Top 4 Strategies For Managing A Bond Portfolio

April 24 2010 | Filed Under » Bonds, Insurance, Options, Retirement For the casual observer, bond investing would appear to be as simple as buying the bond with the highest yield. While this works well when shopping for a certificate of deposit (CD) at the local bank, it's not that simple in the real world. There are multiple options available when it comes to structuring a bond portfolio, and each strategy comes with its own tradeoffs. The four principal strategies used to manage bond portfolios are:

• • • •

Passive, or "buy and hold" Index matching, or "quasi passive" Immunization, or "quasi active" Dedicated and active

Read on to find out how these four strategies are used. (For more on bonds, read out Bond Basics Tutorial.)

Passive Bond Strategy The passive buy-and-hold investor is typically looking to maximize the income generating properties of bonds. The premise of this strategy is that bonds are assumed to be safe, predictable sources of income. Buy and hold involves purchasing individual bonds and holding them to maturity. Cash flow from the bonds can be used to fund external income needs or can be reinvested in the portfolio into other bonds or other asset classes. In a passive strategy, there are no assumptions made as to the direction of future interest rates and any changes in the current value of the bond due to shifts in the yield are not important. The bond may be originally purchased at a premium or a discount, while assuming that full par will be received upon maturity. The only variation in total return from the actual coupon yield is the reinvestment of the coupons as they occur. On the surface, this may appear to be a lazy style of investing, but in reality passive bond portfolios provide stable anchors in rough financial storms. They minimize or eliminate transaction costs, and if originally implemented during a period of relatively high interest rates, they have a decent chance of outperforming active strategies. (Need more insight on buy and hold strategies? Read Ten Tips For The Successful Long-Term Investor.)

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000 $5. Bond Laddering Ladders are one of the most common forms of passive bond investing. Year 1 2 3 4 5 6 7 8 9 10 Princip $100. These types of bonds are well suited for a buy-and hold strategy as they minimize the risk associated with changes in the income stream due to embedded options.0 $100.000 $5. the bonds are completely sold out at issue. This is good for the lender.000 $5.0 $100. Like the stated coupon. the prevailing interest rate is 3% and.One of the main reasons for their stability is the fact that passive strategies work best with very high-quality. This is where the portfolio is divided into equal parts and invested in laddered style maturities over the investor's time horizon. due to the company's good credit rating.000 Incom e Figure 1 Dividing the principal into equal parts provides a steady equal stream of cash flow annually. The main objective of indexing a bond .Call Feature Company A issues a $100 million 5% bonds to the public market. non-callable bonds like government or investment grade corporate or municipal bonds.) Indexing Bond Strategy Indexing is considered to be quasi-passive by design.00 al 00 00 00 00 00 00 00 00 00 0 Coupo n $5. (To learn more about options.000 $5.0 $100. (To learn more.0 $100. which are written into the bond's covenants at issue and stay with the bond for life.0 $100. Figure 1 is an example of a basic 10-year laddered $1 million bond portfolio with a stated coupon of 5%.0 $100.000 $5.000 $5.000 $5. it is able to buy back the bonds at a predetermined price and reissue the bonds at the 3% coupon rate.0 $100.000 $5. but bad for the borrower.) Example .000 $5. read The Basics Of The Bond Ladder. call and put features embedded in a bond allow the issue to act on those options under specified market conditions.0 $100. read our Options Basics Tutorial.0 $100. There is a call feature in the bonds' covenants that allows the lender to call (recall) the bonds if rates fall enough to reissue the bonds at a lower prevailing interest rate Three years later.

It is a much more accurate predictive measure of a bond's volatility than maturity. This eliminates any variability of return. In fact. is commonly used in immunization. Along with the enhanced opportunity for returns obviously comes increased risk. While this strategy carries some of the same characteristics of the passive buy-and-hold. associated with the reinvestment of cash flows. Some examples of active styles include interest rate anticipation. One common index mimicked by portfolio managers is the Lehman Aggregate Bond Index. (To learn more. the purest form of immunization would be to invest in a zero-coupon bond and match the maturity of the bond to the date on which the cash flow is expected to be needed. As in the buy-and-hold strategy. just like a pension fund would use an immunization to plan for cash flows upon an individual's retirement. For example. or the average life of a bond.portfolio is to provide a return and risk characteristic closely tied to the targeted index. valuation and spread exploitation. the opportunity cost of using the immunization strategy is potentially giving up the upside potential of an active strategy for the assurance that the portfolio will achieve the intended desired return. Due to the size of this index. timing. the strategy would work well with a large portfolio due to the number of bonds required to replicate the index. This strategy is commonly used in the institutional investment environment by insurance companies. by design the instruments best suited for this strategy are high-grade bonds with remote possibilities of default. and multiple interest rate scenarios. Duration. pension funds and banks to match the time horizon of their future liabilities with structured cash flows. . it has some flexibility. that same individual could build a dedicated portfolio for his or her own retirement plan. One also needs to consider the transaction costs associated with not only the original investment. Similar to indexing. such as changes in interest rates. Immunization Bond Strategy This strategy has the characteristics of both active and passive strategies. It is one of the soundest strategies and can be used successfully by individuals. The basic premise of all active strategies is that the investor is willing to make bets on the future rather than settle with what a passive strategy can offer.) Active Traders! Join the discussion at Active Bond Strategy The goal of active management is maximizing total return. By definition. read Advanced Bond Concepts: Duration. but also the periodic rebalancing of the portfolio to reflect changes in the index. a bond portfolio can be structured to mimic any published bond index. Just like tracking a specific stock market index. positive or negative. pure immunization implies that a portfolio is invested for a defined return for a specific period of time regardless of any outside influences.

As a portfolio manager he has managed investment portfolios for the institutional and the high-net-worth arena with specialties in value and quantitative equity styles and multiple fixed income strategies. a portfolio manager and an institutional investment consultant with various firms including: Bank of NY Mellon. Evergreen Investments. by Michael Schmidt Michael Schmidt earned an MBA from Loyola University of Chicago and is a Chartered Financial Analyst. Mr. both of which offer some security and predictability. which is not for the casual investor. The buy-andhold approach appeals to investors who are looking for income and are not willing to make predictions. The middle-of-the-road strategies include indexation and immunization.Conclusion There are many strategies for investing in bonds that investors can employ. Schmidt contributes to the CFA Institute as part of the Educational Advisory Board and has been part of the annual grading team since 2001. Schmidt is a staff member of FINRA's Dispute Resolution Board as an arbitrator and chairperson. Mercer Mr. Each strategy has its place and when implemented correctly. He has also testified as an expert witness in arbitrations and security litigation in over 40 cases.asp#ixzz1tAYMJRPF . can achieve the goals for which it was intended. Then there is the active world. As an analyst he provided buy side research for both internal use and published for investors. INDATA and Coastal Asset Management. More from Investopedia • • • • • Get Active In Your Bond Portfolio Bond Portfolios Made Easy Use Duration And Convexity To Measure Bond Risk 10 Tips For The Successful Long-Term Investor How To Become A Day Trader Read more: http://www. He has spent 20 years working as an analyst.investopedia.

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