C' Passive Management

1
C. Passive Management

• Believe bond market is fairly efficient
• Do not attempt to beat the market
• Two main passive strategies
• Bond index funds or ETFs
• Particularly as long-term investment
• Can be part of Markowitz portfolio selection
• Immunize bond portfolio from interest rate risk

2
Immunization

• Immunize bond portfolio from interest rate risk
• Net worth immunization
• Duration of assets Duration of liabilities
• Very important for financial institutions
• FINE4700
• Target date immunization
• Investment horizon Duration of portfolio
• FINE3200

3
How Does Immunization Work?

• For net worth immunization, if
• Duration of assets Duration of liabilities
• Then both sides of the balance sheet have the
  same sensitivity to interest rate changes

4
How Does Immunization Work?

• Target date immunization
• Suppose you have to make a single payment in 2
  years. Put aside money in a bond portfolio for
  this purpose
• If set duration of bond portfolio equal to
  investment horizon (2 years), then bond price
  risk offsets reinvestment risk
• Do question posted on the course website

5
Duration of a portfolio

• May need more than one bond in portfolio to match
  duration to horizon
• How do we calculate the duration of a bond
  portfolio?
• Portfolio duration has a nice property Duration
  of a bond portfolio weighted average of the
  individual bond durations

6
Target Date Immunization

• What if you match term to maturity instead of
  duration?
• Consider a 5-year investment horizon and an
  investment in a 5-year coupon bond
• If interest rates fall, say after 2 years,
  coupons will be reinvested at a lower rate
• Need bond price increase to offset lower
  reinvestment rate.
• However, bond is maturing in year 5 price
  movement is limited, restricted by par value
• Not sufficient to offset the decline in the
  reinvestment rate

7
Target Date Immunization

• If match duration, change in bond price will
  offset change in reinvestment rate
• For coupon bonds, maturity gt duration
• Will need a coupon bond (or a bond portfolio)
  with maturity longer than 5 years
• If interest rates fall, bond price can go up by
  an amount that is sufficient to offset the lower
  reinvestment rate

8
Immunization Problems

• Immunization based on duration matching will only
  work well for small interest rate changes
• Because of convexity
• Is your bond portfolio (asset) more convex or
  your obligation (liability)?
• If bond portfolio is more convex, then duration
  matching will lead to surpluses
• Example in ch.13

9
Immunization Problems

• Portfolio duration does not decrease linearly
  with the passage of time
• Duration of coupon bonds decreases less rapidly
  than maturity ? leads to mismatch over time
• Portfolios need to be rebalanced periodically to
  maintain immunization

10
Immunization Problems

• Analysis more complicated if shift in the yield
  curve is nonparallel
• One solution manage each segment of the yield
  curve separately, i.e., hedge against an interest
  rate movement in each segment
• Multifactor duration models advanced
  quantitative models

11
D. Active Bond Management

• Traditional strategies
• Bond swapping
• Substitution swap
• Pure yield pickup swap
• Intermarket swap
• Rate anticipation swap
• Interest rate swaps

12
Bond Swapping Strategies

• Substitution swap
• Look for mispricing. Two close substitutes
  (maturity, credit quality, coupon, marketability
  and call provisions), but selling at different
  prices
• Take advantage of a temporary mis-alignment in
  prices
• Pure yield pickup swap
• Look for yield improvement over the long term -
  not concerned with interim bond price
  fluctuations. Given two close substitutes, pick
  higher yielding one

13
Bond Swapping Strategies (contd)

• Intermarket spread swap
• If the yield spread between two bond markets
  (e.g., government and corporate) is too wide and
  is expected to narrow, then switch into the
  higher-yielding market
• Rate anticipation swap
• Swapping for higher (lower) duration bonds when
  interest rates are expected to fall (rise)
• http//www.addenda-capital.com/publications/SCU20
  123107(5).pdf

14
Interest Rate Swaps

• First introduced in early 1980s (period of high
  volatility in interest rates)
• Contract between two parties to exchange a stream
  of cash flow. Swap a floating-rate cash flow for
  a fixed-rate cash flow or vice versa
• Rate based on a notional principal. No exchange
  of underlying assets required
• Financial institutions act as swap dealers. May
  also take the other side of the contract

15
Interest Rate Swaps

• Most commonly used short-term floating rate is
  the LIBOR (London Interbank Offered Rate)
• Rate at which banks borrow from each other in the
  Eurodollar market
• Why use these swaps?
• Match cash outflow and inflow, e.g., if one is
  fixed-rate and the other is floating-rate
• Swaps provide a cheaper and more flexible option
  than changing portfolios

16
Interest Rate Swap Example
7.05
6.95
Firm B
Firm A
Swap Dealer
7 coupon obligation
LIBOR obligation
LIBOR
LIBOR

• Bid-ask spread 7.05 - 6.95 0.10 or 10
  basis pts
• Firm A pays the dealer LIBOR in return for a
  fixed rate (6.95)
• transforms fixed rate debt into floating debt
• now pays 7 LIBOR 6.95 LIBOR 0.05
• Firm B pays the dealer a fixed rate (7.05) in
  return for LIBOR

17
Asset-Liability Management

• Defined benefit (DB) pension plan
• Liability/obligation monthly pension payments to
  retirees (cash outflow)
• Investment of assets to generate income (cash
  inflow) to match obligation
• Liability matching (see Addenda immunization
  products)
• Hot topic (see Boots example)