Bond Market Volatility and Portfolio Management
Explore the impact of bond market volatility on investors, active and passive bond portfolio management strategies, interest rate swaps, and more. Learn how volatility affects potential profits and the importance of managing interest rate risk in bond investments.
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Presentation Transcript
FIN 330 Principles of Investing C CHAPTER ONDP PORTFOLIOS HAPTER18 ORTFOLIOS& 18 M MANAGING ANAGINGB BOND & D DURATION URATION
Managing Bond Portfolios & Duration S STUDENT Volatility Volatility in bond prices in bond prices Interest rate term structure and bonds Interest rate term structure and bonds Active bond management strategies Active bond management strategies Passive bond portfolio management Passive bond portfolio management Interest rate swaps Interest rate swaps TUDENT L LEARNING EARNING O OBJECTIVES BJECTIVES
Interest Rate Volatility: 1962:1 2013:12 25.00 20.00 TB3MS DGS10 15.00 MPRIME FEDFUNDS 10.00 5.00 0.00 2004-01-01 1974-11-01 1994-09-01 1995-11-01 1962-01-01 1976-01-01 1997-01-01 2002-11-01 1978-05-01 1984-03-01 1988-11-01 2009-11-01 2000-07-01 1964-05-01 1969-01-01 1972-07-01 1990-01-01 1991-03-01 2008-09-01 1971-05-01 2005-03-01 2006-05-01 1977-03-01 1985-05-01 1979-07-01 1981-11-01 1983-01-01 2012-03-01 1967-11-01 1963-03-01 1970-03-01 1973-09-01 1992-05-01 1993-07-01 2001-09-01 2011-01-01 1966-09-01 1986-07-01 1987-09-01 1965-07-01 1999-05-01 2013-05-01 1980-09-01 1998-03-01 2007-07-01
Euro area yield curves Euro area yield curves 15 April 2019 15 April 2019
History of Bond Market Volatility D. D. Impact Impact of bond volatility on investors of bond volatility on investors Bond volatility affects potential for profits from Bond volatility affects potential for profits from anticipated changes anticipated changes Active bond portfolio management more important in Active bond portfolio management more important in light of volatility light of volatility - - especially since volatility increases especially since volatility increases potential for losses. potential for losses. Volatility makes it difficult to predict the annual rate of Volatility makes it difficult to predict the annual rate of return making strategies to minimize return making strategies to minimize interest rate risk more important more important interest rate risk
Managing Bond Portfolios Bond portfolio composition depends on the Bond portfolio composition depends on the relationship between yield and maturity: the relationship between yield and maturity: the term structure of interest rates structure of interest rates.. Adjustments to the Adjustments to the average duration average duration of a bond portfolio alters the portfolio s sensitivity to changes portfolio alters the portfolio s sensitivity to changes in interest rates. in interest rates. Volatility in bond portfolio values may also be Volatility in bond portfolio values may also be attenuated by attenuated by immunization immunization and strategies. strategies. term of a bond and hedging hedging
Yield Curve Implied Forward Rates Implied Forward Rates The The Spot Rates Spot Rates are today s prevailing rates. are today s prevailing rates. The The Forward Rate Forward Rate is the expected rate at some point in is the expected rate at some point in the future the future If forward rates are implied in the current spot rates, If forward rates are implied in the current spot rates, then knowing the spot rates allows calculating the then knowing the spot rates allows calculating the forward rates. forward rates. Knowing the spot one year rate and the spot two year Knowing the spot one year rate and the spot two year rate allows calculation of the expected one year rate allows calculation of the expected one year forward rate a year from now forward rate a year from now..
Theories of the Yield Curve Pure Expectations Theory: Pure Expectations Theory: Forward rates Forward rates are unbiased estimates of expected future spot are unbiased estimates of expected future spot rates. rates. Liquidity Preference Theory: Liquidity Preference Theory: Reflects investor's bias toward short Reflects investor's bias toward short- -term bonds. Investors will only hold long Investors will only hold long- -term bonds in exchange for a liquidity premium. liquidity premium. Market Segmentation Theory: Market Segmentation Theory: Argues that forward rates are unrelated to future spot rates Argues that forward rates are unrelated to future spot rates because bonds of varying maturities are not substitutes because bonds of varying maturities are not substitutes.. term bonds. term bonds in exchange for a
Managing Bond Portfolios B. B. Interest Interest Rate Expectations Strategies Rate Expectations Strategies As interest rate rise, bond prices fall As interest rate rise, bond prices fall Short maturity bonds (or bills) are preferred. Short maturity bonds (or bills) are preferred. As interest rate fall, bond prices rise As interest rate fall, bond prices rise Long maturity bonds preferred. Long maturity bonds preferred. C. Duration C. Duration measures the relative price sensitivity of bonds measures the relative price sensitivity of bonds to interest rate changes to interest rate changes.. Adjustments in duration of portfolio based on expectations of interest rate trends.
Duration Two Major Sources of Bond Risk Interest Rate Risk: Change in value as YTM varies. Reinvestment Rate Risk: Changes in FVA as YTM varies. Weighted Average Life of a Bond The time period over which the bond s coupon payments and maturity payment are recovered. Bond price sensitivity can be more appropriately related to weighted average life than to just the maturity date. The weighted average life of the bond is its duration. duration.
Duration Example e.g.; Five-year bond pays $80 per year for the next five years plus $1,000 at the end of five years. (Assume annual coupon payments)
Duration Most Important Use of McCauley s Duration Shows the sensitivity of a bond to time and coupon rate Duration is a function of; Time to maturity: number of years until bond matures Coupon Rate: as coupon rate increases, duration decreases Zero coupon bonds: Duration = Maturity Current market Rates (Yield to Maturity or YTM) As interest payments are reinvested it will change future cash flows and as a consequence duration will also be affected. The end result is that portfolios must be readjusted periodically to maintain the desired horizon date (= duration).
Duration and Coupon Rates Duration and Coupon Rates are negatively correlated
Duration and Market Interest Rates (YTMs) Duration and YTM s are negatively correlated As YTM s increase, the duration of a given portfolio will decrease. As YTM s decrease, the duration of a given portfolio will increase.
Homework Questions: 2, 5, 9, 10 Problems: 1, 2
