Bova Anthony - Inside the Yield Book: The Classic That Created the Science of Bond Analysi

Contents

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Copyright 2013 by Sidney Homer and Martin L. Leibowitz. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

The first edition of Inside the Yield Book was published by Prentice-Hall, Inc. in 1972. The second edition of Inside the Yield Book was published by Bloomberg Press in 2004.

Published simultaneously in Canada.

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ISBN 978-1-118-39013-9 (Hardcover); ISBN 978-1-118-42191-8 (ebk); ISBN 978-1-118-61159-3 (ebk); ISBN 978-1-118-41758-4 (ebk)

To all the the portfolio managers, analysts, traders ,

and even competitors in the financial community

who have been so generous in sharing their thoughts ,

their concerns, and their enthusiasm with the

authors over the years.

Preface to the 2013 Edition

The earlier editions of Inside the Yield Book which represent Parts II and III of this edition focused on a single bond that was continuously held either to maturity or to some specified horizon. The bond was analyzed in terms of the impact of various coupon reinvestment rates and the effect of capital gains or losses associated with horizon yield changes.

In contrast to the single-bond model, most actual bond investments take the form of portfolios composed of multiple bond holdings and a continually changing bond composition. The return/risk character of bond portfolios generally differs markedly from the return pattern associated with a continuously held single bond.

Both institutional and individual bond portfolios generally involve some active rebalancing process that maintains certain key characteristics. The sensitivity to yield movements, as measured by the portfolios duration, is one of the most critical of these characteristics. Duration stability can be achieved either explicitly by specifying a duration target, or implicitly by tracking a stable-duration bond index or by preserving some prescribed maturity structure.

Institutional duration targeting (DT) typically entails the sale of aging bonds with shortened terms to fund the purchase of longer-term bonds. In contrast, individual investors who maintain ladderlike portfolios may rebalance using new cash inflows, coupon payments, and/or the proceeds from maturing bonds.

The new material included in Part I of this edition of Inside the Yield Book is devoted to an analysis of the often surprising return behavior exhibited by these DT portfolios over multiyear horizons.

Acknowledgments

The authors would like to first acknowledge the seminal role of our late colleague Terry Langetieg, who was the lead author of the 1990 Financial Analysts Journal paper that first raised the issue of Duration Targeting as the most common form of bond management and provided some initial insights into the very distinctive return characteristics of such funds.

We would also like to express our gratitude to the firm of Morgan Stanley for their support and encouragement of much of the research that formed the basis for this study of Duration-Targeting funds.

And we would be remiss not to acknowledge the role of Wileys master editor Bill Falloon, who played a key role in bringing our past three Wiley books to fruition and who first broached the idea that the time was ripe for a truly new edition of Inside the Yield Book .

Introduction

The standard approach to the analysis of prospective returns and risks of any portfolio combines some estimate of expected returns with a measure of interim volatility. For bonds, volatility is approximated by the product of the yield volatility and the duration. The yield move (and corresponding return) in any one period usually is presumed to be statistically independent of previous yield moves.

At first, the standard return/risk approach appears to provide a reasonable basis for projecting multiperiod returns and risks. However, with duration-targeted (DT) portfolios, where the same duration is maintained over time, returns converge back toward the initial yield, so the multiyear volatility turns out to be far less than that suggested by the initial duration. Perhaps surprisingly, this convergence and volatility reduction holds regardless of whether yields have high volatility or exhibit a steady rising or falling trend over the investment horizon.