Chapter 19 - Bond Portfolio Management Strategies

1
Chapter 19 - Bond Portfolio Management Strategies
2
Alternative Bond Portfolio Strategies

• 1. Passive portfolio strategies
• 2. Active management strategies
• 3. Core-plus management strategy
• 3. Matched-funding techniques
• 4. Contingent procedure (structured active
  management)

3
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
• Indexing
• The objective is to construct a portfolio of
  bonds that will equal the performance of a
  specified bond index

4
Active 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

5
Active 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

6
Bond Swaps

• Pure Yield Pickup Swap
• Substitution Swap
• Tax Swap
• Swap strategies and market-efficiency
• Bond swaps by their nature suggest market
  inefficiency

7
A Global Fixed-Income Investment Strategy

• Factors to consider
• 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

8
Core-Plus Bond Portfolio Management

• This involves having a significant (core) part of
  the portfolio managed passively in a widely
  recognized sector such as the U.S. Aggregate
  Sector or the U.S. Government/Corporate sector.
• The rest of the portfolio would be managed
  actively in one or several additional plus
  sectors, where it is felt that there is a higher
  probability of achieving positive abnormal rates
  of return because of potential inefficiencies

9
Matched-Funding Techniques

• Dedicated Portfolios
• Dedication refers to bond portfolio management
  techniques that are used to service a prescribed
  set of liabilities
• Pure Cash-Matched Dedicated Portfolios
• Most conservative strategy
• Dedication With Reinvestment
• Cash flows do not have to exactly match the
  liability stream

10
Matched-Funding Techniques

• Immunization Strategies
• 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

11
Immunization Strategies

• The process intended to eliminate interest rate
  risk is referred to as interest rate risk
• Components of Interest Rate Risk
• Price Risk
• Coupon Reinvestment Risk

12
Classical Immunization

• Immunization is neither a simple nor a passive
  strategy
• An immunized portfolio requires frequent
  rebalancing because the modified duration of the
  portfolio always should be equal to the remaining
  time horizon (except in the case of the
  zero-coupon bond)

13
Classical Immunization

• Duration characteristics
• Duration declines more slowly than term to
  maturity, assuming no change in market interest
  rates
• Duration changes with a change in market interest
  rates
• There is not always a parallel shift of the yield
  curve
• Bonds with a specific duration may not be
  available at an acceptable price

14
Matched-Funding Techniques

• Horizon matching
• Combination of cash-matching dedication and
  immunization
• Important decision is the length of the horizon
  period

15
Contingent Procedures

• A form of structured active management
• Constrains the manager if unsuccessful
• Contingent immunization
• duration of portfolio must be maintained at the
  horizon value
• cushion spread is potential return below current
  market
• safety margin
• trigger point

16
Implications of Capital Market Theory and the EMH
on Bond Portfolio Management

• Bonds and Total Portfolio Theory
• Bonds and Capital Market Theory
• Bond Price Behavior in a CAPM Framework
• Bond-Market Efficiency