of a 6-year bond after five years (all proceeds reinvested) following an interest rate change

Kristien Smedts (KU Leuven) Managing fixed income portfolios 58 / 68

Passive bond management: need for immunization

To summarize: when interest rates change the fund no longer grows to the
targeted value

when interest rates decrease the coupon bond gains value, but
reinvestment income decreases.
when interest rates increase the coupon bond loses value, but
reinvestment income increases.

Only when duration is appropriately chosen, these two effects offset one
another:

In particular: For an equal duration of assets and liabilities, price

risk and investment risk compensate

Kristien Smedts (KU Leuven) Managing fixed income portfolios 59 / 68

Passive bond management: need for immunization

need for immunization

Instead of funding the liability with a $10,000 investment in 8% coupon
bonds with a maturity of 7 years that sells at par, the insurance company
funds itself with a $10,000 investment in 8% coupon bonds with a
maturity of 6 years that sells at par. What is the final net worth of the
insurance company when the interest rate stays unchanged at 8%. What
happens when interest rates decrease to 7%, or increase to 9%?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 60 / 68

Passive bond management: need for immunization

need for immunization

Source: own calculations based on BKM (2021) p.516

Terminal value of a 6-year bond after five years (all proceeds reinvested)

Kristien Smedts (KU Leuven) Managing fixed income portfolios 61 / 68

Passive bond management: need for immunization

need for immunization

Source: own calculations based on BKM (2021) p.516

Terminal value of a 6-year bond after five years (all proceeds reinvested) following an interest rate change

Kristien Smedts (KU Leuven) Managing fixed income portfolios 62 / 68

Passive bond management: need for immunization
Should we be worried with the small deviations in accumulated
values? Can the fund manager now rest until maturity?

Source: BKM (2021) p.519

Figure 16.10 Immunization. The coupon bond fully funds the obligation at an interest
of 8%. Moreover, the present value curves are tangent at 8%, so the obligation will
remain fully funded even if rates change by a small amount.
Kristien Smedts (KU Leuven) Managing fixed income portfolios 63 / 68
Passive bond management: need for immunization

An immunization strategy requires rebalancing for two reasons

the portfolio is immune at a given moment in time, for small changes
in the interest rate
even if interest rates do not change, portfolio duration changes due to
passage over time
So even though immunization is a passive strategy, it does require
close monitoring

need to rebalance
An insurance company has an obligation of $19,487 in 7 years. The
market interest rate is 10%. They fund this using a 3-year ZCB and a
perpetuity paying annual coupons. How can the obligation be immunized?
Assume now that after 1 year interest rates are still at 10%. Is the
obligation still immunized? If not, what actions are required?

Kristien Smedts (KU Leuven) Managing fixed income portfolios 64 / 68

Passive bond management: need for immunization

need to rebalance

Source: own calculations

Constructing and maintaining an immunization strategy

Kristien Smedts (KU Leuven) Managing fixed income portfolios 65 / 68

Passive bond management: cash flow matching

Clearly, in general, immunization strategies are quite time-expensive

due to the continuous rebalancing that is needed to keep the portfolio
immunized over time
This problem can be solved by focusing on a specific immunization
strategy called cash-flow matching
by matching the cash flows the portfolio is automatically immunized
from interest rate risk
When applied on a multi period basis such cash flow matching is
called dedication strategy
Such dedication strategies have the advantage that it is a
’once-and-for-all approach’, but this comes at a cost of highly reduced
bond choice

Kristien Smedts (KU Leuven) Managing fixed income portfolios 66 / 68

Roadmap

1 The yield curve

2 Interest rate risk

3 Passive bond management

4 Active bond management

Kristien Smedts (KU Leuven) Managing fixed income portfolios 67 / 68

Active bond management

Just like active equity portfolio management, bond portfolios can also
be managed actively
The success of such strategy (again) crucially depends upon how
valuable the information is, on which one trades

Different active bond management strategies can distinguished

1 Substitution swap: exchange a bond for a nearly identical substitute
that is under priced
2 Intermarket swap: exchange bonds of one market for bonds of
another that is under priced
3 Rate anticipation swap: exchange varying maturity bonds when
interest rate changes are anticipated
4 Pure yield pickup swap: exchange low-yield bonds for high-yield
bonds (together with the higher risk!)

Kristien Smedts (KU Leuven) Managing fixed income portfolios 68 / 68