What's the best way to create a Bond Portfolio for Duration and Convexity hedging?

Question

I need to create a bond portfolio, hedge it with duration / convexity and simulate yield shocks to . How would you proceed when creating the bond portfolio? Government or Corporate Bonds (or mixed?) Coupon or Zero Coupon Bonds (or mixed?) Short/long term bonds? Bonds from 1 Country / multiple Countries / from 1 Central Bank Area (only US Treasuries) or multiple Central Bank Areas (US Treasuries and European Bonds mixed) ?

Answer 1

If you do not have short-selling constraints ... It really does not matter.

With any two bonds with different duration you can match duration of another bond/liability perfectly. With any three non-colinear bonds you can match maturity and convexity of any other bond/liability.

Now 3 things to take into consideration:

1. If you really just want immunization, use default free bonds, so that you do not have to worry about default risk;
2. You will always have to rebalance your portfolio frequently to keep the immunization at work. Try using long maturity bonds (less rollover risk);
3. If you can't short, then it's tricky. Then actually, you just need to brute force which combination of bonds would deliver immunization with the least short-selling possible. Those are usually bonds with duration close you your hedging portfolio.