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