FNCE 625 – Investment Analysis and Management

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 18

Bonds: Analysis and Strategy

Why Buy Bonds?

Attractive to investors seeking steady income and investors speculating on interest rate decreases

Yield appeals to long-term investors

Price change appeals to short-term investors

Promised yield to maturity is known at the time of purchase

Tend to have a low correlation with equities

Buying Foreign Bonds

Attractive because foreign bonds:

often offer higher yields than alternative domestic bonds

offer considerable diversification (low correlation)

Can be difficult to buy, so most investors buy foreign-bond mutual funds or E T Fs

Subject to currency risk, which can be hedged

Understanding the Bond Market

Bonds often benefit from a weak economy

Interest rates reflect expected inflation

Increased expected inflation tends to reduce bond prices, increase yields

These relationships do not always hold

Both exchange rates and global economic conditions affect bond prices

Passive Bond Strategies 1

Based on idea that bond market is rational

Risk is the portfolio variable to control

Have lower costs than active strategies

Returns are based on known inputs, not expectations

Investors must still assess market conditions

Evidence tends to support passive approach

Passive Bond Strategies 2

Buy and hold

No attempt to trade in search of higher returns

Ladder and barbell methods help reduce risk

Indexing

Attempt to match performance of a well-known bond index

Mutual funds, E T Fs offer bond index funds

Active Bond Strategies 1

Can be based on

Forecasting interest rate changes

Identifying abnormal yield spreads

Identifying relative mis-pricing

Requires expectations/forecasting

Inputs not known at time of analysis

Active Bond Strategies 2

Forecasting interest rate changes

Notoriously difficult to do accurately

Involves tradeoffs

Shape of yield curve contains valuable information

Horizon analysis

Project bond performance over planned investment horizon

Investor selects bond expected to perform best

Active Bond Strategies 3

Yield spread analysis

Yield spread is difference between two segments of bond market

Assumes there is a “normal” spread level

Attempts to profit from expected changes in differences

Investors sell bonds in one sector and buy in another to profit as yield spread moves to “normal” level

Forecasting the Credit Spread

Active Bond Strategies 4

Identifying mis-pricing

Temporary mis-pricings do occur

Bond swaps

Simultaneous buying and selling of different bonds

Bond market now more accessible to individual investors

Duration

Duration is a weighted measure of a bond’s lifetime

Commonly stated in years

Accounts for both size and timing of the bond’s cash flows

Present-value weighted average of the number of years that investors receive cash flows

Describes weighted average time to all payments

Calculating Duration

Sum of time-weighted P V of cash flows

Duration depends on three factors:

Maturity of the bond

Coupon payments

Yield to maturity

Duration Relationships

Duration increases with time to maturity but at a decreasing rate

For coupon paying bonds, duration is always less than maturity

For zero coupon-bonds, duration equals time to maturity

Duration is inversely related to yield-to-maturity

Duration is inversely related to coupon rate

Why is Duration Important?

Allows comparison of effective lives of alternative bonds

Used in bond management strategies, particularly immunization

Direct measure of interest rate risk

Measures bond price sensitivity to interest rate movements

This characteristic is most important for bond investors

Estimating Price Changes Using Duration

Bond price changes directly relate to duration

Duration indicates change in bond’s price for a given change in interest rates

Modified duration

can be used to calculate the bond’s percentage price

change for a given change in yield

Managing Price Volatility

To obtain maximum (minimum) price volatility, investors should choose bonds with the longest (shortest) duration

Duration is additive

Portfolio duration is just a weighted average

Duration measures volatility due to interest rate changes

Liquidity and default are also prominent types of risk

Convexity

As size of yield change increases, modified duration becomes poorer approximation

Duration equation assumes a linear price-yield relationship, but true relationship is curvilinear

Refers to the degree to which duration changes as the yield to maturity changes

Convexity largest for bonds with low coupon, long-maturity, and low yield to maturity

Bond Convexity

The true price/yield relation is convex; thus, a rate decrease raises prices more than the same increase in rates lowers prices

Yield Change

Decrease from 8% to 6%

Price rises by $231.15

Increase from 8% to 10%

Price drops by $171.59

Immunization 1

Used to protect a bond portfolio against interest rate risk

Interest rate risk composed of price and reinvestment risk

Move in opposite directions, offset each other

Price risk result of relationship between bond prices and rates

Reinvestment risk result of uncertainty about rate at which future coupon income invested

Immunization 2

Risk components move in opposite directions

Favorable results on one side can be used to offset unfavorable results on the other

Portfolio immunized if the duration (not maturity) of the portfolio is equal to investment horizon

In reality, immunization not easy to implement

Immunization requires frequent rebalancing

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FNCE 625 – Investment Analysis and Management

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