160 likes | 350 Views
Bond Portfolio Management Strategies. 03/02/09. Bond Portfolio Management Strategies. What is a bond portfolio investment style? What are some passive and active bond management strategies?. Portfolio Management Strategies.
E N D
Bond Portfolio Management Strategies 03/02/09
Bond Portfolio Management Strategies • What is a bond portfolio investment style? • What are some passive and active bond management strategies?
Portfolio Management Strategies • Investment style for bond portfolios can be based on credit quality and duration. • The Lehman Brothers U.S. Aggregate Bond index is structured to have an average duration of 4-5 years (intermediate) with primarily govt, agency and AAA bonds (high-grade).
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. • Many managers follow a modified approach. • Some use a bond ladder, where investment funds are divided evenly into instruments that mature at regular levels,to address the problem of having to reinvest funds from maturing issues.
Passive Portfolio Strategies • Indexing • The objective is to construct a portfolio of bonds that will equal the performance of a specified bond index. • Bond portfolios are primarily constructed using a stratified sampling approach because of the practical difficulty of replicating an index (numerous issues and frequent adjustment). • Portfolios are constructed to match the underlying index in terms of credit quality, industry composition, duration, coupon rate. • Tracking error is used to evaluate performance.
Active Portfolio Strategies • Interest-rate anticipation • Risky strategies relying on uncertain forecasts of future interest rates. • The yield curve can shift in three ways: • Parallel • interest rates change equally along every point of the yield curve in response to market, economic and political events. • Steepening • Short term yields fall in response to weakening economic fundamentals and/or low inflationary environment • Longer term yields rise in response to rising inflationary trends or strengthening economic fundamentals
Active Portfolio Strategies • Interest-rate anticipation • The yield curve can shift in three ways (contd.): • Flattening • Short term yields rise in response to Fed tightening on strong economic fundamentals or risk of rising inflation • Long term yields fall in response to weakening economic fundamentals or falling inflationary expectations. • Duration-based strategies can be used to take advantage of these forecasts for parallel shifts in the yield curve. • For non-parallel shift expectations, bullet and barbell strategies can be employed.
Active Portfolio Strategies • Interest-rate anticipation • Barbell strategy • Combination of short-term and long-term bonds so that the duration is approximately equal to an intermediate-term bond. • This strategy will outperform in a yield-flattening environment.
Active Portfolio Strategies • Interest-rate anticipation • Bullet strategy • Investment is concentrated on intermediate-term bonds. • This strategy will outperform in a yield-steepening environment.
Active Portfolio Strategies • Credit analysis • Involves detailed analysis of the bond issuer to determine expected changes in its default risk. • Essentially, these strategies attempt to project changes in credit ratings to corporate bonds.
Active Portfolio Strategies • Credit analysis • One model that assesses the financial health of a company is the Altman Z-score which is computed as follows: Z =1.2*X1 + 1.4*X2 + 3.3*X3 + 0.6 * X4 + 1.0 * X5 Where X1 = working capital/total assets; X2 = retained earnings/total assets; X3 = EBIT/Total assets; X4 = MV of equity/Total Liabilities; X5 = Net Sales/Total Assets; Z-score > 3 indicate a safe company; between 2.7 and 2.99 places the company in an ‘on alert’ status; between 1.8 and 2.7 makes the company a good candidate for bankruptcy over the next 2 years, below 1.8 makes the chance of bankruptcy very high.
Active Management Strategies • 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. • Three examples of bond swaps are pure yield pickup swaps, substitution swaps and tax swaps.
Active Management Strategies • Bond swaps • Pure yield pickup swaps • Involves a switch from a low-coupon bond to a higher coupon bond of similar quality and maturity. • The main objective is to seek higher yields. • This strategy does not require interest rate speculation. • Reinvestment risk can be greater with this strategy.
Active Management Strategies • Bond swaps • Substitution swap • This strategy is generally short term. • The strategy looks to take advantage of temporary market anomalies in yield spreads between issues that are equivalent with respect to coupon, quality and maturity. • The rewards of this strategy can be increased yield and capital gains if the anomaly corrects. • One potential risk of this strategy is that the difference in yield spread is permanent.
Active Management Strategies • Bond swaps • Tax swap • This strategy tends to be popular with individual investors as it doesn’t require interest rate projections and has few risks. • The strategy is undertaken when capital gains in once security is offset through the sale of a bond currently held and selling at a discount (loss) from the price paid at purchase. • The sold bonds are replaced with nearly identical bonds.
Readings • RB 19 (pgs. 757-770)