BOND PORTFOLIO
MANAGEMENT
MEANING
Bond is a debt security in which the authorized issuer
owes the holder a debt and is obliged to repay the
principal and interest at a later date, termed maturity.
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It is issued by public authorities, credit institution,
companies and supranational institutions in the
primary markets.
Instrument issued by corporates and governments to
collect funds from public or investors by offering fixed
interest or returns with specific maturity term to the
investors. In India the term bond is associated
generally with loanable instrument issued by public
undertaking.
FEATURES OF BOND
Nominal, principal or face amount
Issue price
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Maturity date
Short Term
Medium Term
Long Term
Coupon
Coupon dates
Indentures and Covenants
TYPES OF BONDS
Fixed Rate Bonds Perpetual Bonds
Floating Rate Bond Bearer Bond
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High Yield Bond Registered Bonds
Zero Coupon Bond Book Entry Bonds
Inflation Linked Municipal Bond
Bonds Lottery Bond
Assets-backed War Bond
Securities Other Index Bond
BOND MANAGEMENT STRATEGIES
Passive strategies
Buy and hold strategies
Ladder strategies
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Semi active strategies (Structured Strategies)
Bond Immunization
Dedication
Active strategies
Interest Rate Anticipation
Bond Swaps
PASSIVE STRATEGY
Buy and hold strategy:
A buy and hold strategy essentially means purchasing and
holding a security to maturity or redemption and then
reinvesting cash proceeds in similar securities.
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Advantages are any capital change resulting from interest
rate change is neutralized or ignored.
Primarily used by income maximizing investors who are
interested in the largest coupon income over a desired
horizon.
Bond ladder strategy:
Building a bond ladder means buying bonds scheduled to come
due at several different dates in the future, rather than all in the
same year.
This process is known as laddering because each group on bonds
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represents a step on the investments maturity ladder.
Advantages are it is beneficial in both situation when interest
rate rise or fall. Effective tool for someone who needs large
amounts of money available on certain future dates, for example,
to pay for a child education.
Disadvantages are if interest rates plunge, investor would be
better off owning only long term bonds Ladders. It also does not
make sense for investors with small amounts of money.
SEMI ACTIVE STRATEGIES
(STRUCTURED STRATEGIES)
Bond Immunization
Changes in the shape of the term structure and changes in the level
of interest rates, investor faces interest rate risk. The elimination of
these risk is called bond immunization.
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Immunization is the investment of asset in such a manner that the
existing business is immunized to a general change in the rate of
interest provided that the average duration of assets is equal to
average duration of liabilities.
Two types of interest risk
Price risk : The price risk occurs due to decrease in price or
value of bond as a result of increasing in interest rate in the
market.
Coupon reinvestment risk: CRR arises because the yield to
maturity computation implicitly assumes that all coupon flows
will be reinvested at the promised yield to maturity.
Dedication:
Dedication is concerned with financing a stream
of liabilities over time. The purpose of dedication
is to fund a sequence of liability payments as
they come due with no interest rate risk.
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There are two approaches that can construct
dedicated portfolio:
Pure Cash Matching
Cash matching with Reinvestment
ACTIVE STRATEGIES
Interest Rate Anticipation:
Interest rate Anticipation is the riskiest strategy for
managing bonds.
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With interest rate anticipation, investor make a forecast of
the direction and quantum of change.
Interest rate sensitivity related to bond duration, the
general rule for interest rate anticipation is to increase the
investment in the long duration bond when the interest
rates are expected to decline.
This will enhance the opportunity to increase total return
in short run due to price appreciation.
Bond Swaps:
A bond swap occurs whenever an investor sell a bond
and exchanges it with another.
An investor may decide to swap bond for many reasons
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such as to increase current yield, quality, or liquidity of
their portfolio.
There are two general types of bond swaps
Risk neutral swaps
Risk altering swaps.
EVALUATION OF BONDS
Goodwill of the cooperation
Past earning of the profit
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Purpose of collection money
BOND RETURN
There are several ways of describing a rate of
return on bond. Some of them are:
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Holding period return
The current yield
Yield to maturity
HOLDING PERIOD RETURN
It is a return in which an investor buys a bond and
liquidates it in the market after holding it for a definite
period of time.
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The formula for calculating holding period of return is as
follows:
Price gain + Coupon payment
Purchase price
It can be calculated on a daily, monthly or annual basis.
THE CURRENT YIELD
It is a measure through which the investors can easily
figure out the rate of cash flow on the investments
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made by them every year.
It is calculated as:
Annual Coupon Payment
Purchase Price
YIELD TO MATURITY
It is the single discount factor that makes the present
value of future cash flows from a bond equivalent to the
current price of the bond.
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The following assumptions are used to calculate yield
to maturity:
There should not be any default.
The interest payments are reinvested at yield to maturity.
The investor has to hold the bond till its maturity.
It is calculated as:
Coupon1 Coupon 2 (Coupon n + Face value)
Present value = 1
+ 2
+....+
(1+y) (1+y) (1+y)n
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