M.B.A.

4th Semester
Investment Management
Unit II : Fixed Income Securities – Analysis, Valuation and Management

Features and types of debt instruments, Bond indenture, factors affecting bond yield. Bond
yield measurement – current yield, holding period return, YTM, AYTM and YTC. Bond
valuation, capitalization of income method, bond-price theorems, valuation of compulsory /
optionally convertible bonds, valuation of deep discount bonds. Bond duration, Macaulay’s
duration and modified Macaulay’s duration, bond convexity. Considerations in managing a
bond portfolio, term structure of interest rates, risk structure of interest rates. Managing Bond
Portfolio, Bond Immunization, active and passive bond portfolio management strategies.

Features and types of debt instruments

A bond represents a security issued in connection with a borrowing arrangement. In essence, it is an
“IOU” issued by the borrower. A bond obligates the issuer to make specified payments (interest and principal)
to the bond holder. A bond may be described in terms of par value, coupon rate, and maturity date. The par
value is the value stated on the face of the bond. It represents the amount the issuer promises to pay at the time
of maturity. The coupon rate is the interest rate payable to the bondholder. The maturity date is the date when
the principal amount is payable to the bondholder. The bond indenture, the contract between the issuer and the
bondholder, specifies the par value, coupon rate and maturity date.
Government Bonds
The largest borrowers in India, and in most other countries, are the central and state governments. The
Government of India periodically issues bonds which are called government securities. These are essentially
medium to long term bonds issued by the RBI on behalf of the Government of India. Interest payments on
these bonds are typically semi-annual. State governments also sell bonds. These are also essentially medium to
long term bonds issued by the RBI on behalf of state governments. Interest payments on these bonds are
typically semi-annual.
Apart from the central and state governments, a number of governmental agencies issue bonds that are
guaranteed by the central government or some state government.

Corporate Bonds
Companies, like the governments, borrow money by issuing bonds called corporate bonds (also called
corporate debentures). Internationally, a secured corporate debt instrument is called a corporate bond whereas
an unsecured corporate debt instrument is called a corporate debenture. In India, corporate debt instruments
have traditionally been referred to as debentures, although typically they are secured. For the sake of
simplicity, we will refer to all corporate debt instruments as corporate bonds.
A wide range of innovative bonds have been issued in India, particularly from the early 1990’s. This
innovation has been stimulated by a variety of factors, the most important being the increased volatility of
interest rates and changes in the tax and regulatory framework. A brief description of various types of corporate
bonds are as follows :

Straight Bonds : The straight bond also called as plain vanilla bond is the most popular type of bond. It pays
a fixed periodic (usually semi-annual) coupon over its life and returns the principal on the maturity date.
Zero Coupon Bonds : A zero coupon bond does not carry any regular interest payment. It is issued at a
steep discount over its face value and redeemed at face value on maturity. For example, the Industrial
Development Bank of India (IDBI) issued deep discount bonds in 1996 which have a face value of Rs.
2,00,000 and a maturity period of 25 years. The bonds were issued at Rs. 5,300.
Floating Rate Bonds : Straight bonds pay a fixed rate of interest. Floating rate bonds, on the other hand,
pay an interest rate that is linked to a benchmark rate such as the Treasury Bill interest rate. For example, in
1993, the State Bank of India came out with the first ever issue of floating interest rate bonds in India. It issued
5 million (Rs. 1000 face value) unsecured, redeemable, subordinated, floating interest rate bonds carrying
interest rate at three percent per annum over the bank’s maximum term deposit rate.
Bonds with Embedded Options : Bonds may have options embedded in them. These options give certain
rights to investors and / or issuers. The more common types of bonds with embedded options are :
(a) Convertible Bonds : Convertible bonds give the bond holder the right (option) to convert them into
equity shares on certain terms.
(b) Collable Bonds : Callable bonds give the issuer the right (option) to redeem them prematurely on
certain terms.
(c) Puttable Bonds : Puttable bonds give the investor the right to prematurely sell them back to the issuer
on certain terms.
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Secured versus Unsecured Bonds : Along the dimension of security, bonds can be classified into
unsecured bonds and secured bonds. Unsecured bonds have no charge on any specific assets of the company
while secured bonds carry a fixed or floating charge in the assets of the company. The distinction between
secured and unsecured bonds becomes relevant in case the issuer defaults in the payment of interest or principal.

Senior versus Subordinate Bonds : This is again a distinction which becomes important in the case of a
default. The senior bondholders have to be paid before the subordinated bondholders. This means that if the
assets of the company are insufficient to pay even the senior bondholders, they get what ever amount can be
realized and the subordinated bondholders will get nothing. If the assets are a little more, the senior
bondholders may be paid in full and the subordinated bondholders may get partial payment.

Registered and Unregistered Bonds : On the dimension of transferability, debentures can be classified as
registered and unregistered debentures. Unregistered debentures or bearer debentures are freely negotiable and
can be transferred by a simple endorsement. On the other hand, registered debentures can be transferred only
by executing a transfer deed and filing a copy of it with the company.

Bond Indenture
The indenture is a long, complicated legal instrument containing the restrictions, pledges and promises
of the contract. Bond indenture involves three parties. The first party is the debtor corporation that borrows the
money, promises to pay interest and promises to repay the principal borrowed. The bond holders are the
second party, they lend the money. They automatically accept the indenture by acquiring their bonds. The
trustee is the third party with whom the bond contract is made. The trustee ensures that the corporation keeps
its promises and follows the provisions contained in the indenture. In other words, the trustee does the
‘watchdog’ job for all the bond holders.

Fixed Income Securities

Bonds and debentures represent long-term debt instruments. The issuer of a bond promises to pay a
stipulated stream of cash flows. This generally comprises periodic interests payments over the life of the
instrument and principal payment at the time of redemption. The fixed income instruments are Government
Securities, RBI relief bonds, private sector debentures, PSU bonds and preference shares.
Bonds or debentures are issued frequently by public sector companies, financial institutions and private
sector companies. A wide range of innovative debt securities have been created in India, particularly from
early 1990’s. This innovation has been stimulated by a variety of factors, the most important being the
increased volatility of interest rates and changes in the tax and regulatory framework. The value of a bond is
equal to the present value of the cash flows expected from it. Hence, determining the value of a bond requires :

 An estimate of expected cash flows.

 An estimate of the required return.

To simply our analysis of bond valuation, we will make the following assumptions :
1. The coupon interest rate is fixed for the term of the bond.
2. The coupon payments are made every year and the next coupon payment is receivable exactly a year
from now.
3. The bond will be redeemed at par on maturity.

Given these assumptions, the cash flow for a bond comprises an annuity of a fixed coupon interest payable
annually and the principal amount payable at maturity. Hence, the value of a bond is :

Where, P = Value of bond

= number of years
C = annual coupon payment
= periodic required return
M = maturity value
= time period when the payment is received.
Since the stream of annual coupon payments is an ordinary annuity, we can apply the formula for the present
value of an ordinary annuity. Hence, the bond value is given by the following formula :
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To illustrate, how to compute the price of a bond, consider a 10 year, 12 % coupon bond with a par value of
Rs. 1,000. Let us assume that the required yield on this bond is 13 %. The cash flows from this bond are as
follows :
 10 annual coupon payments of Rs. 120.
 Rs. 1,000 principal repayment 10 years from now.

The value of the bond is :

Bonds with Semi-Annual Interest

Most of the bonds pays interest semi-annually. To value such bonds, we have to work with a unit
period of six months and not one year. This means that the bond valuation equation has to be modified along
the following lines :
 The annual interest payment, C , must be divided by two to obtain the semi-annual interest payment.
 The number of years to maturity must be multiplied by two to get the number of half-yearly periods.
 The discount rate has to be divided by two to get the discount rate applicable to half yearly periods.
With the above modifications, the basic bond valuation becomes :

Where : P = value of bond

C/2 = semi-annual interest payment
/2 = discount rate applicable to a half year period
M = maturity value
2n = maturity period expressed in terms of half yearly periods.

Return on Bonds
The yield of a bond is, roughly speaking, the return on the bond. The yield is expressed as an annual
percentage of the face amount. However, yield is a little more complicated than the coupon rate. There are
several different measures of yield : nominal yield, current yield and yield to maturity.
The investor in bond typically receives income from the following :
(a) Interest payments at a contractual rate, i.e., coupon interest.
(b) Capital gain or loss arising out of sale of the bond.
(c) Cash realization on sale of bond.
(d) Redemption of the bond by the issuer at a contracted value.

Items (a) and (b) constitute returns to the bond investor, while (c) and (d) are principal recoveries. An
investor’s income on bond investment depends on whether he holds the bond to maturity of disinvests before
maturity. If the bond is held to maturity, cash flows (a) and (b) will accrue. However, if he sells before
maturity, he receives cash flows (a), (b) and (c) above. The return to the bond investor can be measured in
terms of the following :

1. Current Yield
2. Yield to Maturity (YTM)

Current Yield
The current yield is the annual interest due on it divided by the bond’s market price. The current yield
is a reliable measure of the returns earned by perpetual bonds and / or almost any bond with a long time
remaining to maturity. Investors use the current yield to determine the rate of return earned on each invested
rupee, but they knew this yield has some handicaps. It means bond returns over an indefinite time period. In
theory, the current yield assumes bonds are without a maturity date when interest payments cease or that a bond
will be sold at the same price as the purchase price.
Current Yield = Coupon Interest / Prevailing market price
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Coupon Rate or Nominal Yield
 The coupon rate is the stated interest rate on a bond. It is the interest paid on the face value of a
corporate bond. The coupon rate is decided upon after taking into account risk of default, the credit standing of
the company, the convertible option, the investment position of the industry, the security backing of the bond
and the market rate of interest for the firm’s industry, size and risk class. After all these factors have been
taken into account, a coupon rate is set with the objective that it will be just high enough to attract investors to
pay the face value of the bond. Later, the market price of the bond may change from its face value as market
interest rate changes, while the contractual coupon rate remains fixed. In buying bonds, the investor should be
aware of the possible capital gains or losses due to changes in the market price of a bond, since this is as
important as the interest income in calculating yield.

Bond Price Theorem

Based on the bond valuation model, several bond value theorems have been derived. They state the
effect of the following factors on bond value :

1. Relationship between the required rate of return and the coupon rate.
2. Number of years to maturity.

The following theorems show how bond values are influenced by the relationship between the required rate of
return and the coupon rate.

1. When the required rate of return is equal to the coupon rate, the value of a bond is equal to its par value.
2. When the required rate of return is greater than the coupon rate, the value of a bond is less than its par
value.
3. When the required rate of return is less than the coupon rate, the value of a bond is more than its par
value.

Principles of Bond Price Movements

 The yield to maturity is inversely related to price of the bond. As yield to maturity increases, the price
of the bond decreases and as the yield to maturity decreases, the price of bond increases.
 For a difference between the coupon and the YTM, the extent of change in the price of the bond
depends on the remaining term to the maturity. The larger the period, the greater will be the price
change.
 The increase in the price of a bond associated with the changes in the interest rates will be at a
diminishing rate as the term to maturity increases.
 For every change in the interest rate, there will be corresponding change in the price of the bond.
However, the same change in the interest rate in either direction, the corresponding change in the price
is not by the same magnitude. The price decrease caused by a yield decrease is always more than the
increase from a yield increase.
 For a given change in a bond’s yield to maturity, the percentage price change will he higher for low
coupon bonds than for high coupon bonds.

Yield to Maturity (YTM)

The yield measure most commonly used for bonds is not current yield but yield to maturity (YTM) i.e.,
the percentage yield that will be earned on the bonds from purchase date to maturity date. The yield to maturity
puts bonds income into a common denominator that permits investors to make yield comparisons. The yield to
maturity need not consider capital gains, bonds are redeemed at their face value at maturity. Indeed, the yield
to maturity has several other virtues. It considers the time value of money, market discounts and premiums,
and is the return earned over the remaining life of a bond issue. The yield to maturity is a complex computation
based upon a rather simple data. It is the discount rate that equals the present value of all cash flows from a
bond to the current market price.

The internal rate of return or Yield to Maturity (YTM) of a bond is the discount rate that equates the
present value of a bond’s cash flows to the bonds current market price.
Suppose the market price of a Rs. 1,000 par value bond, carrying a coupon rate of 9 % and matures
after 8 years, is Rs. 800. What rate of return would an investor earn if he buys this bond and holds it till its
maturity ? The rate of return that he earns, called the yield to maturity (YTM) is the value of Kd in the
following equation :

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To find the value of Kd, which satisfies the above equation, we may have to try several values of Kd till we
hit on the right value. Let us begin with a discount rate of 12 per cent. Putting a value of 12 %, for Kd, we
find that the right hand side of the above expression become equal to :

Since this value is greater than Rs. 800, we try a higher value for Kd. Let us try Kd = 14 %. This makes the
right hand side equal to :

Since this value is less than Rs. 800, we try a lower value for Kd. Let us try Kd = 13 %. This makes the right
hand side equal to :

Thus, Kd lies between 13 % and 14 %. Using the linear interpolation, in the range of 13 % and 14 %, we
find that the Kd is equal to 13.2 % as follows :

The following is the formula to calculate an approximate YTM.

Approximation to YTM
Many investors do not bother to calculate the YTM, and instead analyse the return earned in a very
simple way. The reason is that the total return consists of interest payments and the capital gain / loss on
redemption. The average annual return is then :

Average annual return = (Annual interest + capital gains) / Number of years.

Similarly, one can also calculate the average investment as the average of the current price and the redemption
value. Many investors then compute the yield as the average annual return divided by the average investment.

Average annual return =

Where, ‘C’ is the coupon , ‘F’ is the redemption value and the ‘P’ is the purchase price.
Many other approximations of this kind are in common use. Some approximations do not use the notions of
average investment, but divide the return either by the redemption value or by the price. There are some who
divide the annual interest by the price and divide the capital gains by the redemption value. All these
approximations involve the same error of ignoring the timing of the cash flows. These approximations are
however, very useful in calculating the YTM by trial and error since they provide a very good initial guess,
the process of trial and error gives the true YTM in a few steps.

Yield to Call (YTC)

Most modern corporate bonds are callable at the discretion of the issuer. This gives the issuing company
the right to recall a bond before it reaches maturity. For example, suppose a corporation originally issues
bonds for Rs. 1,000 each at a high rate of interest, but, since the date of issue, market interest rates have
fallen and the market value of the bond has risen. It may be to the benefit of the company to recall the bonds,
retire them, and then issue new bonds at a lower rate. In that case, the investor would be unable to continue to
receive an interest rate that is higher than the prevailing market rate. To compensate for the undesirable callable
features, a new issue of callable bonds will carry a higher interest rate than a comparable issue to uncallable
bonds.
Some bonds carry a call feature that entitles the issuer to call (buy back) the bond prior to the stated
maturity date in accordance with a call schedule (which specifies a call price for each call date). For such
bonds, it is a practice to calculate the yield to call (YTC) as well as the YTM. The procedure for calculating
the YTC is the same as for the YTM. Mathematically, the YTC is the value of r in the following equation :
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Where C is the annual interest , M is the call price and n is the number of years until the assumed call date.

Assumptions underlying YTM

The YTM of a bond represents the expected or required rate of return on a bond. While computing the
YTM. The following assumptions are made :

1. All coupon and principal payments are made on schedule.

2. The bond is held to maturity.
3. The coupon payments are fully and immediately reinvested at precisely the same interest rate as the
promised YTM.

The YTM and the realized yield would be equal if the above conditions are fulfilled. Any violation of the
above assumptions will cause YTM to differ from realized yield.

Bond Immunization
A bond holder faces the interest rate risk and fluctuations in rates will lead to changes in bond returns.
A bond which is of longer period faces longer fluctuations with a given change in interest rate than a short
duration bond. Bond investor faces the interest rate risk between the time of investment and the future holding
period. Interest rate risk is composed of two risks. Price risk and coupon re-investment risk. If the interest rate
rise in the meantime, the bond price will fall and there will be capital depreciation. Second risk is the coupon
re-investment risk, as the yield to maturity computation implicitly assume that the coupon flows will be re-
invested. Thus, if the interest income is re-invested at a higher rate, then the total end sum would be above
that expected.
The above two effects are opposed to each other. While one increases, the total bond return, the other
decreases it, in the case of fall in the interest rate. The reverse is true in the case of rise in interest rats. The
elimination of these risks is called bond immunization. If the realized return on investment in bonds is sure to
be atleast as large as the appropriately computed yield to the time horizon, then the investment is immunized.
The maximization is achieved by making the duration of the portfolio as equal to the desired holding
period. Duration is the time period at which price risk and coupon re-investment risk of a bond portfolio are of
equal magnitude and opposite in direction.

Duration
Investors are subject to interest rate risk on two counts – the re-investment of annual interest and the
capital gain / loss on sale of the bond at the end of the holding period.
When interest rate rise, there is a gain on re-investments and a loss on liquidation. The converse is true
when interest rates fall.
For any bond, there is a holding period for which these two effects exactly balance each other. What is
lost on re-investment is exactly compensated by a capital gain on liquidation and vice-versa. For this holding
period, there are not interest rate risks.
This holding period for which interest rate risk disappears is known as the duration of the bond.
Fortunately, we do not need to try out various holding periods to determine the period for which the interest
rate risk is eliminated. There is a simple way of computing the desired holding period (duration). The duration
strategy can be used to neutralizing interest rate risk through the process of immunization. The duration of the
bond helps in finding out the value of the bond through realized yield. The maturity period of a bond also be
used.
The calculation of duration is necessary for a study of the effect of changes in interest rates on bond
prices and yields. This concept is also useful to make proper investment decision on bonds. Macaulay’s
Duration is defined as the weighted average number of years, until the cash flows occur, where the relative
present values of each cash payment are used as the weights.
The duration can be used as a measure of the responsiveness of bond price to changes in market yields.
It is used to immunize a bond from interest rate risk by setting the investment horizon equal to bond’s duration.

Macaulay’s Duration : Frederick Macaulay defined duration as the weighted average maturity of a bond’s
cash flows, where the present values of the cash flows serve as weights. This definition highlights the effect
that periodic payments of interest have on the bond’s total cash flow. Duration is a very important concept in
fixed income portfolio management for two reasons :
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 It is a simple summary statistic of the effective average maturity of the bond and a portfolio of bonds.
 It is a measure of the interest rate sensitivity of bond.
Duration also known as Macaulay Duration or MD measures the weighted average maturity of a bond’s cash
flows on a present value basis. The present value of cash flows are used as the weights in calculating the
weighted average maturity. Thus MD = Number of years needed to fully recover purchase price of a bond,
taking present values of its cash flows. MD is always expressed in terms of years.

Macaulay’s Duration and Modified Macaulay’s Duration are two measures of bond price volatility.
Duration gives us a good estimate of a bond’s price change for a small change in yield. However, it does not
give us a good estimate for large changes in yield.

Modified Macaulay’s Duration

So far we saw how Macaulay’s Duration can be used as a measure of a Bond’s life, now we shall see
its application to measure the interest rate sensitivity of a bond. MD is first used to calculate a measure called
Modified Macaulay Duration (MMD). The MMD is used to calculate the percentage price change in a bond
for a given change in YTM.

MMD =

Where m = number of coupon payments per year.

YTM = yield to maturity expressed as a decimal.

Uses of Bond Duration

Bond investors have many uses of duration analysis. One use, for example, is to measure the price-
volatility of a particular issue. Another, perhaps more important, use of duration is in the structuring of bond
portfolios. For example, if a bond investor believes that interest rates are about to increase, he could calculate
the expected percentage decrease in the value of his portfolio, given a certain change in the market interest
rates and the overall duration of the portfolio by selling higher-duration bonds and buying those of shorter
duration. Such a strategy would prove quite profitable since short duration instruments do not decline in value
to the same degree as longer bonds. Of course, if the investor believed that interest rats were about to decrease,
the opposite strategy would be optimal.
Although active short term investors frequently use duration analysis in their day-to-day operations,
longer term investors have also employed duration analysis in planning their investment decisions. Indeed, a
strategy known as bond portfolio immunization represents one of the most important uses of duration.

Properties of Duration
Duration of a bond is influenced by three key factors – time to maturity, coupon rate and yield to
maturity. The following are the properties of duration.

Property 1 : The duration of a zero coupon bond will always equal to its term to maturity. Regardless
of the term to maturity, zero coupon bonds duration equals its term to maturity as no cash inflows accrue
during the life of the bond. There is only one single cash inflow at the end of the bond term. That is why its
MD is equal to its term to maturity.

Property 2 : Holding coupon rate constant, the duration of a coupon bond will be less than its term to
maturity. The payment of coupon shortens the period of time for receipt of cash flows, thus making the
duration less than the term to maturity. Additionally, the longer the term to maturity the less impact this cash
flow has on the present value of the bond. These in turn increases the difference between the term to maturity
and the duration for long term bonds relative to the short term bonds.

Property 3 : Holding term to maturity and yield to maturity constant the higher the coupon rate, the
lower is the bond’s duration. This property is attributable to the impact of early coupons on the average
maturity of a bonds payment. Thus we see duration is inversely related to a bond’s coupon. Higher coupon
bonds have greater amounts of cash flow before maturity, thus reducing the impact that the principal payment
has in the present value of the cash flows. But for lower coupon bonds, the present value of total cash flows
depends more heavily on the principal repayments.

Property 4 : Holding coupon rate constant, bond’s duration increases with its term to maturity.
Bonds with longer maturity generate cash flow streams over a longer term of increase the duration, but at the
same time the discounting process assigns progressively lower present value factor to these flows, in term
causing duration to increase at a decreasing rate. An exception to the above being zero coupon bond’s duration
which increases in a linear fashion with increasing maturity.
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Property 5 : Holding term to maturity and coupon rate constant, the lower (higher) the required
yield, the greater (smaller) will be the duration of the bond. Existing level of market yields also affect the
bond duration – the higher (lower) the current level of yields, the lower (higher) will be the duration of the
bond. Thus as market yields fall, the process of discounting assigns relatively larger weights to the more
distant cash flows, in particular, the principal payment and assigns lower weights to the near term cash flows.
This process in turn increases the duration. The reverse occurs for increase in interest rates. Because very short
term bonds have few short term cash flows, changes in market yields have relatively little effect on the duration
of these securities.

Type of Bond Risks

Risk is defined as variability of returns. Most of the investors in fixed income securities are seeking a
steady stream of interest income over the life of the bond and a return of principal at maturity. Though these
investors are only seeking a basic return that the bond offers, their actually realized returns may vary from the
promised return. This variability in returns can be attributed primarily to various kinds of risks that fixed
income securities are exposed to, they are :

Default Risk : It is that portion of an investor’s total risk, that occurs due to the inability of the bonds issuers
to repay interest or principal. Default risk is also called financial risk or bankruptcy risk.

Interest Rate Risk : It is the variability in the return of an investment that grows out of fluctuations in the
market rate of investment. We know that there exists an inverse relationship between bond price and yields and
that interest rates fluctuate substantially. As interest rates rise and fall, bond investors experience capital losses
and gains. Even default free bonds returns are affected by interest rate risk. Bonds with more futurity or
duration have more interest rate risk.

Collability Risk : It is the variability in returns caused due to the call option present in the bonds indenture.
Callable bonds can be redeemed before maturity, thus cutting short the returns causing the returns to fluctuate.

Convertibility Risk : It is the variability in returns caused due to the convertibility option present in the
bond’s indenture. Convertible bonds are usually converted to common stock and since the returns on common
stock are difficult to predict, it could result in fluctuation of returns.

Purchasing Power Risk : Rise in general prices over time or inflation is the usual norm in almost all
countries. Inflation results in the erosion of returns generated by our financial investments. This happens to
bond investments too. The real returns generated by the bond investment do not compensate the investor for
inflation.

Bond Portfolio Management Strategies

Fixed income securities seem to be a suitable investment for those individuals who desire to establish a
high level of steady income, or to accumulate money so as to reach some target level of wealth, or desire a
regular income.
Returns generated by fixed income securities especially by bonds are increasingly becoming more
volatile, especially in the current market scenario. Changes in bond yields directly affect a bonds total returns,
particularly its price, causing bond investors to be concerned about this risk. Consequently, many bond
portfolio management strategies are designed either to limit the effect of interest rates on bond portfolio values
or to profit from anticipated changes in interest rates. Broadly all the strategies available to a bond investor can
be classified into passive and active strategies.

Passive Management Strategies

While managing their portfolios using this strategy, investors do not actively indulge in trading
possibilities in order to outperform the market. The most commonly used passive strategies are :
1. Buy and Hold Strategy.
2. Immunization Strategy.
3. Rebalancing Strategy.

Buy and Hold Strategy : It is ideal for investors to establish and maintain a steady level of current income.
The buy and hold strategy is an approach wherein the securities are simply bought and held until maturity over
a time that matches the investment horizon of the buyer. An important pre-requisite of this strategy is that
investors must choose the most promising bonds.
Immunization Strategy : The strategy of protecting the returns of a portfolio against interest rate risk is called
immunization. The variability in returns of coupon paying bonds due to changes in interest is caused due to two
factors.
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 The price risk resulting from the inverse relationship between price and required rate of return.
 The re-investment rate risk resulting from the uncertainty about the rate at which future coupon income
can be re-invested.
If interest rate rise, re-investment returns rise, but price falls. Both these components of interest rate risk move
in opposite directions. Similarly, when interest rates fall, re-investments returns fall but the price of the bond
appreciates. Immunization strategy uses the favourable results of one interest rate risk component to offset the
unfavourable results of the other component. Immunization uses the concept of Duration. A portfolio is said to
be immunized if the investor matches the investment horizon not with the maturity of the bond but with the
duration of the bond. Duration achieves this result because it is that time period which exactly offsets re-
investment risk and price risk against each other.

Rebalancing : Immunization however has its share of drawbacks too. As interest rates fluctuates asset
durations continually change and one needs to constantly realign the duration of portfolio investment with the
duration of the liability. This is known as portfolio rebalancing. Even if interest rates do not change, passage
of time alone causes asset durations to change. Of course, rebalancing of a portfolio entails transaction costs as
assets are bought or sold, so continuous rebalancing is not practical. In perfect immunization, we are
continuously trying to strike a balance between continuous rebalancing and the need to control trading costs,
which requires less frequent balancing.

Active Management Strategies

Although one generally invests in fixed income securities with the intention of holding them till
maturity, there are some investors who invest in them for their price appreciation potential and not for income
protection. Investors who feel their way use active management strategies which seek to profit either by
forecasting changes in interest rates or by identifying relative mis-pricing between various fixed income
securities. Here the investors trade actively on their bond portfolios. Two of the most commonly used active
management strategies are :

Forecasting Changes in Interest Rates : Since changes in interest rates is a major factor affecting bond
prices, investors try to forecast interest rates using tools like Yield Curve and Horizon Analysis to cash in on
the price appreciation potential of a bond.

 Yield Curve : The yield curve is a graphical depiction of the YTM’s of bonds with different
maturities. The shape of the Yield Curve at any point of time is a very good indicator of the future
course of interest rates, which in turn helps investors decide which segment of the bond market to invest
in.

 Horizon Analysis : It involves the projection of bond performance over a planned investment horizon.
To do this, investor has to make assumptions about the reinvestment rates and future yields, and by
doing so he is able to consider how different scenarios will affect the performance of the bonds being
considered.

Identifying Mispricings Among Securities : This active management strategy involves the use of bond
swaps. Bond swaps refers to the purchase and sale of bonds in an attempt to improve a bond portfolio’s return
by identifying temporary mispricings in the bond market.
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