Question

In its white paper titled “Investing in a Rising Rate Environment,” Baird’s Private Wealth Management Research team suggest that active bond managers have available 5 broad active investment strategies. They specifically cite both: Duration Management and Yield Curve Management. Explain in details the difference between the two strategies.

Explain the difference between thw two strategies duration management and yield curve management

Answer 1

Ans). Bonds in comparison to equity looks less glamorous and exciting as the bondholder is supposed to get fixed interest as against equity where the equity share holders receive much lucrative divends but on the same bond interest is fixed and the bondholder gets the interest irrespective of the market situation.Typically bond prices fluctuates less than the equity prices and the investor who desires superior performance has to be on the lookout for even small differentials in prices and returns.Hece there are active bond portfolio management strategies.Some investors get big returns through active bond portfolio management strategies.Yield curve management strategy is based on the timing for the sale of the investment in bonds as it is a fact that the market value of a long term bond increases and its yields decreases when the time of maturity is near hence to maximize the profit the bond should be sell at a point where its market value is high and the yield to maturity is getting lower for example take a 10 year bond the bond holder will get a premium on market price by selling at 6th year and the interest earned is also an additional benifit till the holding period.However much of the gain depends upon the market overall interest rate if the overall all interest rate is higher holding shorter term bond would still be profitable. The second strategy is the duration management  which lays on the importance of duration as it measures the bond sensitivity towards interest rate. The duration is calculated by taking the weighted average of the maturity time of each coupon or the payment of principal of the bond.By using duration formula we can measure the interest rate sensitivity of the bond. In a greater depth we can understand that the bond time to maturity and duration are different as bond time to maturity is unaffected by the interest rate where the duration as mentioned above undergoes changes with respect to the interest rate as there is a reduction in time to maturity. In a more simple way duration measures how long will the total cash flow will take to repay the bond holder. Also a long duration meand there is a greater interest risk we can take an example of a 10 year bond has higher sensitivity than a 5 year bond towards the interest rate change as a 1 percent interest increase will lead to 10 % reduction in price of 10 year bond and 5 percent reduction in the price of 5 year bond ( By multiplying interest rate rise by year of bond).Hence the factors that affect the bond duration are the time to maturity the higher it is the more is the duration and more is the interest rate risk.The coupon rate is the other important factor as the higher the coupon rate the less it will take to cover the cost and it would have short duration and less senstivity to interest that is true with other things identical.