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Lecture 05dm Fixed Income Portfolio Analysis

The lecture covers fixed income portfolio analysis, focusing on bond portfolios, risk assessment, and immunization techniques to manage interest rate changes. Key risks associated with bonds, such as interest rate risk, call risk, and default risk, are discussed along with methods for hedging and calculating portfolio duration. Examples illustrate the immunization process and the importance of matching portfolio durations with obligations to mitigate risks effectively.

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Bert Joseph Rico
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0% found this document useful (0 votes)
5 views21 pages

Lecture 05dm Fixed Income Portfolio Analysis

The lecture covers fixed income portfolio analysis, focusing on bond portfolios, risk assessment, and immunization techniques to manage interest rate changes. Key risks associated with bonds, such as interest rate risk, call risk, and default risk, are discussed along with methods for hedging and calculating portfolio duration. Examples illustrate the immunization process and the importance of matching portfolio durations with obligations to mitigate risks effectively.

Uploaded by

Bert Joseph Rico
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Lecture 5

Fixed Income Portfolio


Analysis

References: Villalobos, Luenberger, Faerber


Lecture Topics
• Bond portfolios
• Immunization
• Examples
• Assignments
Risk Review
• We think of risk as the chance that an investment's actual return will
be different than expected (worse).
• Risk is often measured by calculating the standard deviation of
historical returns or average returns of a specific investment.
• We are interested in the relationship between risk and return.
• In general:
– The greater the risk that an investor is willing to take, the greater
the potential return.
– It seems justified that an investor should be compensated for
taking on greater risk.
• For example, a U.S. Treasury bond is considered to be one of the
safest investments.
– It has a lower rate of return than a corporate bond.
– The risk that a corporation goes bankrupt is much higher than the
US government.
– So, we are offered higher rates of return if we invest in corporate
bonds than US government bonds.
The Risks of Bonds
• Interest rate risk: Changes in interest rates reduce (or increase) the
market value of a bond.
– Interest rate risk, or market risk, is greater the longer you plan to
hold onto a bond.
– Rising interest rates also make new bonds more attractive.
• This would be an opportunity risk which is the risk that a better
opportunity will occur that you are unable to respond to.
• Call risk: When the bond's principal is repaid early and you are unable
to find a bond with a similar attractive yield.
• Default risk: The bond issuer is with the payments to holders, pays a
negotiated reduced amount, or is unable to pay at all.
– Five rating agencies are used
• AM Best, Dominion Bond Rating Service, Fitch Ratings, Moody's
Investors Service, and Standard & Poor's (S&P)
• Review information about bond issuers, especially financial
information, and assign a rating to an issuer's bonds – from AAA
(or Aaa) to D (or no rating).
• https://www.investopedia.com/terms/b/bondrating.asp
Historical Patterns – 10 Year Treasury

https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=billratesAll
https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart
Risk Reduction - Hedging
From Investopia:
• Hedge: Making an investment to reduce the risk of adverse
price movements in an asset.
• Normally, a hedge consists of taking an offsetting position in a
related security, such as a futures contract.
• An example of a hedge would be if you owned an asset then
sold a futures contract stating that you will sell your asset at a
set price, therefore avoiding market fluctuations.
• Investors use this strategy when they are unsure of what the
market will do. A perfect hedge reduces your risk to nothing
(except for the cost of the hedge).

• Today’s lecture will present a technique to protect against


changes in the value of a portfolio of bonds due to changes in
interest rates.
Duration Refresher
• As you recall from the last lecture, the simplified formula for
the Macaulay Duration is:

1+ y 1+ y + n (c − y )
D
= −
my mc (1 + y )n − 1 + my
 

• And that the duration is a “weighted average” of the times that


payments are made.

• It is a single point estimate for the cash flow.


Duration of a Portfolio
• We can expand the idea of duration to a portfolio of bonds.

• Suppose we have m fixed income securities with prices of Pi


and durations of Di, where i =1,2, …, m, all computed at a
common yield.
– A portfolio consisting of the aggregate of these securities
has price P and duration D given by:
P = P1 + P2 +  + Pm
D = w1 D1 + w2 D2 +  + wm Dm
– Where
Pm
wm =
P
Example
• Suppose that you have a portfolio of one bond of GE Capital
and one of GE.
– What is the duration of the portfolio at different rates?
• The following durations were obtained by using the formula and
a composite cash flow (see Lecture 5 Excel file).
Annual Discount Rate
0.02 0.04 0.06 0.08 0.10
Duration (Years)
GE Cap 12.43 11.79 11.10 10.39 9.67
GE 5.71 5.66 5.60 5.54 5.48
Present Value Price
GE Cap 1495.12 1177.61 941.89 765.26 631.61
GE 1182.01 1056.74 946.83 850.22 765.16
Weight
GE Cap 0.56 0.53 0.50 0.47 0.45
GE 0.44 0.47 0.50 0.53 0.55
Portfolio Duration (Years)
Port 9.47 8.89 8.34 7.84 7.37
Immunization Procedure
• The idea is to immunize our portfolio against interest rate
changes.

• It is important to think of this as a process, and not just another


set of calculations.
– Start by defining our objectives.
– What are your future needs or obligations?
– How do we match our portfolio with our objectives and
maintain this while yields change due to various influences?

• The immunization process tries to solve this problem by


matching durations and present values.
Immunization Procedure
• Immunization is a security selection technique that matches the
duration of a portfolio of securities to the present value of an
obligation (or target).
• If the duration of the portfolio matches that of an obligation
stream, then the cash value of the portfolio and the present value
of the obligation stream will correspond identically to a change in
yield.
• In a two bond portfolio the immunization portfolio is found by
solving the equations:

V1 + V2 = PV (of obligation)
D1V1 + D2V2 = Target Portfolio Duration x PV

• Where V1 and V2 are the amounts invested in the bonds


Luenberger Example
• The X corporation has an obligation to pay one million dollars
in 10 years. It wishes to invest money now sufficient to meet
this obligation. The bond choices available are:
– Bond 1: 6% rate, 30 yr maturity, $69.04 price and 9% yield
– Bond 2: 11% rate, 10 yr maturity, $113.01 price and 9% yield
– Bond 3: 9% rate, 20 yr maturity, $100 price and 9% yield
• Calculating the Durations we get
D1 = 11.44
D2 = 6.54
D3 = 9.61
• We need to make the maturity of the set of bonds we choose to
coincide with the obligation.
• We select bonds 1 and 2 to meet the obligation (can we select
bonds 2 and 3?)
Luenberger Example
• Our two equations that we need to solve are:

V1 + V2 = $414,643.00 (PV of $1M obligation at 9% yield)

11.44V1 + 6.54V2 = 10 x $414,643.00

• Solving these two equations we get?


Luenberger Example
• Our two equations that we need to solve are:

V1 + V2 = $414,643.00 (PV of $1M obligation at 9% yield)


11.44V1 + 6.54V2 = 10 x $414,643.00

• Solving these two equations we get:

V1 = $292,788.70
V2 =$121,854.27

• These numbers are rounded up to determine the investment to


be made.
• We can determine the quantity of each bond that we need to
purchase to achieve these two values.
Immunization Process
• Luenberger shows the effect of yield changes on the portfolio
of the two bonds from Example 3.10.
– Very minimal impact as expected.

• It is important to note that once the yields have a significant


change, the portfolio will need to be rebalanced or adjusted to
maintain the immunization process.
– In general, it is a good idea to monitor and rebalance the
portfolio on a regular basis.
Additional Example
Security Category: Corporate Security Category: Corporate
Price 80 Price 92.55
Yield 9.313% Yield 9.313%
Issue Description SR NT Issue Description DEB
Issuer Name HERTZ CORP Issuer Name COLUMBIA/HCA HEALTCARE CORP
Coupon Rate 7.00% Coupon Rate 8.36%
Coupon Type Fixed Coupon Type Fixed
Maturity Date 1/15/2040 Maturity Date 4/15/2036
S&P Rating NR S&P Rating B-
Payment Frequency Semi-annual Payment Frequency Semi-annual
Callable No Callable No
Security Category: Corporate
Price 95.56
Yield 9.328%
Issue Description MTN SER A
Issuer Name USX CORP
Coupon Rate 8.75%
Coupon Type Fixed
Maturity Date 9/16/2034
S&P Rating BBB+
Payment Frequency Semi-annual
Callable No
Additional Example
• Durations for the three bonds are:
Hertz D1 = 9.54
Columbia D2 = 8.12
USX D3 = 7.52

• Let’s use the first 2 bonds (Hertz and Columbia) to meet the
obligation of the previous example of $1M in 9 years.

• PV of the $1M obligation at an annual 9.313% = $440,766.20


(18 periods at 4.6565%)

• The two equations that we need to solve are:


V1 + V2 = 440,766.20
9.54V1 + 8.12V2 = 9 x 440,766.20
Additional Example
• Solving our two equations results in:
V1 = $272,336.68 / (Hertz)  341 bonds
V2 = $168,429.52 / (Columbia)  182 bonds

• Total investment needed is:


341 x $800 + 182 x $925.5 = $441,241.00

See this example in the Excel file.


Sensitivity to Yield
Sensitivity Analysis
Yield Hertz Columbia Portfolio Obligation Difference
8.000% 308780.01 187465.91 496245.92 493628.12 -2617.80
9.000% 280801.19 172724.17 453525.36 452800.37 -724.99
9.313% 272809.63 168446.29 441255.92 440766.20 -489.72
10.000% 256419.69 159572.05 415991.74 415520.65 -471.09

• These changes in yield result in approximately “zero”


difference between our investment and our obligation.

• What would have happened if you chose only one bond?


Additional Bond Information
• US bond market is the largest securities marketplace in the world
– Issuance (as of July) $5,037.3 billion, +2.9% Y/Y
– Trading (as of July) $1,058.5 billion, +3.6% Y/Y
– Outstanding (as of 4Q21) $52.9 trillion, +5.5% Y/Y
• Typically twice the size of the combined market capitalization of all
U.S. stock markets US FI Outstanding
ABS Agency MMs
3.0% 2.7% 1.9%
Other Federal Agency Debt
Asset Backed Securities Munis
Municipal Bonds 7.7%
Corporate Bonds
Money Market Instruments UST
Mortgage Backed Securities 42.7%
Corporates
US Treasury 18.9%

https://www.sifma.org/resources/research/
us-fixed-income-securities-statistics/
MBS
23.1%
Assignments
• Luenberger 3.3, 3.7, 3.10, 3.13, 3.14, 3.16

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