Question

A portfolio manager expects interest rates to increase as a result of strength in the economy. The manager manages the portfolio on the basis of duration. (a) Based on this expectation for interest rates, should the manager increase or decrease duration? (b) Will longer or shorter maturities be consistent with the decision summarized in (a)? (c) Will higher or lower coupons be consistent with the decision summarized in (a)?

Answer 1

(a) The expectation of interest rate is that, the interest rates are going to increase in the future. Bonds and interest rates are inversely related. The higher interest rates, lower is the value of the bonds as hence the value of the portfolio decreases.

Now, that the interest rates are expected to increase, the duration of the bonds should decrease so that the value of the portfolio falls by a small amount and not by a large amount due to a high duration. Shorter maturity bonds will have a lower duration and a lower risk.

(b) Obviously large maturities bonds are more sensitive to a change in interest rates, so we should have short maturities bond in the portfolio which will be consistent with the decision to reduce the duration of bonds.

(c) Duration is inversely related to the bond's coupon rate. So, as we are deciding to reduce the duration we should include bonds which are of a high coupon rate.