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to accompany

Investment Analysis and Portfolio Management

Seventh Edition by

Frank K. Reilly & Keith C. Brown

Chapter 20

Bond Portfolio Management Strategies

Alternative Bond Portfolio Strategies

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

(1) 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 Two prominent strategies under this approach are the Laddered and Barbell strategies (see next six slides)

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

Classic Passive Management Strategies

A laddered strategy distributes fixed income dollars throughout maturity the yield curve. A barbell strategy differs from the laddered strategy in that less investment is made in the middle maturity maturities. A credit barbell is a bond portfolio containing a mix of high-grade and low-grade securities.

par value

par value

Classic Passive Management Strategies

Insert Figure 19-7 here.

Classic Passive Management Strategies

Insert Figure 19-8 here.

Classic Passive Management Strategies

Insert Figure 19-9 here.

Classic Passive Management Strategies

Insert Figure 19-10 here.

The Risk of Barbells and Ladders

If durationladdered portfolio > durationbarbell portfolio ,

rising interest rate
interest rate risk
reinvestment rate risk

falling interest rate

ladder favored
ladder favored

barbell favored
barbell favored

Yield curve inversion means short-term rates are rising faster than long-term rates. Duration as a pure measure of interest rate risk only works for parallel shifts in the yield curve.

(2) 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

(2) Active Management Strategies

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

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

(3) 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

(3) 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

Immunization Strategies
Components of Interest Rate Risk
Price Risk Coupon Reinvestment Risk

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)

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

(3) Matched-Funding Techniques

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

(4) 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

End of Chapter 20
Bond Portfolio Management Strategies