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Portfolio investment process

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The ultimate aim of the portfolio manager is to reduce the risk and increase the return to the investor in

order to reach the investment objectives of an investor. The manager must be aware of the investment

process. The process of portfolio management involves many logical steps like portfolio planning,

portfolio implementation and monitoring. The portfolio investment process applies to different situation.

Portfolio is owned by different individuals and organizations with different requirements. Investors should

buy when prices are very low and sell when prices rise to levels higher that their normal fluctuation.

Portfolio investment process is an important step to meet the needs and convenience of investors. The

portfolio investment process involves the following steps:

1. Planning of portfolio

2. Implementation of portfolio plan.

3. Monitoring the performance of portfolio.
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1) Planning of portfolio:

Planning is the most important element in a proper portfolio management. The success of the portfolio

management will depend upon the careful planning. While making the plan, due consideration will be

given to the investors financial capability and curren t capital market situation. After taking into

consideration a set of investment and speculative policies will be prepared in the written form. It is called

as statement of investment policy. The document must contain (1) The portfolio objective (2) Applicable

strategies (3) Investment and speculative constraints. The planning document must clearly define the

asset allocation. It means an optimal combination of various assets in an efficient market. The portfolio

manager must keep in mind about the difference between basic pure investment portfolio and actual

portfolio returns. The statement of investment policy may contain these elements. The portfolio planningcomprises the following situation for its better performance:

(A) Investor Conditions: - The first question which must be answered is this What is the purpose of

the security portfolio? While this question might seem obvious, it is too often overlooked, giving way

instead to the excitement of selecting the securities which are to be held. Understanding the purpose for

trading in financial securities will help to: (1) define the expected portfolio liquidation, (2) aid in

determining an acceptable level or risk, and (3) indicate whether future consumption (liability needs) are

to be paid in nominal or real money, etc. For example: a 60 year old woman with small to moderate
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saving probably (1) has a short investment horizon, (2) can accept little investment risk, and (3) needs

protection against short term inflation. In contrast, a young couple investing couple investing for

retirement in 30 years has (1) a very long investment horizon, (2) an ability to accept moderate to large

investment risk because they can diversify over time, and (3) a need for protection against long-term

inflation. This suggests that the 60 year old woman should invest solely in low-default risk money market

securities. The young couple could invest in many other asset classes for diversification and accept

greater investment risks. In short, knowing the eventual purpose of the portfolio investment makes it

possible to begin sketching out appropriate investment / speculative policies.

(B) Market Condition: - The portfolio owner must known the latest developments in the market. He may

be in a position to assess the potential of future return on various capital market instruments. The

investors expectation may be two types, long term expectations and short term expectations. The most

important investment decision in portfolio construction is asset allocation. Asset allocation means the

investment in different financial instruments at a percentage in portfolio. Some investment strategies are

static. The portfolio requires changes according to investors needs and knowledge. A continues changes

in portfolio leads to higher operating cost. Generally the potential volatility of equity and debt market is 2

to 3 years. The another type of rebalancing strategy focuses on the level of prices of a given financialasset.

(C) Speculative Policies: - The portfolio owner may accept the speculative strategies in order to reach

his goals of earning to maximum extant. If no speculative strategies are used the management of the

portfolio is relatively easy. Speculative strategies may be categorized as asset allocation timing decision

or security selection decision. Small investors can do by purchasing mutual funds which are indexed to a

stock. Organization with large capital can employ investment management firms to make their speculative

trading decisions.

(D) Strategic Asset Allocation: - The most important investment decision which the owner of a portfolio

must make is the portfolios asset allocation. Asset allocation refers to the percentage invested in various

security classes. Security classes are simply the type of securities: (1) Money Market Investment, (2)Fixed Income obligations; (3) Equity Shares, (4) Real Estate Investment, (5) International securities.

Strategic asset allocation represents the asset allocation which would be optimal for the investor if all

security prices trade at their long-term equilibrium values that is, if the markets are efficiency priced.

2) Implementation of portfolio plan

In the implementation stage, three decisions to be made, if the percentage holdings of various assets

classes are currently different from the desired holdings as in the SIP, the portfolio should be rebalances

to the desired SAA (Strategic Asset Allocation). If the statement of investment policy requires a pure

investment strategy, this is the only thing, which is done in the implementation stage. However, many

portfolio owners engage in speculative transaction in the belief that such transactions will generate

excess risk-adjusted returns. Such speculative transactions are usually classified as timing or selectiondecisions. Timing decisions over or under weight various assets classes, industries, or economic sectors

from the strategic asset allocation. Such timing decision deal with securities within a given asset class,

industry group, or economic sector and attempt to determine which securities should be over or under-

weighted.

(A) Tactical Asset Allocation: - If one believes that the price levels of certain asset classes, industry, or

economic sectors are temporarily too high or too low, actual portfolio holdings should depart from the

asset mix called for in the strategic asset allocation. Such timing decision is preferred to as tactical asset


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allocation. As noted, TAA decisions could be made across aggregate asset classes, industry

classifications (steel, food), or various broad economic sectors (basic manufacturing, interest-sensitive,

consumer durables).

Traditionally, most tactical assets allocation has involved timing across aggregate asset classes. For

example, if equity prices are believes to be too high, one would reduce the portfolio s equity allocation

and increase allocation to, say, risk-free securities. If one is indeed successful at tactical asset allocation,

the abnormal returns, which would be earned, are certainly entering.

(B) Security Selection: - The second type of active speculation involves the selection of securities within

a given assets class, industry, or economic sector. The strategic asset allocation policy would call for

broad diversification through an indexed holding of virtually all securities in the asset in the class. For

example, if the total market value of HPS Corporation share currently represents 1% of all issued equity

capital, than 1% of the investors portfolio allocated to equity would be held in HPS corporation shares.

The only reason to overweight or underweight particular securities in the strategic asset allocation would

be to off set risks the investors faces in other assets and liabilities outside the marketable security

portfolio. Security selection, however, actively overweight and underweight holding of particular securities

in the belief that they are temporarily mispriced.(3) Monitoring the performance of portfolio

Portfolio monitoring is a continuous and on going assessment of present portfolio and the portfolio

manger shall incorporate the latest development which occurred in capital market. The portfolio manager

should take into consideration of investors preferences, capital market condition and expectations.

Monitoring the portfolio is up-grading activity in asset composition to take the advantage of economic,

industry and market conditions. The market conditions are depending upon the Government policy. Any

change in Government policy would reflect the stock market, which in turn affects the portfolio. The

continues revision of a portfolio depends upon the following factors:

1. Change in Government policy.

2. Shifting from one industry to other

3. Shifting from one company scrip to another company scrip.

4. Shifting from one financial instrument to another.

5. The half yearly / yearly results of the corporate sector

Risk reduction is an important factor in portfolio. It will be achieved by a diversification of the portfolio,

changes in market prices may have necessitated in asset composition. The composition has to be

changed to maximize the returns to reach the goals of investor

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 requirements


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Bond 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, all investors are interested in a bond investmentstrategy. There are three major types of strategies:

1. passive portfolio management strategies2. active portfolio management strategies3. 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, andinterest rates became more volatile. Thus, with more volatileinterest rates, there was a great amount of profit potential withbonds. Also, in the 1970s the Macauley duration measure was re-discovered.

Not all investors viewed the rise in interest rate volatility as a goodthing. The pension fund and insurance companies that invest in

bond found their job much more difficult. Thus, strategies based onduration were developed to aid pension fund managers to matchtheir liabilities with properly constructed 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 untilmaturity. Bond investors would examine such factors as qualityratings, coupon levels, terms to maturity, call features and sinkingfunds. These investors do not trade actively to earn returns, rather


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they look for bonds with maturities or durations that match theirinvestment horizon.

There is also a modified buy-and-hold strategy in which investorsbuy bonds with the intention of holding them until maturity, butthey still actively look for opportunities to trade into more desirablepositions. [However, if you modify this too much it turns into anactive strategy.]

While the buy-and-hold strategy is a passive strategy, it stillinvolves a great deal of work. Agency issues typically provide highquality bonds at a higher return than Treasury securities, callabilityaffects the attractiveness of an issue, etc. Plus, you may want todevelop a portfolio in which coupon payments are structured (and

principal repayments).

Techniques, Vehicles and Costs: Only default-free or very highquality securities should be held. Also, those securities that arecallable by firm (allows the issuer to buy back the bond at aparticular price and time) or putable by holder (allows bondholder tosell the bond to issuer at a specified price and time) will introducealterations in the firm's cash flows, and probably should not beincluded in the buy-and-hold strategy. Also, those investors seekingto lock in a rate of return may choose a zero-coupon bond--goodstrategy for college tuition or retirement. The buy-and-hold strategyminimizes transaction costs and, if implemented astutely, can behighly productive. For example, if interest rates are currently highand are expected to remain so for an extended period of time, thebuy-and-hold strategy will do well.

Indexing

Indexing involves attempting to build a portfolio that will match the

performance of a selected bond portfolio index, such as theShearson Lehman Hutton Government/Corporate Bond Index,Merrill Lynch Index, etc. This portfolio manager is judged on hisability to track the index.

Techniques, Vehicles and Costs: The fixed income market isbroader (in terms of security types) than the equity market. Also,


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even though the Shearson Lehman Hutton Corporate Bond Indexhas over 4,000 securities, it only represents high quality corporatebond issues. Thus, a compromise must be made when selectedamong different indexes. Also, the strategy of buying every bond in

a market index according to its weight in the index is not a practicalone. However, a relevant subset is possible. We may choose toemulate a narrower bond index.

Alternative Vehicles: We may choose to randomly select bondsfrom the universe of bonds, or, we may choose the stratifiedapproach (segmenting the index into components from whichindividual securities are chosen). When choosing the indexingoption, bond portfolio management cannot be considered entirelypassive. Also, there will be transaction costs associated with (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 targetindex changes. Whereas full replication of the target index wouldwork best, this is impractical. If you choose the stratified method,your performance will probably not mirror your target index.

How many securities should you have in your portfolio if you use therandom sampling approach? McEnally and Boardman (1979) have

found that, once an index is selected, close replication is possiblewith perhaps 40 bonds (for the long term).

Stratified Approach: Consists of analyzing the index to determinevarious stratification levels (what portion of securities that make upindex are Treasury, Aaa Industrial, Baa Financial, of X years tomaturity, of X% coupon rate, etc.). The next step is to select thesecurities for your portfolio. Typically, at selection and at therebalancing period (usually once a month) one security is chosenfrom 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 totake advantage of interest rate fluctuations, etc. There are fivemajor active bond portfolio management strategies:


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1. Interest rate anticipation2. Valuation analysis3. Credit analysis4. Yield spread analysis5.

bond swaps

In each strategy, the manager hops to outperform the buy-and-holdpolicy by using acumen, skill, etc.

Interest Rate Anticipation

This is the riskiest strategy because the investor must act onuncertain forecasts of future interest rates. The strategy is designedto preserve capital (lose as little as possible) when interest rates

rise (and bond prices drop) and to receive as much capitalappreciation as possible when interest rates drop (and bond pricesrise).

These objectives can be obtained by altering the maturity orduration of their portfolios. Longer maturity, or longer duration,portfolios will benefit the most from an interest rate decrease andvice versa. Thus, if a manager expects an increase in interest rates,they would structure portfolio to have the lowest possible duration.

The problem faced with this type of strategy is the risk of mis-estimating interest rate movements. It is difficult (EXTREMELY) topredict (with accuracy) interest rate movements.

However, if this is your strategy, you should be concerned with:

direction of the change in interest rates the magnitude of the change across maturities, and the timing of the change.

How your bond will be affected by changes in interest rates canusually be directly related to the security's duration. Thus, if youexpect IR to drop, you should shift to high duration securities. Also,the timing as to when you expect the interest rate shift isimportant. You don't want to shift too early, because you may


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compromise some return. Obviously, you don't want to wait toolate.

Scenario Analysis: Say, "what if" interest rates rise/fall by thismuch over the next month/year/etc. Analyze the individual bondswithin your portfolio under each scenario and see how the returnsare affected under each scenario. [See p. 8-30] The scenarioanalysis leads us to further analysis.

Relative Return Value Analysis: We can calculate the overallexpected return for each bond in our scenario (expected returnunder each interest rate scenario weighted by the probability of thatscenario occurring) and the current duration of each bond in ourportfolio and graph the relationship. Those bonds falling above a

regression line (showing the general relationship) would be doingok!

Strategic Frontier Analysis: We can graph the bonds in ourportfolio with the best case scenario (an interest rate decrease) onthe vertical axis and the worst case scenario on the horizontal axis,as shown below:


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Those securities which fall into Quadrant I represent aggressive

securities--if the best case happens, they will do well; however ifthe worst case happens they will be the worst performers. Thosesecurities falling into Quadrant II are superior securities--they willperform well regardless of which scenario occurs. Quadrant IIIrepresents defensive securities--they will do well under the worstcase scenario, but perform poorly if the best case occurs. QuadrantIV securities are inferior as they will perform poorly regardless ofthe scenario. You should sell securities falling into Quadrant IV.Normally a few securities would fall into Quadrants II and IV, with

most falling into Quadrants I and III.

Valuation Analysis

The portfolio manager looks for undervalued bonds--those bondsthat have a computed value (according to the portfolio manager)higher than the current market price). This also translates to those


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bonds whose expected YTM is lower than the current YTM. Thisstrategy requires lots of analysis (continuous evaluations) and lotsof trading based on the analysis. Based on your confidence in youranalysis, you would buy undervalued bonds and sell overvalued

bonds (or ignore them if they are not in your portfolio).

Valuation Analysis: We can examine the term structure of purediscount bonds (zero coupon) and thus determine the value of USTreasuries, thus we can determine the default free characteristics ofany other type of bond. Then we can attempt to determine theother factors that will affect bond yield by using multiple factorregression analysis (looking at things such as: quality rating,coupon effect, sector effect, call provision, sinking fund attributes,etc.) Using this factor analysis, we can determine the expected yield

for the security (if the expected yield < current YTM then buy).However, there is some subjectivity in factor analysis. For instance,if there is some "event risk" (something affecting the financialstability of firm) missing from the analysis, or if there is anyanticipation of a market upgrade...

Credit Analysis

Credit analysis involves examining bond issuers to determine if anychanges in the firm's default risk can be identified. We try todetermine if the bond rating agencies are going to change the firm'srating. Rating changes are prompted by internal changes within thefirm as well as external changes. Various factors examined includefinancial ratios, GNP, inflation, etc.

Many more downgradings occur during economic contractions[However from 1985-1990 downgradings increased substantiallydespite an economic expansion.]. To be successful in utilizing bondrating changes, you must accurately predict when the bond rating

change will occur and take action prior to the change. The marketdoes react to unexpected bond rating changes, however, it reactsquickly.

Credit Analysis of High-Yield Junk Bonds. Junk bonds have awide spread over bonds rated BBB and higher. Also, these yieldspreads widen over time (during poor economic times the spread


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widens). Altman and Nammacher point out that the net return ofjunk bonds (average gross return minus losses from bonds thatdefaulted) has been superior to higher-rated debt [Of course,they're of higher risk.] Other points to note: Even though the rating

categories have not changed, the quality of bonds today that fallinto, let's say, the A category, has lessened over time. "Specifically,the average values of the financial ratios that determine whetherbonds are included in the B or CCC rating classes have declined overtime."

Thus, bond portfolio managers will have to involved themselves indetailed credit analysis to determine those bonds that will notdefault.

Credit Analysis: The assessment of default risk. Default risk hasboth systematic and unsystematic elements. First, individual bondissuers may experience difficulty in meeting their debt obligations.This could be an isolated incident, and can be diversified away (oreliminated by effective credit analysis). However, if default risk isprecipitated by adverse general business conditions, then this wouldrequire more macro-oriented analysis. Many fixed-income investorscomplement the bond ratings providing by bond agencies (Fitch's,Moody's, Duff & Phelps, S&P's) with their own credit analysis, citing

reasons such as: more accurate, comprehensive, and timelyanalyses and recommendations.

Yield Spread Analysis

A portfolio manager would monitor the yield relationships betweenvarious types of bonds and look for abnormalities. If a spread werethought to be abnormally high, you would trade to take advantageof a return to a normal spread. Thus, you need to know what the"normal" spread is, and you need the liquidity to make trades

quickly to take advantage of temporary spread abnormalities.

Spread Analysis: Involves anticipating changes in sectoralrelationships. For example, prices and yields on lower investmentgrade bonds tend to move together (identifiable classes of securitiesare referred to as sectors). Changes in relative yields (or thespread) may occur due to:


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altered perceptions of the creditworthiness of a sector ofthe market's sensitivity to default risk

changes in the market's valuation of some attribute orcharacteristic of the securities in the sector (such as a

zero coupon feature); or

changes in supply/demand conditions.

The objective is to invest in the sector or sectors that will displaythe strongest relative price movements. Brokerage firms maintainhistorical records of yield spreads and are able to conductspecialized analyses for clients, such as measurement of thehistorical average, maximum, and minimum spread among sectors.

Potential drawbacks of this method include the need to make

numerous trades, the possibility of poor timing (how long will it takefor the market to realize the abnormal spread), and the danger thatoverall changes in interest rates will dwarf these efforts.

Matched-Funding Techniques

The matched-funding techniques incorporates the passive buy-and-hold strategy and active management strategies. The manager triesto match specific liability obligations due at specific times to aportfolio of bonds in a way that minimizes the portfolio's exposureto interest rate risk (the uncertainty of returns due to possiblechanges in interest rates over time). These techniques are meant toavoid or offset risk, and they typically require constant monitoringand many transactions to achieve the intended goal.

Many of these techniques were developed in the 1980s (due tohighly volatile interest rates) for pension funds (known obligations),individual retirement planning, college education, etc. Theseinvestors needed $x at x date. With interest rates that were highly

volatile, at the needed date, bond prices could be down(substantially below the needed amount). Thus, many investorswanted techniques that would help them match future liabilitystreams with bond portfolios that would provide the required fundswithout having to worry about where interest rates would be at thetime.


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Dedicated Portfolios

Pure Cash-matched dedicated portfolio: most conservative method.Construct a bond portfolio with a stream of payments, sinkingfunds, and maturing principal payments to exactly match specificliability schedule. This requires estimating your future obligations(pension fund payouts, college tuition, etc.) You could choose zero-coupon bonds that had maturity dates exactly when you needed thefunds. This is an entirely passive portfolio that requires noreinvestment (zero coupon bonds pay no cash coupon payment andmatures the day you need the funds, so as soon as you receive yourmaturity payment, you would payout your pension money).Technically it is difficult to determine exactly WHEN your cash flowpayouts will be due, so it is best to apply a somewhat conservative

approach.

Dedicated Cash-matched portfolio with reinvestment: Assumes thatcash flows don't always come when needed (may come earlier) andwill be reinvested. Therefore, will require smaller sums of initialfunds to meet future goals.

Portfolio Immunization

Attempts to enable one to "lock-in" going interest rates and nothave to worry about interest rate shifts. Developed by Fisher andWeil in 1971.

Components of Interest Rate Risk: One of the major problems facedby bond portfolio managers is having the needed amount of fundsat a specific date (the ending wealth requirement) -- yourinvestment horizon. If interest rates never changed during yourinvestment horizon, you could reinvest your coupon payments atthe stable interest rate and earn the promised YTM. However, in

reality, the yield curve is not flat and interest rates do change.Consequently, investors face interest rate risk. There are twocomponents of interest rate risk:

Price risk: if interest rates change before the end ofyour investment horizon and the bond is sold prior to


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maturity (you would "win" with an interest rate decreaseand "lose" with an interest rate increase.

Coupon reinvestment risk: The promised YTM assumesthat all coupon payments are reinvested at the promised

YTM. If interest rates change, this cannot beaccomplished. You will "win" with an increase in IR andvice versa.

Immunization and Interest Rate Risk: Note that the "win" situationunder price risk is exactly opposite the "win" situation under couponreinvestment risk. Bond portfolio managers would like to eliminatethese two interest rate risks. Fisher and Weil (because of theopposing effects of IR on price and coupon reinvestment risk)developed a precise immunization process to eliminate IR risk.

Fisher and Weil argue that a portfolio has been immunized if itsvalue at the end of the period is the same (or higher) than what itwould have been if interest rates had not changed during theinvestment horizon. They assume that IR changes will affect allrates by the same amount (i.e. all rates will rise by .005 or fall by.005--long term bonds won't rise by .007 and short term by .005,both will rise by .005). If this is the case, then portfolioimmunization can be achieved by holding a portfolio of bonds with amodified duration equal to the remaining investment horizon. "To

obtain a given portfolio duration, you set the value-weightedaverage modified duration of the portfolio at the investment horizonand keep it equal to the remaining horizon value over time."

Example of Immunization. Compare the results of choosing a bondwith a maturity equal to the investment horizon vs. a modifiedduration equal to the investment horizon. Assumptions: investmenthorizon is 8 years, current YTM is 8% on 8 year bonds. If there is nochange in yields, the expected ending-wealth would be $1000 *1.08^8 = $1,850.90. This should also be the expected ending-wealth for a fully immunized portfolio.

There are two strategies for portfolio immunization:

1. the maturity strategy (term to maturity equal toinvestment horizon); and


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2. the duration strategy (set modified duration equal toinvestment horizon).

Under the maturity strategy simply choose a bond with 8 years tomaturity. Under the duration strategy, find a bond with a modifiedduration that equal 8 (or as close to 8 as possible). Now we'll workthrough the example assuming that interest rates decrease from8% to 6% in year 4 and again from 8% to 12% in year 4.

From 8% to 6%:

Results with Maturity Strategy Results with Duration Strategy

Year CashFlow

Reinv.

Rate

Ending

Value

Cash

Flow

Reinv.

Rate

Endin

Value

1 80 .08 80 80 .08

2 80 .08 166.40 80 .08 166

3 80 .08 259.71 80 .08 259

4 80 .08 360.49 80 .08 360

5 80 .06 462.12 80 .06 462

6 80 .06 596.85 80 .06 596

7 80 .06 684.04 80 .06 684

8 1080 .06 1805.08 1120.64 .06 1845

From 8% to 12%

Results with Maturity Strategy

Results with DurationStrategy

Year CashFlow

Reinv.

Rate

Ending

Value

Cash

Flow

Reinv.

Rate

End

Val

1 80 .08 80 80 .08


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2 80 .08 166.40 80 .08 16

3 80 .08 259.71 80 .08 25

4 80 .08 360.49 80 .08 36

5 80 .12 483.75 80 .12 48

6 80 .12 621.80 80 .12 62

7 80 .12 776.42 80 .12 77

8 1080 .12 1949.59 1012.4 .12 188

Notice that under the maturity strategy you would lose (from anexpected value of $1,850.90 to an actual value of $1,805.08);

whereas under the duration strategy you would still have anexpected value of $1,850.90 and you would achieve $1,845.72 or$1,881.99 (depending on whether interest rates fell or rose). Whilewe would have preferred the ending wealth achieved under the risein IR scenario using the maturity strategy, due to the uncertainty ofIR changes, it's impossible to know, before the fact, where interestrates will actually be. The duration strategy actually achieved theending wealth closest to the expected wealth under both scenarios.

Implementing Immunization. While on the surface the immunization strategy

may seem simple, even passive, in reality it is not (except zero couponbonds face no coupon reinvestment risk or price risk--as its duration is itsterm to maturity). Most portfolios (non-zero-coupon portfolios) requirefrequent rebalancing to maintain the modified duration/investment horizonmatching. You cannot initially set them equal and then ignore them afterthat. Duration is positively affected by term to maturity, so, as time passesas your investment horizon shortens, so does the duration of the bondportfolio (assuming nothing else has changed). However, duration changesat a slower pace than term to maturity. Also, duration is affected by changesin interest rates, etc. So, it takes constant rebalancing to keep track of

duration matching immunization strategy.

Top 4 Strategies For Managing A BondPortfolio


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Posted: Apr 24, 2010 | Reprints

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FILED UNDER

BONDS

INSURANCE

OPTIONS

RETIREMENT

Michael SchmidtContact |Author Bio

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 outBond

Basics Tutorial.)
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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 flowfrom 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 portfoliosprovide 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? ReadTen Tips For The Successful Long-Term Investor.)

One of the main reasons for their stability is the fact that passive strategies work best with

very high-quality, non-callable bonds like government or investment grade corporate

or municipal bonds. 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,

which are written into the bond's covenants at issue and stay with the bond for life. Like the

stated coupon, call and put features embedded in a bond allow the issue to act on those

options under specified market conditions. (To learn more about options, read ourOptions

Basics Tutorial.)

blic market; the bonds are completely sold out at issue. There is a call feature in the bonds' covenants that allows the lender

d, due to the company's goodcredit rating, it is able to buy back the bonds at a predetermined price and reissue the bonds
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Bond Laddering

Ladders are one of the most common forms of passive bond investing. This is where the

portfolio is divided into equal parts and invested in laddered style maturities over the

investor's time horizon. Figure 1 is an example of a basic 10-year laddered $1 million bond

portfolio with a stated coupon of 5%.

3 4 5 6 7 8

00,000 $100,000 $100,000 $100,000 $100,000 $100,000 $

,000 $5,000 $5,000 $5,000 $5,000 $5,000 $

Dividing the principal into equal parts provides a steady equal stream of cash flow annually.

(To learn more, readThe Basics Of The Bond Ladder.)

Indexing Bond Strategy

Indexing is considered to be quasi-passive by design. The main objective of indexing a bond

portfolio is to provide a return and risk characteristic closely tied to the targeted index.

While this strategy carries some of the same characteristics of the passive buy-and-hold, it

has some flexibility. Just like tracking a specific stock market index, a bond portfolio can be

structured to mimic any published bond index. One common index mimicked by portfolio

managers is the Lehman Aggregate Bond Index.

Due to the size of this index, the strategy would work well with a large portfolio due to the

number of bonds required to replicate the index. One also needs to consider the transaction

costs associated with not only the original investment, but also the periodic rebalancing of

the portfolio to reflect changes in the index.

Immunization Bond Strategy

This strategy has the characteristics of both active and passive strategies. By definition, pure

immunization implies that a portfolio is invested for a defined return for a specific period of

time regardless of any outside influences, such as changes in interest rates. Similar to

indexing, the opportunity cost of using the immunization strategy is potentially giving up
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the upside potential of an active strategy for the assurance that the portfolio will achieve the

intended desired return. As in the buy-and-hold strategy, by design the instruments best

suited for this strategy are high-grade bonds with remote possibilities ofdefault. In fact, the

purest form of immunization would be to invest in a zero-coupon bondand match the

maturity of the bond to the date on which the cash flow is expected to be needed. This

eliminates any variability of return, positive or negative, associated with the reinvestment of

cash flows.

Duration, or the average life of a bond, is commonly used in immunization. It is a much

more accurate predictive measure of a bond's volatility than maturity. This strategy is

commonly used in the institutional investment environment by insurance companies,

pension funds and banks to match the time horizon of their future liabilities with structured

cash flows. It is one of the soundest strategies and can be used successfully by individuals.For example, just like a pension fund would use an immunization to plan for cash flows

upon an individual's retirement, that same individual could build a dedicated portfolio for

his or her own retirement plan. (To learn more, readAdvanced Bond Concepts: Duration.)

Active Bond Strategy

The goal of active management is maximizing total return. Along with the enhanced

opportunity for returns obviously comes increased risk. Some examples of active styles

include interest rate anticipation, timing, valuation and spread exploitation, and multiple

interest rate scenarios. 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.

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