FINM 3421
Tutorial 5: Bond Portfolio Management (I)
Bond Portfolio Strategies
1. Compare the returns on a bullet and a barbell portfolio given the following information.
Time to Convexity
Maturity Coupon YTM Modified Duration Price
Bond A 2 5 5 1.881 3.925 $100.00
Bond B 5 5.5 5.5 4.320 16.271 $100.00
Bond C 8 4 6 6.634 31.392 $87.44
A). What portfolio weights would you use to create a barbell portfolio of Bonds A and C that matches the
modified duration of the bullet portfolio invested entirely in Bond B?
Bond A: 0.488
Bond B: 0.513
0.487*1.881+0.513*6.634=4.319
B). Suppose the required YTMs shift to: (1) 4.50% for Bond A; (2) 6.00% for Bond B; (3) 7.50% for
Bond C. Which portfolio will outperform (the bullet portfolio vs. the barbell portfolio)?
Bond A: [-1. 881 x -0. 005] + [0. 5 x 3. 925 x -0. 0052 ] = 0. 95%
Bond B: [-4. 320 x 0. 005] + [0. 5 x 16. 271 x 0. 0052 ] = -2. 14%
Bond C: [-6. 634 x 0. 015] + [0. 5 x 31. 392 x 0. 0152 ] = -9. 60%
Bullet Portfolio Return: -2.14%
Barbell Portfolio Return: 0.487×0.95% + 0.513×(-9.60%) =-4.46%
The bullet portfolio will outperform.
C). Suppose the required YTMs shift to: (1) 1.50% for Bond A; (2) 6.00% for Bond B; (3) 7.50% for
Bond C. Which portfolio will outperform (the bullet portfolio vs. the barbell portfolio)?
D).
Bond A: [-1. 881 x -0. 035] + [0. 5 x 3. 925 x -0. 0352 ] = 6. 82%
Bond B: [-4. 320 x 0. 005] + [0. 5 x 16. 271 x 0. 0052 ] = -2. 14%
Bond C: [-6. 634 x 0. 015] + [0. 5 x 31. 392 x 0. 0152 ] = -9. 60%
Bullet Portfolio Return: -2.14%
Barbell Portfolio Return: 0.487×6.82% + 0.513×(-9.60%) =-1.60%
The barbell portfolio will outperform.
1
The Use of Leverage
2. Suppose that the initial value of an unlevered portfolio of Treasury securities is $100 million
and the duration is 10. Suppose that the manager can borrow $400 million and invest it in the
identical Treasury securities so that the levered portfolio has a value of $500 million. What is
the duration of this levered portfolio (with respect to the portfolio’s equity value)?
Answer: 100 million, if there is 1% change in interest rates, then the dollar change in value
would be: 10 million. For 500 million value, the dollar change in value would be 50 million.
The equity value is 100 million. So, the duration of the levered portfolio is 50.
2
Tracking Error
3. A portfolio manager pursues an index-matching portfolio management strategy. The
benchmark index is the Barclays Aggregate Bond Index.
A). Compute the annualized tracking error from the following information:
Portfolio’s Barclays Aggregate
Month 2017 Return (%) Bond Index Return (%)
January 2.15 1.65
February 0.89 –0.10
March 1.15 0.52
April –0.47 –0.60
May 1.71 0.65
June 0.10 0.33
July 1.04 2.31
August 2.70 1.10
September 0.66 1.23
October 2.15 2.02
November –1.38 –0.61
December –0.59 –1.20
Answer:
Portfolio Lehman Aggregate Active Differences
Month 2001 A’s Return Bond Index Return Return Squared
January 2.15% 1.65% 0.50% 0.0707(%2)
February 0.89% –0.10% 0.99% 0.5713(%2)
March 1.15% 0.52% 0.63% 0.1567(%2)
April –0.47% –0.60% 0.13% 0.0109(%2)
May 1.71% 0.65% 1.06% 0.6820(%2)
3
June 0.10% 0.33% –0.23% 0.2155(%2)
July 1.04% 2.31% –1.27% 2.2625(%2)
August 2.70% 1.10% 1.60% 1.8655(%2)
September 0.66% 1.23% –0.57% 0.6467(%2)
October 2.15% 2.02% 0.13% 0.0109(%2)
November –1.38% –0.61% –0.77% 1.0084(%2)
December –0.59% –1.20% 0.61% 0.1413(%2)
Sum of Portfolio Returns = 2.81%
Mean Active Return = 0.2342%
Variance (sum of differences squared / 11) = 0.6947(%2)
Standard Deviation = Tracking Error = 0.8335%
Tracking error in basis points = 83.35
Tracking error in basis points annualized = 288.74
B). Is the tracking error computed above a backward-looking or forward-looking tracking error?
Answer: backward-looking
C). An investor found that the forward-looking tracking error at the start of 2017 was quite
different from the backward-looking tracking error at the end of 2017. What could be the
portfolio manager’s explanations to the investor?
Answer: There is no guarantee that the forward-looking tracking error at the start of, say, a year
would exactly match the backward-looking tracking error calculated at the end of the year. There
are two reasons for this. The first is that as the year progresses and changes are made to the
portfolio, the forward-looking tracking error estimate would change to reflect the new exposures.
The second is that the accuracy of the forward-looking tracking error at the beginning of the year
depends on the extent of the stability in the variances and correlations that commercial vendors
use in their statistical models to estimate forward-looking tracking error. These estimates of
variance-covariance matrixes can change during the year.
