Chapter 13
Bond Selection
1
To preserve their independence, we must not let our
rules load us with perpetual debt. We must make
our election between economy and liberty, or
profusion and servitude.
- Thomas Jefferson
2
Outline
 Introduction
 The
meaning of bond diversification
 Choosing bonds
 Example: monthly retirement income
3
Introduction
 In
most respects selecting the fixed-income
components of a portfolio is easier than
selecting equity securities
 There
are ways to make mistakes with bond
selection
4
The Meaning of
Bond Diversification
 Introduction
 Default
risk
 Dealing with the yield curve
 Bond betas
5
Introduction
 It
is important to diversify a bond portfolio
 Diversification of a bond portfolio is
different from diversification of an equity
portfolio
 Two types of risk are important:
• Default risk
• Interest rate risk
6
Default Risk
 Default
risk refers to the likelihood that a
firm will be unable to repay the principal
and interest of a loan as agreed in the bond
indenture
• Equivalent to credit risk for consumers
• Rating agencies such as S&P and Moody’s
function as credit bureaus for credit issuers
7
Default Risk (cont’d)
 To
diversify default risk:
• Purchase bonds from a number of different
issuers
• Do not purchase various bond issues from a
single issuer
– E.g., Enron had 20 bond issues when it went
bankrupt
8
Dealing With the Yield Curve
 The
yield curve is typically upward sloping
• The longer a fixed-income security has until
maturity, the higher the return it will have to
compensate investors
• The longer the average duration of a fund, the
higher its expected return and the higher its
interest rate risk
9
Dealing With the
Yield Curve (cont’d)
 The
client and portfolio manager need to
determine the appropriate level of interest
rate risk of a portfolio
10
Bond Betas
 The
concept of bond betas:
• States that the market prices a bond according
to its level of risk relative to the market average
• Has never become fully accepted
• Measures systematic risk, while default risk and
interest rate risk are more important
11
Choosing Bonds
 Client
psychology and bonds selling at a
premium
 Call risk
 Constraints
12
Client Psychology and
Bonds Selling at A Premium
 Premium
bonds held to maturity are
expected to pay higher coupon rates than
the market rate of interest
 Premium
bond held to maturity will decline
in value toward par value as the bond
moves towards its maturity date
13
Client Psychology & Bonds
Selling at A Premium (cont’d)
 Clients
may not want to buy something they
know will decline in value
 There
is nothing wrong with buying bonds
selling at a premium
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Call Risk
 If
a bond is called:
• The funds must be reinvested
• The fund manager runs the risk of having to
make adjustments to many portfolios all at one
time
 There
is no reason to exclude callable bonds
categorically from a portfolio
• Avoid making extensive use of a single callable
bond issue
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Constraints
 Specifying
return
 Specifying grade
 Specifying average maturity
 Periodic income
 Maturity timing
 Socially responsible investing
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Specifying Return
 To
increase the expected return on a bond
portfolio:
• Choose bonds with lower ratings
• Choose bonds with longer maturities
• Or both
17
Specifying Grade
 A legal
list specifies securities that are
eligible investments
• E.g., investment grade only
 Portfolio
managers take the added risk of
noninvestment grade bonds only if the yield
pickup is substantial
18
Specifying Grade (cont’d)
 Conservative
organizations will accept only
U.S. government or AAA-rated corporate
bonds
 A fund
may be limited to no more than a
certain percentage of non-AAA bonds
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Specifying Average Maturity
 Average
maturity is a common bond
portfolio constraint
• The motivation is concern about rising interest
rates
• Specifying average duration would be an
alternative approach
20
Periodic Income
 Some
funds have periodic income needs
that allow little or not flexibility
 Clients
will want to receive interest checks
frequently
• The portfolio manager should carefully select
the bonds in the portfolio
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Maturity Timing
 Maturity
timing generates income as needed
• Sometimes a manager needs to construct a bond
portfolio that matches a particular investment
horizon
• E.g., assemble securities to fund a specific set
of payment obligations over the next ten years
– Assemble a portfolio that generates income and
principal repayments to satisfy the income needs
22
Socially Responsible Investing
 Some
clients will ask that certain types of
companies not be included in the portfolio
 Examples
are nuclear power, military
hardware, “vice” products
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Example: Monthly
Retirement Income
 The
problem
 Unspecified constraints
 Using S&P’s Bond Guide
 Solving the problem
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The Problem
 A client
has:
• Primary objective: growth of income
• Secondary objective: income
• $1,100,000 to invest
• Inviolable income needs of $4,000 per month
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The Problem (cont’d)
 You
decide:
• To invest the funds 50-50 between common
stocks and debt securities
• To invest in ten common stock in the equity
portion (see next slide)
– You incur $1,500 in brokerage commissions
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The Problem (cont’d)
Stock
Value
Qrtl Div.
3,000 AAC
$51,000
$380
Jan./April/July/Oct.
1,000 BBL
50,000
370
Jan./April/July/Oct.
2,000 XXQ
49,000
400
Feb./May/Aug./Nov.
5,000 XZ
52,000
270
March/June/Sept./Dec.
7,000 MCDL
53,000
0
1,000 ME
49,000
370
Feb./May/Aug./Nov.
2,000 LN
51,000
500
Jan./April/July/Oct.
4,000 STU
47,000
260
March/June/Sept./Dec.
3,000 LLZ
49,000
290
Feb./May/Aug./Nov.
6,000 MZN
43,000
170
Jan./April/July/Oct.
$494,000
$3,010
Total
Payment Month
--
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The Problem (cont’d)
 Characteristics
of the fund:
• Quarterly dividends total $3,001 ($12,004
annually)
• The dividend yield on the equity portfolio is
2.44%
• Total annual income required is $48,000 or
4.36% of fund
• Bonds need to have a current yield of at least
6.28%
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Unspecified Constraints
 The
task is meeting the minimum required
expected return with the least possible risk
• You don’t want to choose CC-rated bonds
• You don’t want the longest maturity bonds you
can find
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Using S&P’s Bond Guide
 Figure
13-1 is an excerpt from the Bond
Guide:
• Indicates interest payment dates, coupon rates,
and issuer
• Provides S&P ratings
• Provides current price, current yield
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Using S&P’s
Bond Guide (cont’d)
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Solving the Problem
 Setup
 Dealing
with accrued interest and
commissions
 Choosing the bonds
 Overspending
 What about convertible bonds?
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Setup
 You
have two constraints:
• Include only bonds rated BBB or higher
• Keep the average maturities below fifteen years
 Set
up a worksheet that enables you to pick
bonds to generate exactly $4,000 per month
(see next slide)
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Setup (cont’d)
Security
Price
Jan.
Feb.
March
April
3,000 AAC
$51,000
$380
$380
1,000 BBL
50,000
370
370
2,000 XXQ
49,000
5,000 XZ
52,000
7,000 MCDL
53,000
1,000 ME
49,000
2,000 LN
51,000
4,000 STU
47,000
3,000 LLZ
49,000
6,000 MZN
43,000
Equities
$400
May
$400
$270
$270
370
370
500
500
260
260
290
290
170
$494,000 $1,420
June
170
$1,060
$530
$1,420
$1,060
$530
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Dealing With Accrued
Interest and Commissions
 Bond
prices are typically quoted on a net
basis (already include commissions)
 Calculate
accrued interest using the midterm heuristic
• Assume every bond’s accrued interest is half of
one interest check
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Choosing the Bonds

The following slide shows one possible solution:
•
•
•
•

Stock cost: $494,000
Bond cost: $557,130
Accrued interest: $9,350
Stock commissions: $1,500
Do you think this solution could be improved?
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Bonds
Security
Price
Jan.
Feb.
March April
May
June
$80,000 Empire
71/2s02
$86,400
$80,000 Energen
8s07
82,900
$100,000 Enhance
61/4s03
105,500
$80,000 Enron
65/8s03
84,500
$90,000 Enron
6.7s06
97,200
$100,000
Englehard 6.95s28
100,630
Bonds subtotal
$557,130 $3,000
$3,200
$3,370
$2,650 $3,010
$3,470
$4,420
$4,260
$3,900
$4,070 $4,070
$4,000
Total income
$3,000
$3,200
$3,370
$2,650
$3,010
$3,470
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Overspending
 The
total of all costs associated with the
portfolio should not exceed the amount
given to you by the client to invest
 The
money the client gives you establishes
another constraint
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What About
Convertible Bonds?
 Convertible
bonds can be included in a
portfolio
• Useful for a growth of income objective
• People buy convertible bonds in hopes of price
appreciation
• Useful if you otherwise meet your income
constraints
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