CHAPTER TWO

BOND PORTFOLIO MANAGEMENT STRATEGIES

Different strategies are viable for certain portfolios with different needs and risk profile.

PASSIVE MANAGEMENT STRATEGIES

1. BUY AND HOLD STRATEGY

It involves collecting bonds with desired quality, coupon levels, and term to maturity and
indenture provisions i.e call features. This does not attempt to generate above the market
returns but rather takes asset prices as fair and only concentrate on managing interest
rate risk of their portfolio. Many successful investors follow a modified buy and hold
strategy which involves investing with the intention of holding the asset up to the end of
the investment horizon but still actively look for opportunities to trade into more desirable
positions.

Aggressive buy and hold investors also incorporate timing considerations by using their
knowledge of market rates and expectations, BUT there is still diversifiable risk because
you are not holding all assets.

2. INDEXING STRATEGY

Though empirical studies show that many managers have not been able to match the risk
return performance of common stock or bond indexes, they still try to index part of their
portfolios. The intention is to match the performance of a selected bond market index e.g
Merill Lynch Index, Gvt Bond Index, Lehman Brothers Index.

The manager is judged not by the return and risk but by how closely the portfolio tracks
the chosen index. It involves examining the tracking error i.e the difference between the
rate of return for the portfolio and the rate of return on the bond market index.

Problems;

1. Indexes include more than 5000 securities making it difficult to purchase

each security in the index in proportion to its market value.
 2. Many bonds are thinly traded; it’s difficult to identify their owners and
purchasing the securities at a fair market price.
3. Portfolio rebalancing because maturing bonds are dropped from the index
and new bonds also issued hence constant rebalancing is needed hence at
times stratified sampling is used.

ACTIVE MANAGEMENT STRATEGIES

INTEREST RATE ANTICIPATION

It relies on uncertain forecast of future interest rates, hence the riskiest. It preserves
capital when interest rates are anticipated to increase and achieve capital gains when
interests are expected to decline. This is done by altering the duration (maturity) of the
portfolio i.e reduce the portfolio duration when rates are expected to rise and increase
duration when a decline is anticipated. When maturities are shortened, to preserve
capital, substantial income could be sacrificed and the opportunity for capital gains could
be lost if interest rates decline rather than rise.

If anticipating a fall in interest rates, we move into longer term bonds because they are
more sensitive to interest rates, hence gain in capital but it also involves a decrease in
current due to lower coupons on longer duration bonds. It also exposes the portfolio to
interest rate fluctuations if interest move in the opposite direction.

If you anticipate an increase in interest, you move into high yielding short term TBs –high
yield to cover for the reduced horizon and also benefit from high income.

N.B The high the credit quality of the bond, the more sensitive it is to interest rates.

VALUATION ANALYSIS

It involves determining a bond’s intrinsic value based on its characteristics and the value
of these in the market e.g bond rating, maturity (longer maturity might be worth more basis
points, maturity spread, call provision might have high yields, sinking fund might mean
lower yields. Given these characteristics and the normal cost of these characteristics in
terms of yield, you determine the bond’s required yield i.e its implied intrinsic yield.
Compare the derived value and the market value to determine undervalued or overvalued
bonds.

CREDIT ANALYSIS

Involves detailed credit analysis of the bond issuer to determine expected changes in its
default risk. During periods of strong economic expansion, even financially weak firms
may survive and prosper and during severe economic contractions normally strong firms
may find it very difficult to meet financial obligations. Hence there is a cyclical pattern in
which downgrades increase during economic contraction and decline during economic
expansions.

The idea is to predict rating changes before they are announced by agencies. The
strategy becomes to acquire bonds that are expected to experience upgrading and sell
/avoid those bond issues expected to be downgraded.

CREDIT ANALYSIS OF HIGH YIELD (JUNK) BONDS

Substantial rates of return can be derived by investing in high yield bonds if you do the
credit analysis required to avoid defaults which occur with these bonds at substantially
higher rates than the overall bond market.

YIELD SPREAD ANALYSIS (BID-ASK) ………..

Aims to identify anomalies between bonds in different sectors. Spreads widen during
periods of economic uncertainty and recession because investors require large risk
premium (large spreads) and the spread will decline during periods of economic
confidence and expansion.

BOND SWAPS

Swapping bonds with similar characteristics improves return. It intends to increase current
yield, YTM, take advantage of shifts in I rates or realignment of yield spreads, and improve
quality of portfolio or for tax purposes. The risks involve the market moving against you,
yield spreads may fail to move in the anticipated direction or the new issues may not be
perfect substitutes.

E.g Pure Yield Pickup Swap which involves swapping out of a low coupon bond into a
comparable high coupon bond to realize an automatic and instantaneous increase in
current yield and yield to maturity.

SUBSTITUTION SWAP…

A GLOBAL FIXED INVESTMENT STRATEGY

The global AA should consider the following factors that have a bearing on portfolio
performance;

1. The local economy in each country that include the effects of domestic and
international demand.

2. The impact of this total demand and domestic monetary policy on inflation and
interest rates.

3. The effect of the economy, inflation and interest rates on the exchange rate among
countries.

A manager must decide the relative weight for each country, then within each country
allocation can be among government, municipal and corporate bonds.

MATCHED-FUNDING TECHNIQUES

DEDICATED PORTFOLIO

This refers to a bond portfolio that is dedicated to service a given set of liabilities. It needs
to create a set of streams of cash flows that will extinguish the liability or maturities. What
weakness comes from this strategy?

a) PURE CASH-MATCHED STRATEGY

The coupons, sinking funds and maturity principal should exactly match the specified
liabilities. It is mainly a conservation strategy and it can involve investing in zero coupon
TBs that will exactly offset the liabilities i.e Total Passive.

b) DEDICATION WITH RE-INVESTMENT

The cash flows will not exactly match the liability but any inflows that are not used
currently can be re-invested at a reasonable conservative rate.

IMMUNISATION STRATEGY

It aims to immunize the portfolio from the rate changes. It aims to derive a specified return
for given horizon usually close to market return through managing the impact of interest
rates. Interest rate risk can be eliminated by matching the term to maturity of the asset
and the investor‘s horizon. If the duration of assets and liabilities are matched, price and
re-investment risk will cancel out and for a, duration equal to investment horizon also price
and re-investment risk exactly cancel out.

CONTINGENT PROCEDURES

It involves pursuing the highest possible returns through active strategies while relying on
classical bond immunization techniques to ensure a given minimal return over the
horizon.

IMPLICATION OF CAPITAL MARKET THEORY AND EFFICIENT MARKET

HYPOTHESIS

BONDS AND TOTAL PORTFOLIO THEORY

Bonds offer significant diversification benefits and in an efficient market they should be
mixed with stocks to provide superior risk adjusted return compared to either one taken
alone.

Since the correlation between bonds and stocks is around 0.30, the combination provide
good return per unit of risk.
The stocks offer superior returns to bond yields, they are also risky and since stocks are
more responsive to business cycles and their cash flows are volatile and not
predetermined like that of bonds, including bonds in such a portfolio reduces the level of
risk

BONDS AND CAPITAL MARKET THEORY

It states there should be an upward sloping market line which depicts that higher returns
should be accompanied by higher risk.

Bonds should be found at the lower end of the market line because they are low risky
securities.

Reilly and Wright examined 36 classes of long-term securities and the basic findings of
the study show that government and high-grade corporate bonds were at the low end of
the risk spectrum.

BOND PRICES AND CAPM

Interest rate risk for investment-quality bonds is non-diversifiable since it is market wide.
Also some evidence exist that default risk is largely non-diversifiable because default
experience is closely related to business cycles.

Therefore, because major bond risk is non diversifiable, we should be able to define bond
returns in the context of CAPM.

Evidence that high grade bond risk is almost all systematic risk is found in the Reilly and
Wright study, which shows that the returns among these investment–grade bonds of
sector (gvt, corporate, mortgages) or rating were 0.90 to 0.99.

The correlation between high yield bonds and investment grade bonds is lower than the
strong correlation between high yield bonds and common stocks, which is because both
have substantial unsystematic risk.