Bond values depend on their stated coupon rates in relation to the current market interest rates. A low-coupon bond loses value during rising interest rates and a high-coupon bond gains value as interest rates fall. Professional portfolio managers employ analytical tools such as duration and yield curve analysis to create strategies that minimize loss or maximize gain during changes in market interest rates. These strategies are particularly important when interest rates rise, because the loss of dollar value in bonds is exponential as a result of how yield-to-maturity is figured.
Bond Portfolio Management
The task of a bond portfolio manager is to achieve the highest rate of return on his portfolio of bonds. Rate of return is measured as the coupon rate of interest received plus any dollar price appreciation or loss as a result of market rate changes. To achieve this, the portfolio manager uses duration to estimate the effect a given change in market interest rates will have on the dollar prices of the bonds in the portfolio. The higher the duration, the greater the rate of change in the dollar price for a given change in market interest rates. The lower the duration, the smaller the price change. Longer maturities have higher duration and short maturities have low duration.
The rise and fall of market interest rates directly affects the dollar prices of bonds because those dollar prices adjust up or down to make the investment return from semi-annual coupon payments yield what the market demands. This price adjustment is what duration measures. Bonds trade on yield-to-maturity, which is a complex calculation that takes into account the coupon rate, dollar price and maturity date, plus all coupon payments to that maturity date and the rate at which that interest income is reinvested. This causes the price performance on bonds to move exponentially greater in the long maturities than in short maturities.
When a portfolio manager expects interest rates to rise, he will sell his long-maturity bonds, which have high duration, and buy short-term maturities with low duration. When interest rates are rising, bonds issued at lower coupons see their dollar prices drop, so moving into shorter maturities from longer maturities minimizes the drop in dollar price. The ultimate defensive strategy during rising rates is to simply sell out and keep the cash in money market instruments until rates reach a peak. When interest rates rise, the rise is seen first in the short maturities, so moving from a long maturity to a short maturity may not represent a great difference in interest income and rates on money market instruments will follow market rates higher, increasing the interest income without dollar price risk.
Maintain Current Coupon
If the portfolio manager is constrained by investment guidelines so he can't just park the portfolio in money market funds until rates finish rising, he will actively trade the portfolio to maintain current coupon. This means he will sell older, lower-coupon, longer-maturity bonds and reinvest in shorter current-coupon bonds, taking a small dollar price loss but picking up higher interest income. He will repeat this continually as rates rise. As rates reach their peak, the portfolio manager starts extending the average maturity of his portfolio by selling short maturities and buying longer maturities.
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