Bonds 2 Flashcards
Duration
The duration measure assumes that the % change in price is proportional to a change in 1+y (linear approximation). While no one can predict the future direction of interest rates, examining the “duration” of each bond provides a good estimate of how sensitive your fixed income holdings are to a potential change in interest rates. Investment professionals rely on duration because it rolls up several bond characteristics (like maturity date, coupon payments, etc.) into a single number that gives a good indication of how sensitive a bond’s price is to interest rate changes. If rates were to rise 1%, a bond or bond fund with a 5-year average duration would likely lose approximately 5% of its value. Duration is expressed in terms of years, but it is not the same thing as a bond’s maturity date. It represents the average time it takes to receive the bond’s cash flows, weighted by their present values. The maturity date of a bond is one of the key components in figuring duration, as is the bond’s coupon rate. In the case of a zero-coupon bond, the bond’s remaining time to its maturity date is equal to its duration. When a coupon is added to the bond, however, the bond’s duration number will always be less than the maturity date. The larger the coupon, the shorter the duration number becomes. Generally, bonds with long maturities and low coupons have the longest durations. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing rate environment. The opposite happens with bonds with short maturities.
Convexity
While duration may provide a good estimate of the potential price impact of small and sudden changes in interest rates, it may be less effective for assessing the impact of large changes in rates. This is because the relationship between bond prices and bond yields is not linear but convex function of 1+y. So far, we have talked only about the relationship between price and yield for bonds without call features. When bonds have call features the relationship is not so simple. Because of this call feature, the price-yield relationship for a callable bond can be non-linear. As interest rates rise, the value of the call option decreases, which can cause the price of the bond to increase despite the increase in yield and vice-versa. Overall, the relationship between price and yield for a callable bond is complex and depends on a variety of factors, including the level of interest rates, the timing and likelihood of the call feature being exercised, and the creditworthiness of the issuer.
Intro
Major risk for all bonds is the unanticipated changes in interest rates. Different measures have been developed to estimate how sensitive the bond price to a change in interest rates.
Cash Flow Matching
Exact matching involves finding the lowest cost portfolio that produces cash flows exactly matching the outflows that are financed by the investment. These cash flows might be needed to meet pension payments. The bond portfolio is the investment used to meet these obligations. An exact matching program would determine a bond portfolio of one-, two-, and three-year bonds so that the coupons plus principal exactly match the three flows mentioned. One key advantage of the cash flow method is that it can help investors manage interest rate risk by matching the cash flow timing of the portfolio to their expected cash flow needs.
Immunization
Immunization theory attempts to eliminate sensitivity to shifts in the term structure by matching the duration of the assets to the duration of the liabilities. If duration is truly a measure of sensitivity to interest rate shifts, a shift in the term structure will have the same impact on the present value of both assets and liabilities and will leave unchanged the ability of the program to meet any obligations. If interest rates rise, the present value of assets and liabilities will fall by the same amount. Similarly, if interest rates fall, then the value of the assets and liabilities will rise by the same amount. This strategy can be an effective approach for investors who are primarily concerned with generating a stable stream of cash flows to meet their future obligations and who want to minimise interest rate risk. However, it may not be suitable for investors who are primarily focused on generating higher returns, as the portfolio’s returns may be constrained by the need to maintain duration matching with liabilities.
Indexation
Indexation strategy for bond management is an investment approach that involves replicating the performance of a particular bond market index. This strategy is used by investors who seek to achieve returns that are like those of a particular bond market index. The indexation strategy involves investing in a portfolio of bonds that are included in the chosen index, in the same proportion as the index. The objective of this strategy is to match the performance of the index as closely as possible, while minimizing tracking error, which is the difference between the returns of the index and the returns of the portfolio. The advantages of this strategy are Low-cost: Because the strategy does not involve active management. Diversification: By replicating the performance of an index, investors can achieve broad diversification across a range of bond issuers and maturities. However, there are some disadvantages as well, such as: Lack of flexibility does not allow investors to take advantage of market opportunities. Limited potential for outperformance as the strategy seeks to match the performance of the index, it may not be able to generate higher returns than the index.
Aggregate Interest Rate Forecasting
Bond prices are inversely related to interest rates, meaning that when interest rates rise, bond prices generally fall, and when interest rates fall, bond prices generally rise. As a result, aggregate interest rate forecasting can help bond portfolio managers make informed decisions about buying and selling bonds to optimise returns. Aggregate interest rate forecasting involves predicting the direction and magnitude of interest rate movements for a specific economy or region. A bond portfolio with a longer duration will be more sensitive to changes in interest rates than a portfolio with a shorter duration. By using aggregate interest rate forecasting, bond portfolio managers can adjust the duration of the portfolio to minimise the impact of interest rate movements on the value of the portfolio.
Sector Selection
Sector selection strategy is an investment approach that involves selecting specific sectors or industries within the bond market to achieve targeted returns and manage risk. This strategy aims to capitalise on differences in credit risk, interest rate sensitivity, and other factors that vary across different sectors of the bond market. The selection of specific sectors within the bond market is often based on a combination of factors, including macroeconomic conditions, market trends, and individual sector performance. For example, if the economy is experiencing inflationary pressures, a bond portfolio manager may seek to increase exposure to sectors that historically perform well in inflationary environments, such as commodities, energy, or real estate.
Sector Rotation
Sector rotation strategy for managing bond portfolios involves periodically adjusting the allocation of the portfolio to different sectors within the bond market in response to changes in market conditions, economic indicators, and other factors. This strategy is often based on a top-down approach that begins with an analysis of macroeconomic conditions and market trends. Bond portfolio managers will assess factors such as inflation rates, interest rate levels, and other economic indicators to identify sectors that are likely to outperform or underperform in the current environment. Once potential sectors have been identified, bond portfolio managers will typically analyse individual securities within each sector to select investments that offer the most attractive risk-reward trade-offs.
Mispriced Bonds
This strategy involves seeking out bonds that are undervalued or overvalued in the market, relative to their underlying fundamentals. This strategy aims to generate higher returns by buying undervalued bonds that are expected to increase in value, or by selling overvalued bonds that are expected to decrease in value. The mispricing of bonds can be caused by a variety of factors, such as changes in interest rates, changes in credit ratings, or changes in market conditions. Bond portfolio managers may use a variety of quantitative and qualitative methods to identify mispriced bonds, including analysing credit ratings, yield spreads, and other market indicators.
