Bond Portfolio Management Strategies

Bond Portfolio Performance

Style and Strategy

• Bond Portfolio Performance

– less return and less volatility
– A generally observed low historical correlation between fixed-income
returns and equity securities returns (around 0.08 for several
performance indexes over the 20-year period ending in 2010 in US)
has made bond portfolios an excellent tool for diversifying risk

– http://www.crisil.com/capital-markets/indices.html
– http://www.asiaindex.co.in/indices/fixed-income/sp-bse-india-10-year-
sovereign-bond-index
– http://www.bseindia.com/sensexview/IndexHighlight.aspx?expandabl
e=2
 Bond Portfolio Performance
Style and Strategy

• Bond Portfolio Style

– The investment style of a bond portfolio can be summarized by its
two most important characteristics: credit quality and term
– The average credit quality of the portfolio can be classified as high,
medium, and low grades
– The interest rate sensitivity of the bond portfolio can be separated on
the basis of term structure (short-term, intermediate-term and long-
term)
 Passive Portfolio Strategies
• Buy and hold
– A manager selects a portfolio of bonds based on the objectives and
constraints of the client with the intent of holding these bonds to maturity
– Can be modified by trading into more desirable positions (modified buy & hold
strategy)

– Bond Ladder – invest in a series of bonds with intermediate period maturity

which are equally spaced in time.
Total investment is 1000 for 10 years;
Invest 100 in 1 year maturity -> maturity -> reinvest in 10 year maturity
Invest 100 in 2 year maturity -> ,, -> ,,
…
Invest 100 in 10 year maturity -> ,, -> ,,

Benefit of bond laddering is that it allows for opportunities to gain from

intermediate term interest rate fluctuations; provides intermediary liquidity; it
allows for diversification through time
Bond portfolio strategy - laddering
 Passive Portfolio Strategies

• Indexing
– The objective is to construct a portfolio of bonds that will track the
performance of a bond index
– Index Portfolio Strategy Construction Techniques
• Full replication
• Sampling
• Quadratic optimization or programming (risk minimization, return
maximization, etc.)
– Performance analysis involves examining Tracking error (Example 1) for
differences between portfolio performance and index performance
(essentially a modified form of SD of returns)
– Methods of Index Portfolio Investing
• Index Funds
• Exchange-Traded Funds
 Semi-active strategies
Matched-Funding Strategies

• Dedicated Portfolios
– Designing portfolios that will service liabilities
– Exact cash match
 Conservative strategy, matching portfolio cash flows to needs
for cash (best option is to go for a series of zero coupon bonds)
 Useful for sinking funds and maturing principal payments
(Example 2)
– Dedication with reinvestment
 Does not require exact cash flow match with liability stream
 Great choices, flexibility can aid in generating higher returns
with lower costs (Example 3)
Bond Immunization
 Matched-Funding Techniques

• Immunization Strategies
– The process is intended to eliminate interest rate risk that includes:
 Price Risk
 Coupon Reinvestment Risk
– A portfolio manager (after client consultation) may decide that the
optimal strategy is to immunize the portfolio from interest rate
changes
– The immunization techniques attempt to derive a specified rate of
return during a given investment horizon regardless of what
happens to market interest rates
 Matched-Funding Techniques

• Classical Immunization
– Immunize a portfolio from interest rate risk by keeping the portfolio
duration equal to the investment horizon
– Duration strategy superior to a strategy based only a maturity since
duration considers both sources of interest rate risk (reinv. & price)
– An immunized portfolio requires the modified duration of the portfolio
always to be equal to the remaining time horizon
 Example 4 - Duration
Consider the a bond has a 10 year term and 5% coupon. With current
market interest rate as 6.9%

Example 5 – Immunization

Let’s see…what happens if market interest rate changes from 6.9% to

7.5% or 6.5% given that investor holds the bond to its duration.

Keep in mind the convexity correction to the duration especially for

large changes in TYM
 Matched-Funding Techniques
• Horizon matching
– Combination of cash-matching dedication and immunization
– Important decision is the length of the horizon period for cash match
– Benefits are
• certainty of cash match in the initial years (controls for non-parallel shifts
in yield curve mostly observed in the initial years)
• Cost savings and flexibility of immunization for the subsequent years
(because non-parallel yield curve reshaping does not take place with
much impact at the long end of horizon.
– This horizon matching can be done again for the shorter end of the
remaining period once manager reaches the end of cash matched
period defined initially.
 Active Management Strategies

• Active management strategies attempt to beat the market (the

designated benchmark)
• Attempt is to generate an alpha compared to benchmark index returns
 Active Management Strategies

• Interest-rate anticipation
– Risky strategy relying on uncertain forecasts
– Shorten the duration (anticipating rise in interest rates) and elongate
the duration (anticipating fall in interest rates)

• Valuation analysis
– The portfolio manager attempts to select bonds based on their
intrinsic value

• Credit analysis
– Involves detailed analysis of the bond issuer to determine expected
changes in its default risk (select high yield bond which have low
likelihood to default)
– Defaulted debt – required knowledge of legal proceedings of
bankruptcy, in addition to financial analysis

– Altman (Z score) to predict probability of default within two years

 Altman Z score
• Z-Score (1977)
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

A = Working Capital/Total Assets

B = Retained Earnings/Total Assets
C = Earnings Before Interest & Tax/Total Assets
D = Market Value of Equity/Total Liabilities
E = Sales/Total Assets
Altman found that ratio profile for the bankrupt group fell at -0.25 avg, and for the non-
bankrupt group at +4.48 avg. This range for discrimination varies for different sectors and
market.
• Modified Z-Score (1987)
Z = a0+ a1X1 + a2X2 + a3X3 + … + anXn

X1 = EBIT/Total Assets
X2 = Std. Error of Est. of EBIT / TA ………….. (normalized for 10 years)
X3 = EBIT/Int. expenses
X4 = Retained earnings / TA
X5 = CA/CL
X6 = Mkt value of equity / Total Capital ……………(five years average)
X7 = total tangible assets
 Active Management Strategies

• Yield spread analysis

– Assumes normal relationships exist between the yields for bonds in
alternative sectors
– When abnormal relationship occurs, a bond manager could execute
various sector swaps
– The spread widens during economic recession
– Interest rate volatility also affects the spread

• Bond swaps
– Involve liquidating a current position and simultaneously buying a
different issue in its place with similar attributes but having a chance
for improved return
 Active Management Strategies
• Bond Swaps Types
– Pure yield pickup swap
 Swapping low-coupon bonds into higher coupon bonds
– Substitution swap
 Swapping a seemingly identical bond for one that is currently
thought to be undervalued
– Tax swap
 Swap in order to manage tax liability (especially with differential
tax rates)
– Swap strategies and market-efficiency
 Bond swaps by their nature suggest market inefficiency
 Active Global Bond Investing

• An active approach to global fixed-income management must consider

the following three interrelated factors
– The local economy in each country including the effects of domestic
and international demand
– The impact of total demand and domestic monetary policy on
inflation and interest rates
– The effect of the economy, inflation, and interest rates on the
exchange rates among countries
 Core-Plus Management Strategies

• A combination of passive and active styles ( a form of enhanced

indexing)
• A large, significant part of the portfolio is passively managed in one of
two sectors:
– The aggregate sector, which includes mortgage-backed and asset-
backed securities
– The Government/Corporate sector alone
• The rest of the portfolio is actively managed
– Often focused on high yield bonds, foreign bonds, emerging market
debt
– Diversification effects help to manage risks
 Contingent and Structured Strategies

• Contingent procedures for managing bond portfolios are a form of what

has come to be called structured active management
• Contingent Immunization
– Duration of portfolio must be maintained at the horizon value
– Cushion spread is potential return between the current market return
and the minimum acceptable return to the client.
– Safety margin is a portfolio value above the minimum acceptable
value
– Trigger point refers to the minimum return that will stop active
portfolio management (Example 6)