Investment Analysis and Portfolio
Management
16
First Canadian Edition
By Reilly, Brown, Hedges, Chang
Chapter 16
Bond Portfolio Management Strategies
• Bond Portfolio 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 Performance,
Style, and Strategy
• Fixed-income portfolios generally produce
both less return and less volatility than
found in other asset classes (e.g., domestic
equity, foreign equity)
• The low historical correlation between fixedincome 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 Performance,
Style, and Strategy
• Investment style of a bond portfolio can be
summarized by two important characteristics:
• credit quality
• interest rate sensitivity
• Average credit quality of the portfolio can be
classified as high, medium, and low grades
• Interest rate sensitivity of the bond portfolio can be
separated as:
• short-term
• intermediate-term
• long-term
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Bond Portfolio Performance,
Style, and Strategy
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Bond Portfolio Performance,
Style, and Strategy
• Bond Portfolio Strategies (Exhibit 16.3)
• Passive Portfolio Strategies
• Active Management Strategies
• Core-plus Management Strategy
• Matched-funding Techniques
• Contingent Procedure (Structured Active
Management)
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Bond Portfolio Performance,
Style, and Strategy
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Passive Management 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
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Passive Management Strategies
• 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 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 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
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Active Management Strategies
• Valuation analysis
• 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
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Active Management Strategies
• Credit Analysis Models
• High-Yield Bond Research
• Modified Z-score model
• Exhibit 16.7, p. 503
• Yield spread analysis
• Assumes normal relationships exist between the
yields for bonds in alternative sectors (Chapter
12)
• Active Bond Transactions
• Pure Yield Pickup Swap
• Substitution Swap
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Active Global Bond Investing
• An active approach to global fixed-income
management must consider the following
three interrelated factors:
• Local economy in each country including the
effects of domestic and international demand
• Impact of total demand and domestic monetary
policy on inflation and interest rates
• Effect of the economy, inflation, and interest
rates on the exchange rates among countries
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Core-Plus Management Strategies
• Combination of passive and active styles (a form of
enhanced indexing)
• Large part of the portfolio is passively managed in
one of two sectors:
• U.S. aggregate sector, which includes mortgage-backed
and asset-backed securities
• U.S. Government/corporate sector alone
• 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 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 Strategies
• Immunization Strategies
• Process is intended to eliminate interest rate risk
that includes:
• Price Risk
• Coupon Reinvestment Risk
• Portfolio manager (after client consultation) may
decide that the optimal strategy is to immunize
the portfolio from interest rate changes
• 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 Strategies
• 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 Strategies
• 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 Strategies
• 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
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Matched-Funding Strategies
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Contingent & Structured Strategies
• Contingent procedures for managing bond portfolios are a
form of what has come to be called structured active
management
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Contingent & Structured Strategies
• 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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Contingent & Structured Strategies
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Contingent & Structured Strategies
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Contingent & Structured Strategies
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