Duration, Credit and the Laddered Portfolio
A corporate treasurer holds 5 million in a bond portfolio: 60% in a single A-rated 10-year bullet bond yielding 5.2%, 40% in short government bills yielding 3.1%. Rates have risen sharply and the 10-year bond's price has fallen about 8%. The treasurer is being pressured by the board to "stop the losses" and move everything into bills. Separately, the issuer of the 10-year bond has been downgraded one notch to BBB+, and the treasurer asks whether that changes anything. A bank has offered a floating-rate note whose coupon resets quarterly at the reference rate plus 1.4%.
1. Explain the source of the 8% price decline and evaluate the proposal to move entirely into bills.
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The decline is duration-driven, not a credit event. Modified duration on a 10-year bond near par is roughly 7.5–8, so a rate rise of about 100 basis points produces roughly an 8% price fall. That loss is unrealized unless sold; the bond's yield to maturity has risen, so holding to maturity recovers par plus the higher coupons reinvested.
Moving everything to bills crystallizes the loss and replaces a 5.2% yield with about 3.1%, while introducing reinvestment risk: bills must be rolled continuously, and if rates fall the income stream drops. It also removes the portfolio's duration, which may be a liability-hedging asset if the treasurer has long-dated obligations. The better framing is a gap analysis: match asset duration to the timing of known cash needs. If some cash is needed within a year, hold bills for that portion; if the 10-year bond funds a long-dated obligation, selling it after a rate rise is the wrong response. A ladder that matures bonds across the horizon is a middle path.
2. Assess the impact of the one-notch downgrade to BBB+ and whether it forces a sale.
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BBB+ is still investment grade, one notch above the BBB− threshold. The downgrade raises spread and default expectations modestly but does not by itself trigger a sale unless the mandate or IPS contains a rating floor. The first step is to check the governing documents: many institutional mandates require sale only below a stated threshold (often BBB− or BB+), and some require sale on any downgrade to below A. If the floor is A, the position must be reduced; if it is BBB−, the decision becomes discretionary.
Substantively, evaluate the issuer's fundamentals, the size of the position (60% is a large single-name concentration), and liquidity of the bond. A prudent response is to reduce concentration regardless of the rating, and to set a watchlist with triggers. Also note the interaction with the earlier loss: a forced sale after both a rate rise and a downgrade locks in the worst of both. Document the reasoning and any waiver obtained.
3. Compare the floating-rate note with the existing fixed-rate exposure and state when the FRN is the better choice.
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The FRN has low duration because the coupon resets quarterly, so its price is far less sensitive to rate changes; it protects against rising rates but gives up the fixed 5.2% if rates fall, and its spread can widen if the issuer's credit deteriorates. It also carries basis and reset risk - the reference rate may not move exactly with the treasurer's liabilities.
The FRN is preferable if the treasurer expects rates to keep rising, needs to reduce mark-to-market volatility, or has short-dated liabilities. The fixed bond is preferable if the treasurer wants to lock in a known yield to match long-dated obligations and believes rates are near a peak. A blend is often sensible: keep fixed duration against long liabilities and use the FRN for the portion tied to floating needs. The decision should follow from the liability profile, not from the recent price move.