BOND PORTFOLIO MANAGEMENT STRATEGIES
INTRODUCTION
Corporate bonds represent the debt of a corporation owed to its bondholder. More
specifically a corporate bonds is a security by a corporation that represents a
promise to pay to its bond holder’s affixed sum of money at a future maturity date,
along with periodic payments of interest. The fixed sum paid at maturity is the bonds
principal also called its par or face value. The periodic interest payments are called
coupons. From an investor’s point of view, corporate bonds represent an investment
distinct from common stock. The three most fundamental differences are these.
1.
Common stock represents an ownership claim on the corporation, whereas
bonds represents creditor’s claim on the corporate.
2.
Promised cash flows-that is coupons and principles–to be paid to
bondholders are stated in advance when the bond is issued. By contrast, the
amount and timing may change at any time.
3. Most corporate bonds are issued as callable bonds, which mean that the
bond issuer has the right to buy back outstanding bonds before the maturity
date of the bond issue. When a bond issue is called, coupon payments stop
and the bondholders are forced to surrender their bonds to the issuer in
exchange for the cash payment of a specified call price. By contrast,
common stock is almost never callable.
The pattern of corporate bond ownership is largely explained by the fact that
corporate bonds provide source of predictable cash flows. While individual bonds
occasionally default on their promised cash payments, large institutional investors
can diversify away most default risk by including a large number of different bond
issues in their portfolios. For this reason, life insurance companies and pension funds
find that corporate bonds are a natural investment vehicle to provide for future
payments of retirement and death benefits, since both the timing and amount of
these benefit payment can be matched with bond cash flows. These institutions can
eliminate much of their financial risk by matching the timing of cash flows received
from a bond portfolio to the timing of cash flows needed to make benefit payments
a strategy called cash flow matching. For this reason, life insurance companies and
pension funds together own more than half of all outstanding corporate bonds. For
similar reasons, individual investors might own corporate bonds as a source of steady
cash income. However, since individual investors cannot easily diversify default risk,
they should normally invest only in bonds with higher credit quality such as treasury
bonds.
Every corporate bond issue has a specific set of issue terms associated with it. The
issue terms associated with any particular bond can range from a relatively simple
arrangement, where the bond is little more than an IOU of the corporation, to a
complex contract specifying in great detail what the issuer can and cannot do with
respect to its obligations to bondholders. Bond issued with a standard, relatively
simple set of features are popularly called plain vanilla bonds or “bullet” bonds.
BOND PORTFOLIO MANAGEMENT STRATEGIES
For a 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 trade offs. The strategies used to manage bond
portfolio are:

Passive Bond Strategy

Active Bond Management strategies

Matched – Funding Techniques
Passive Bond Portfolio Strategy
This is where investors believes in EMH (Efficient market hypothesis) and thus once a
well diversified portfolio is constructed it is held for a relatively longer period because
it is believed that the markets are efficient. He or she relies on the forces of demand
and supply in the market. Under this, investors do not actively involve themselves in
the stock market. Passive strategy also involves a situation where the investor may
employ a manager or a company to manage his/her portfolio. Investor is not
directly involved in managing the portfolio.
There are two major passive strategies;
 Buy-and-Hold strategy
 Indexing strategy
 Immunization strategy
a) Buy- and-Hold Strategy
Buy and hold involves purchasing individual bonds and holding them to maturity.
The premise of this strategy is that bonds are assumed to be safe predictable
sources of income. The passive buy-and-hold investor is typically looking to maximize
the income generating properties of bonds. 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 portfolios provide
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 out performing active strategies.
This strategy of buying a bond and holding it until maturity implies that bond investors
would examine such factors as quality ratings, coupon levels, terms to maturity, call
features and sinking funds. Thus investors will not trade actively to earn returns, rather
they will look for bonds with maturities and durations that match their investing
horizon.
There is also a modified buy-and-hold strategy in which investors buy bonds with the
intention of holding them until maturity, but they still actively look for opportunities to
trade into more desirable positions.(However, if you modify this too much it turns into
an active strategy).
While buy-and-hold strategy is a passive strategy, it still involves a great deal of work.
Agency issues typically provide high quality bonds at a higher return than Treasury
bonds, callability affects the attractiveness of an issue e.t.c. plus, one may want to
develop a portfolio in which coupon payments are structured (and principal
repayments).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.
Example – Call Feature
Company A issues a $ 100 million 5% bonds to the public market; the bonds are
completely sold out at issue. There is a call feature in the bonds’ covenant that
allows the lender to call (recall) the bonds if rates fall enough to reissue the bonds at
a lower prevailing interest rate.
Three years later, the prevailing interest rate is 3% and, due the company’s good
credit rating, it is able to buy back the bonds a predetermined price and reissue the
bonds at 3% coupon rate. This is good for the lender, but bad for the borrower.
Bond Laddering
Ladders are one of the most common forms of passive bond invested. This is where
the portfolio is divided into equal parts and invested in laddered style maturities over
the investor’s time horizon. Below is an example of a basic 10 – year laddered and 1
million bond portfolio with stated coupon 5%.
Year
1
2
3
4
5
6
7
8
9
10
Principal 100000 100000 100000 100000 100000 100000 100000 100000 100000 100000
Coupon
5000
5000
5000
5000
5000
5000
5000
5000
5000
5000
Income
b) Indexing Bond Strategy
This strategy involves attempting to build a portfolio that will match the performance
of selected bond portfolio index. 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 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, such as the Shearson Lehman
Hutton Government/Corporate Bond Index, Merrill Lynch index, the Nairobi – 20
security index (NSE20) etc. Due to the size of (say) the Lehman Aggregate Bond
index i.e. (4000 securities), the strategy would work well with a large portfolio due to
the number of bonds required to replicate the index, since it only represent high
corporate bond issues. Thus, a compromise must be made when selecting among
different indexes. Also, the strategy of buying every bond in the market index
according to its weight in the index is not a practical one. However, a relevant
subset is possible. Hence an investor may choose to emulate a narrower bond index.
The investor may choose alternatively to randomly select bonds from the universe of
bonds, or may choose the stratified approach (i.e. segmenting the index into
components from which individual securities are chosen). When choosing the
indexing option, bond portfolio management cannot be considered entirely
passive. Also, there will be transaction cost associated with.
 Purchasing the issues used to construct the index
 Reinvesting cash payment from coupon and principal repayments and
 Rebalancing of portfolio if the composition of the target index changes.
Whereas full replication of the target index would work best, this is impractical. If the
investor chooses the stratified method, his performance will probably not mirror his
target index. How many Securities/Bonds should an investor have in his portfolio if he
selects the random sampling approach? McEnally and Boardman (1979) did find
out that once an index is selected, close replication is possible with perhaps 40
bonds (for the long term).
Immunization Bond Strategy
It involves protecting bonds from interest rate risk by equating the duration of the
bond portfolio to the time horizon of the investor’s portfolio of bond. Developed by
Fisher and Weil 1971, 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 the indexing, the opportunity cost of using the
immunization strategy is potentially giving up 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 of default. In fact, the purest
form of immunization would be to invest in zero – coupon bond and 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 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 horizons 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 pension fund would use an
immunization to plan for the cash flows upon an individuals retirement, that same
individual could build a dedicated portfolio for his or her own retirement plan.
Example of Immunization
Compare the results of choosing a bond with a maturity equal to the investment
horizon Vs a modified duration equal to the investment horizon.
Assumptions:
Investment horizon is 8 years, current YTM (Yield to Maturity) is 8% on 8 years bonds. If
there is no change in yields, the expected ending – wealth would be $1000 × (1.8)8 =
$1850.90. This should also be the expected ending – wealth for a fully immunized
portfolio.
There are two strategies for portfolio immunization.
 The maturity strategy (term to maturity equal to investment horizon)
 The duration strategy (set modified duration equal to investment horizon)
Under the maturity strategy an investor can simply choose a bond with 8 years to
maturity, while on the other hand, under the duration strategy he can find a bond
with a modified duration that equals to 8 (or as close to 8 as possible)
Active Bond Portfolio Strategy
Under this strategy of managing the portfolio, investor believes that markets are not
efficient and price are not correct and hence one can exploit the mispricing and
make a kill for both equities and fixed income securities.This is where the market
timing and selectivity are vital.Investor is aware that a lot of issues in the market
affect the bond income, capital gain and reinvestment income. Therefore investor
actively involves himself/her self in the stock market to take advantage of any
inefficiency that can give him income.
The goal of active management is maximizing total return. The strategies employed
here require major adjustments to portfolios, trading to take advantage of interest
rate fluctuations etc. There are five major active bond portfolio management
strategies namely.

Interest rate anticipation

Valuation analysis

Credit analysis

Yield analysis

Bond swaps
In each strategy, the manager hops to outperform the buy -and- hold policy by
using acumen, skill, etc.
Interest rate anticipation
This is the riskiest strategy because the investor must act on uncertain forecast of
future interest rates. The strategy is designed to preserve capital (lose as little as
possible) when interest rates rise (and bond prices drop) and to receive as much
capital appreciation as possible when interest rates drop (and bond prices rises).
These objectives can be obtained by altering the maturity or duration of the
portfolios. Longer maturity or longer duration, portfolios will benefit the most from an
interest rate decrease and vice versa. Thus if a manger 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 misestimating interest rate
movements. In the ideal situation, it’s difficult to accurately predict interest rate.
However if this is the strategy to be taken by the investor then he should be
concerned with:

Direction of the change in interest rates
 The magnitude of the change across maturities, and
 The timing of the change