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Bond Portfolio Management Strategies

Bond Portfolio Management Strategies

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Published by Dimple Sutaria

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Published by: Dimple Sutaria on Sep 06, 2011
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04/13/2012

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Bond Portfolio Management Strategies
 
Stock market investors will choose a particular risk level on the SML andinvest at this point, choosing only those securities that lie on the SML (orabove it). Stock investors have different levels of risk/return requirementsBond investors will do the same thing. A young, aggressive bond investormay choose a high risk bond & is willing to risk his principal investment. Aretiree may not be willing to take a risky bond investment and may, insteadinvest in conservative bonds.
 
Individual investors choose to invest in bonds. Also, pension plans, banks,insurance companies and other institutions invest in bonds. At any rate, allinvestors are interested in a bond investment strategy. There are threemajor types of strategies:
 1.
 
passive portfolio management strategies
 2.
 
active portfolio management strategies
 3.
 
matched-funding strategies
 
In the 1950s the bond market was considered a safe, conservativeinvestment. At that time a buy-and-hold strategy was sufficient. However,times changed, in the 1960s inflation increased, and interest rates becamemore volatile. Thus, with more volatile interest rates, there was a greatamount of profit potential with bonds. Also, in the 1970s the Macauleyduration measure was re-discovered.
 
Not all investors viewed the rise in interest rate volatility as a good thing.The pension fund and insurance companies that invest in bond found their job much more difficult. Thus, strategies based on duration were developedto aid pension fund managers to match their liabilities with properlyconstructed bond portfolios.
 
Passive Bond Portfolio Strategies
 
There are two major passive strategies:
 
 
buy-and-hold
 
 
indexing
 
Buy-and-hold Strategy
 
This strategy simply involves buying a bond and holding it until maturity.Bond investors would examine such factors as quality ratings, coupon levels,
 
terms to maturity, call features and sinking funds. These investors do nottrade actively to earn returns, rather they look for bonds with maturities ordurations that match their investment horizon.
 
There is also a modified buy-and-hold strategy in which investors buy bondswith the intention of holding them until maturity, but they still actively lookfor opportunities to trade into more desirable positions. [However, if youmodify this too much it turns into an active strategy.]
 
While the buy-and-hold strategy is a passive strategy, it still involves a greatdeal of work. Agency issues typically provide high quality bonds at a higherreturn than Treasury securities, callability affects the attractiveness of anissue, etc. Plus, you may want to develop a portfolio in which couponpayments are structured (and principal repayments).
 
Techniques, Vehicles and Costs
: Only default-free or very high qualitysecurities should be held. Also, those securities that are callable by firm(allows the issuer to buy back the bond at a particular price and time) orputable by holder (allows bondholder to sell the bond to issuer at a specifiedprice and time) will introduce alterations in the firm's cash flows, andprobably should not be included in the buy-and-hold strategy. Also, thoseinvestors seeking to lock in a rate of return may choose a zero-coupon bond--good strategy for college tuition or retirement. The buy-and-hold strategyminimizes transaction costs and, if implemented astutely, can be highlyproductive. For example, if interest rates are currently high and areexpected to remain so for an extended period of time, the buy-and-holdstrategy will do well.
 
Indexing
 
Indexing involves attempting to build a portfolio that will match theperformance of a selected bond portfolio index, such as the ShearsonLehman Hutton Government/Corporate Bond Index, Merrill Lynch Index, etc.This portfolio manager is judged on his ability to track the index.
 
Techniques, Vehicles and Costs
: The fixed income market is broader (interms of security types) than the equity market. Also, even though theShearson Lehman Hutton Corporate Bond Index has over 4,000 securities, itonly represents high quality corporate bond issues. Thus, a compromisemust be made when selected among different indexes. Also, the strategy of buying every bond in a market index according to its weight in the index isnot a practical one. However, a relevant subset is possible. We may chooseto emulate a narrower bond index.
 
 
Alternative Vehicles
: We may choose to randomly select bonds from theuniverse of bonds, or, we may choose the stratified approach (segmentingthe index into components from which individual securities are chosen).When choosing the indexing option, bond portfolio management cannot beconsidered entirely passive. Also, there will be transaction costs associatedwith (1) purchasing the issues used to construct the index; and (2)reinvesting cash payments from coupon and principal repayments; and (3)rebalancing of portfolio if the composition of your target index changes.Whereas full replication of the target index would work best, this isimpractical. If you choose the stratified method, your performance willprobably not mirror your target index.
 
How many securities should you have in your portfolio if you use the randomsampling approach? McEnally and Boardman (1979) have found that, oncean index is selected, close replication is possible with perhaps 40 bonds (forthe long term).
 
Stratified Approach
: Consists of analyzing the index to determine variousstratification levels (what portion of securities that make up index areTreasury, Aaa Industrial, Baa Financial, of X years to maturity, of X%coupon rate, etc.). The next step is to select the securities for your portfolio.Typically, at selection and at the rebalancing period (usually once a month)one security is chosen from each category (there could be 40 categories).There's no requirement as to which security is selected from each class.
 
Active Management Strategies
 
These strategies require major adjustments to portfolios, trading to takeadvantage of interest rate fluctuations, etc. There are five major active bondportfolio management strategies:
 1.
 
Interest rate anticipation
 2.
 
Valuation analysis
 3.
 
Credit analysis
 4.
 
Yield spread analysis
 5.
 
bond swaps
 
In each strategy, the manager hops to outperform the buy-and-hold policyby using acumen, skill, etc.
 
Interest Rate Anticipation
 
This is the riskiest strategy because the investor must act on uncertainforecasts of future interest rates. The strategy is designed to preserve

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