Bond Portfolio Management Strategies (1)

Bond Portfolio Management StrategiesBond Portfolio Management Strategies

–Performance, Style, and Strategy–Passive Management Strategies–Active Management Strategies–Core-Plus Management Strategies–Matched-Funding Strategies–Contingent and Structured Strategies

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Bond Portfolio PerformanceStyle and Strategy

Bond Portfolio PerformanceStyle and Strategy

• Bond Portfolio Performance– Fixed-income portfolios generally produce both less

return and less volatility than found in other asset classes (e.g., domestic equity, foreign equity)

– shows this in the examination of the investment performance of different long-term securities over the 21-year time horizon

– The low historical correlation between fixed-income and equity securities—Reilly and Wright (2004) calculated this to be 0.27—has made bond portfolios an excellent tool for diversifying risk

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Bond Portfolio PerformanceStyle and Strategy

Bond Portfolio PerformanceStyle and Strategy

• Bond Portfolio Style– The investment style of a bond portfolio can be

summarized by its two most important characteristics: credit quality and interest rate sensitivity

– 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 as short-term, intermediate-term, and long-term

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Bond Portfolio PerformanceStyle and Strategy

Bond Portfolio PerformanceStyle and Strategy

• Bond Portfolio Strategies

– Passive Portfolio Strategies

– Active Management Strategies

– Core-plus Management Strategy

– Matched-funding Techniques

– Contingent Procedure (Structured Active Management)

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Passive Portfolio StrategiesPassive 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 by modified by trading into more desirable positions

• Indexing– The objective is to construct a portfolio of bonds

that will track the performance of a bond index – Performance analysis involves examining tracking

error for differences between portfolio performance and index performance

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Active Management StrategiesActive Management Strategies

• Active management strategies attempt to beat the market

• Mostly the success or failure is going to come from the ability to accurately forecast future interest rates

• Active Strategy Attributes – Scalability – Sustainability – Risk-adjusted performance– Extreme values

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Active Management StrategiesActive Management Strategies

• Interest-rate anticipation– Risky strategy relying on uncertain forecasts– Ladder strategy staggers maturities– Barbell strategy splits funds between short duration

and long duration securities

• 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 – See Exhibit 19.6

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Exhibit 19.6Exhibit 19.6

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Active Management StrategiesActive Management Strategies

• High-Yield Bond Research– Several investment houses such as Merrill Lynch,

First Boston, Lehman Brothers, etc., have developed specialized high-yield groups that examine high-yield bond issues and monitor high-yield bond spreads

• Yield spread analysis– Assumes normal relationships exist between the

yields for bonds in alternative sectors

• 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

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• 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 (taxable & munis)

– Swap strategies and market-efficiency• Bond swaps by their nature suggest market

inefficiency

Active Management StrategiesActive Management Strategies

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Active Global Bond InvestingActive 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

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Core-Plus Management StrategiesCore-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 U.S. aggregate sector, which includes mortgage-backed and asset-backed securities

– The U.S. 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

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Matched-Funding StrategiesMatched-Funding Strategies

• Dedicated Portfolios– Designing portfolios that will service liabilities– Exact cash match

• Conservative strategy, matching portfolio cash flows to needs for cash

• Useful for sinking funds and maturing principal payments

– 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

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Matched-Funding TechniquesMatched-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

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Matched-Funding TechniquesMatched-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

– An immunized portfolio requires frequent rebalancing because the modified duration of the portfolio always should be equal to the remaining time horizon

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Matched-Funding TechniquesMatched-Funding Techniques

• Difficulties in Maintaining Immunization Strategy

– Rebalancing required as duration declines more slowly than term to maturity

– Modified duration changes with a change in market interest rates

– Yield curves shift

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Matched-Funding TechniquesMatched-Funding Techniques

• Horizon matching – Combination of cash-matching dedication and

immunization

– Important decision is the length of the horizon period

– With multiple cash needs over specified time periods, can duration-match for the time periods, while cash-matching within each time period

– See Exhibit 19.17

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Contingent and Structured StrategiesContingent 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 below the

current market return– Safety margin is a portfolio value above the

required value– Trigger point refers to the minimum return that will

stop active portfolio management

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