Trading bonds is a complex and risky job that requires knowledge of the nuances of the market and the rules of interactions in it. However, most of the patterns are available and well known to bond portfolio managers and the general public; thus, anyone can master them. This paper will consider such basic concepts as premium risk, bond duration, and rate anticipation swap strategy to understand the specifics of their application in practice.
The most appropriate and logical approach to investing is to minimize the risks of losing income due to changes in stock rates and prices. However, many stocks carry high risks, but companies need to sell them to make a profit. At the same time, investors can take these risks to get a return and make a profit on them if the purchase is successful. Common stocks carry high risks, especially if they belong to new and little-known companies; thus, they have higher chances of investment loss, since they are limited liability financial instruments (CFA Institute, 2018).
In addition, in the case of bankruptcy of a company, the owners of common stocks have the right to receive their property last after the owners of proffered and other shares (CFA Institute, 2018). For this reason, investors require the risk premium for common stock, that is, income over what they could earn from risk-free investment (CFA Institute, 2018). Thus, common stocks must have a risk premium to boost investor interest and make them buy these stocks.
Furthermore, short-term and long-term bonds have different sensitivity to changes in interest rates, and, accordingly, price, which forms in inverse proportion to the interest rate, increases or decreases. This sensitivity of bonds to small changes in interest rates is a measure of duration that is stated in years (Wiley, 2017). This measure is related to the maturity of bonds and portfolio management strategies since they are interconnected.
There are different types of duration measures, which imply different relationships between bonds’ interests rates and the likelihood of their price changes. Modified duration assumes a direct measure of the relationship between changes in bond yields and percentage changes in bond prices (CFA Institute, 2018). In doing so, it gives an approximate estimate of the percentage change, considering the full price.
At the same time, effective duration estimates the change in bond price depending on the benchmark yield curve (CFA Institute, 2018). In other words, it determines the price reaction to changes in the benchmark yield but not the bonds’ yield. This duration is similar to the modified one but more flexible, which makes it possible to make calculations if the bonds have an embedded option (CFA Institute, 2018). Other measurement durations differ in the period and approach to assessing changes.
Furthermore, duration and maturity are similar measures that are related; however, they have different calculation processes. Maturity determines the date when the principal of the bond with interest is repaid, which is usually set at issue day and does not change (Tucker, 2015). However, the time of maturity changes as the point of reaching the date gets closer. For example, the maturity of a 5-year bond is five years, but four years after its issue, there is only one year left until its maturity. At the same time, the maturity of bonds, their coupons rate, and yield affect the calculations of duration (Willey, 2017). Consequently, the shorter the time of maturity, the less the duration and impact of interest rate changes on bond prices.
Moreover, factors such as coupon rate and yield to maturity affect duration. The coupon rate, which is the yield that a bond issuer pays on the date of issue, has an inversely proportional effect on duration (Jensen & Jones, 2019). In other words, the higher the coupon rate, the less the bond’s duration and its sensitivity to changes in interest rate. Yield to maturity, which is defined as the total expected return of a bond if it is held to maturity, is also inversely proportional to duration (Jensen & Jones, 2019). Thus, these factors affect the duration and price sensitivity of bonds.
All of these factors demonstrate that duration has a significant impact on bond portfolio management as managers consider this measure while making decisions about selling or buying bonds. Rate anticipation swap is one of the active strategies based on predicting future interest rates according to duration (Johnson, 2017). The main management method in such an approach is the exchange of long-term and short-term stocks, depending on changes in interest rates. Since bond prices change in inverse proportion to interest rates, the manager’s task is to maximize profits or minimize losses due to their changes.
Long-term stocks are more sensitive to rate changes, and while a 1% rise or fall in rates for short-term rates shifts their value by 1%, for long-term stocks the price can change by 10% (Johnson, 2017). Therefore, the rate anticipation swap strategy is based on the bond portfolio manager predicting future changes and buying or selling stocks to maximize profits. However, such an approach is risky as it depends on the manager’s ability to forecast changes, and if he or she lacks experience, such an operation can lead to even greater losses.
Nevertheless, the strategy orientation only on duration has its drawbacks, since it does not take into account the credit quality of bonds or their strategy. In other words, the duration will not matter if the company that issued the bonds goes bankrupt or is fraudulent, and investors lose their money. This feature is extremely important for bonds with a lower trust rate, for example, bonds of new and little-known companies. In addition, the average duration of bonds within a portfolio can change as the maturity time changes as well as interest rates. Therefore, the manager needs to constantly monitor and evaluate the average duration to minimize risks and invest in profitable areas, as well as consider other factors related to bonds’ profitability.
In conclusion, a study of these concepts demonstrates that they are related and have a significant impact on the success of bond portfolio management. The premium risk concept explains why investors buy stocks that are risky and how they reduce the chances of losing profits and earning from common stocks. The theory of duration is directly related to the rate anticipation swap strategy as it is central to forecasting changes in the price of bonds. At the same time, managing a portfolio based only on its duration is risky because it does not take into account other important factors affecting the price of stocks, and also mostly relies on the manager’s ability to predict changes in interest rates.
References
CFA Institute. (2018). CFA program curriculum 2019 level III volumes 1-6. Willey.
Jensen, G., & Jones, C. (2019). Investments: Analysis and management (14th ed.). Willey.
Johnson, R.S.(2017). Derivatives markets and analysis. Willey.
Tucker, M. (2015). The difference between duration and maturity. Business Insider. Web.
Willey. (2017). Wiley FINRA series 65 exam Review 2017: The uniform investment adviser law examination. Willey.