Duration Switch in a Rising-Rate Environment
You are advising the investment committee of a Hong Kong pension scheme with an HKD 80 million fixed-income allocation. The portfolio is invested in a 7-year bullet bond with a 5.5% coupon, yield 4.1%, modified duration 6.8 and convexity 55. The committee expects a parallel upward shift of 100 basis points over the next 12 months and stable credit spreads. An adviser proposes switching the entire allocation into a 2-year floating-rate note paying 3-month HIBOR plus 85 basis points, subject to a 5.50% cap and a 0% floor. The FRN issuer is rated A, the existing bond is rated AA, and the FRN market is less liquid. Round-trip transaction cost on the existing bond is 0.35% of principal; the FRN carries a 0.15% annual expense. The committee asks whether the switch protects value, what could go wrong, and what information is missing.
1. Estimate the price impact on the existing bond of a parallel 100 bp rise in yields using duration and convexity. Show the calculation.
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Approximate percentage price change = −D × Δy + 0.5 × C × (Δy)². With D = 6.8, C = 55 and Δy = 0.01: −6.8 × 0.01 = −0.068, plus 0.5 × 55 × 0.0001 = 0.00275. Total = −0.06525, or −6.525%. On HKD 80 million, the estimated capital loss is about HKD 5.22 million. The bond's coupon carry is 5.5% of principal, or HKD 4.4 million over a year, so the approximate one-year total return before costs is HKD 4.4m − 5.22m = −HKD 0.82m, or about −1.0%. Convexity reduces the loss slightly. This is an approximation for a parallel shift; it ignores spread changes, rolldown and reinvestment. If the 100 bp move is already priced, the actual loss may be smaller.
2. Assess whether switching to the FRN is likely to protect value, including cap, floor, credit, liquidity and cost issues.
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The FRN has low duration, so its price should be much less sensitive to a 100 bp rise than the 7-year bond. But it is not risk-free. Its coupon is HIBOR + 85 bp subject to a 5.50% cap and 0% floor. If 3-month HIBOR rises above 4.65%, the cap binds and the client gives up upside; if HIBOR falls, the floor protects only to zero. The FRN's credit quality is A versus AA, so the switch adds credit and spread duration; if credit spreads widen, the FRN can fall. The FRN market is less liquid, so exit may be costly. Round-trip cost on the existing bond is 0.35% = HKD 280,000, plus 0.15% annual FRN expense = HKD 120,000 per year. The expected rate rise must be large enough to overcome these costs. A 100 bp rise may already be partly discounted. The committee should compare scenario outcomes: rates up 100 bp, unchanged, down 100 bp, and credit spread widening. The FRN is a rate-risk reduction tool, not a value guarantee.
3. What additional information should the committee request before deciding?
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Request the FRN's issue documents, cap/floor mechanics, reset dates, reference rate fallback, issuer credit analysis, and secondary-market liquidity. Obtain the existing bond's spread duration, credit spread, call features and tax treatment. Clarify the scheme's liabilities and liquidity needs: a 2-year FRN may match short liabilities better than a 7-year bond. Ask for scenario analysis including non-parallel shifts, a 200 bp rise, a rate cut, and a 50 bp spread widening. Check the transaction cost and accounting treatment. Confirm whether the 100 bp expectation is the committee's house view or the adviser's, and whether the switch is a tactical or strategic decision. Compare holding the fixed bond and hedging with swaps or futures instead of selling. Document the rationale and the rebalancing threshold.