Even default-free bonds such as Treasury issues are subject to interest rate risk. Longer term bonds generally are more sensitive to interest rate shifts than short-term bonds. A measure of the average life of a bond is Macaulay's duration, defined as the weighted average of the times until each payment made by the security, with weights proportional to the present value of the payment.
Duration is a direct measure of the sensitivity of a bond's price to a change in its yield. The proportional change in a bond's price approximately equals the negative of duration times the proportional change in 1 + y.
Immunization strategies are characteristic of passive bond portfolio management. Such strategies attempt to render the individual or firm immune from movements in interest rates. This may take the form of immunizing net worth or, instead, immunizing the future accumulated value of a bond portfolio.
Convexity refers to the curvature of a bond's price-yield relationship. Accounting for convexity can substantially improve on the accuracy of the duration approximation for bond-price sensitivity to changes in yields.
Immunization of a fully funded plan is accomplished by matching the durations of assets and liabilities. To maintain an immunized position as time passes and interest rates change, the portfolio must be periodically rebalanced.
A more direct form of immunization is dedication or cash flow matching. If a portfolio is perfectly matched in cash flow with projected liabilities, rebalancing will be unnecessary.
Active bond management can be decomposed into interest rate forecasting techniques and intermarket spread analysis. One popular taxonomy classifies active strategies as substitution swaps, intermarket spread swaps, rate anticipation swaps, or pure yield pickup swaps.
Interest rate swaps are important instruments in the fixed-income market. In these arrangements, parties trade the cash flows of different securities without actually exchanging any securities directly. This can be a useful tool to manage the duration of a portfolio.
