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.
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.
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.
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.
