Modern Portfolio Theory and Investment Analysis, 9th Edition

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The Management of Bond Portfolios

In the previous chapter, we discussed the determination of interest rates and the characteristics of bonds that affect their return and value. In this chapter we discuss bond portfolio management. Modern portfolio theory has made less of an impact on bond management than it has on common equity management. Furthermore, some of the portfolio management techniques used in bond management are specific to the bond area and not outgrowths of modern portfolio theory. In this chapter we discuss the techniques specifically developed for the bond area as well as applications of general portfolio theory to the bond area.

The chapter is divided into four parts. First we discuss the major source of risk facing bond managers, changes in the yield curve, and measures used to examine a bond's sensitivity to this source of risk. Next we discuss ways of constructing a bond portfolio to insulate against this risk. These are normally referred to as passive portfolio strategies, although, as we will see, they generally involve actively adjusting the portfolio. Next we will discuss active bond management. We discuss both techniques developed specifically for active bond management and bond management in a modern portfolio theory context, discussing first estimation of expected return and then estimation of the variance–covariance structure. Finally, we discuss bond and interest rate swaps.

DURATION

The return on a bond has two components: interest income and capital ...