Fixed Income Portfolio Management 101: An Introduction

 

Fixed Income Portfolio Management 101: An Introduction

Constructing an effective investment portfolio requires much more than just assembling a selection of investments- it requires careful planning, research, and discipline.

Preliminary Steps

Before any investment decisions are made, it is important to give careful consideration to the following items:

Investment Objectives

As in most endeavors, setting goals is an important part of the process of creating an investment portfolio.  After all, it’s very difficult to get somewhere if you have no idea where you are going.  Investment objectives are the goals that every investor should consider when creating a portfolio.  Investment objectives should not only be identified, but prioritized as some goals may conflict with others.

Current Income

It stands to reason that anyone considering the creation of a bond portfolio would have current income high on their list of objectives, if not the primary goal.  The maximization of current income becomes a risk/reward decision as higher yielding bonds present greater risks.

Capital Appreciation

Capital appreciation is when an investment or portfolio increases in value.  Many people do not think about bonds when it comes to capital appreciation, but the reality is that bonds do fluctuate in value, and can be used to meet this investment objective, though they should probably not be the only asset class in the portfolio.  Longer maturity and discount bonds provide the most price movement when interest rates change, but this also increases the portfolio’s price risk.

Capital Preservation

Capital preservation is when a portfolio’s principal maintains its value.  Investors that are seeking the preservation of capital are looking to minimize price risk. Investors looking for capital preservation would usually want to purchase bonds with shorter maturity with high credit ratings.

Tax Minimization

This is usually considered a secondary objective, but investors seeking to minimize taxes may want to consider municipal bonds.

Risk Profile

Once you have identified your investment objectives, the next thing that you need to determine is your risk profile- the level of risk that you can comfortably assume to meet your investment objectives.  In order to do this, you need to ask yourself some questions:

  1. How would you describe yourself as a risk taker?
    1. I avoid risk;
    2. I am cautious;
    3. I am willing to take a calculated risk; or
    4. I am a gambler;
    5. You have been saving and planning a big vacation.  A few weeks before leaving, you lose your job, so you:
      1. Cancel the vacation;
      2. Make plans for a modest vacation;
      3. Go as scheduled; or
      4. Extend your vacation since you now have plenty of time.
      5. When do you plan to retire?
        1. Over 20 years;
        2. 10 to 20 years;
        3. 5 to 10 years; or
        4. Less than 5 years
        5. Do you see any large expenditure in the next few years that would require liquidating part of your portfolio?
        6. How would you react to a 5% drop in value of an investment, even if it may be temporary?
          1. I lose sleep;
          2. I worry;
          3. I am disappointed;
          4. I am confident that it will work out well in the long run.
          5. How would you react to a 10% drop in value of an investment, even if it may be temporary?
            1. I lose sleep;
            2. I worry;
            3. I am disappointed;
            4. I am confident that it will work out well in the long run.
            5. How would you react to a 20% drop in value of an investment, even if it may be temporary?
              1. I lose sleep;
              2. I worry;
              3. I am disappointed;
              4. I am confident that it will work out well in the long run.

Interpreting the Results

For questions 1 and 2, answer “a” indicates real risk aversion, “b” indicates some aversion, “c” indicates little risk aversion, and “d” indicates a willingness to assume risk.  For question 3, answer “a” indicates you can take considerable risk if you wish, “b” indicates you can take moderate risk if you wish, “c” indicates you can take a small amount risk if you wish, “d” indicates you should take minimal to no risk.  If you answer yes to question 4, you should consider setting aside a portion of your portfolio in low risk, liquid investments in the amount of the expected expenditure.  Questions 5 through 7 should give you an idea of how much price risk you would feel comfortable with.  For example, answering “a” to question 5 indicates you should take little to no price risk, while answering “d” to question 7 indicates you are willing to take on considerable risk.

If you have not done so already, you should read the lesson on Bond Risk.

Portfolio Management Style

Now that you have determined your objectives and risk profile it is time to decide whether you wish to pursue a passive, enhanced indexing, structured, or active management style.

Passive Portfolio Management

Passive portfolio management is essentially a buy-and-hold approach.  Passive portfolio management provides the least amount of risk, but also the lowest potential returns.

Passive portfolio management is also known as indexing, because it involves choosing an index that you wish to match the return of, and recreating it in the portfolio.  Matching an index by replicating every security in it is not practical, as many indexes contain hundreds or thousands of securities.  Professional portfolio managers will index by creating a portfolio of securities that match various characteristics of the index such as coupon, maturity, duration, and credit rating.  The duration component is probably the most important determinant of portfolio performance, followed closely by the credit rating.

Most retail bond investors pursue a passive strategy by simply buying a number of bonds that they are comfortable with, and holding them until maturity.  It is a good idea, however, to monitor the weighted average duration and credit rating of the portfolio.  This will give you a good idea of the level of risk in the portfolio.  While not absolutely necessary, matching these weighted averages against an index will provide you with a benchmark for monitoring the portfolio’s performance.

Enhanced Indexing

Enhanced indexing is a hybrid of passive and active portfolio management.  The objective is to outperform the targeted index, but it also presents the risk of underperforming the index.

One strategy involves deviating from the characteristics of the portfolio.  For example, a manager may create a portfolio with a slightly longer average duration or lower average credit rating.  Another strategy involves creating an indexed portfolio with most of the assets, and actively managing a smaller portion of the assets.

Asset-Liability Management

Asset-liability management (ALM) is a portfolio management strategy that involves matching the cash flows of the portfolio assets with liabilities.  In other words, the portfolio is constructed so the interest payments and maturities of the bonds in the portfolio are matched against the future payment obligations. While this is popular with large institutional investors, such as insurance companies, it is less common with retail investors.  However, it can be an effective strategy for investors that are retired or are approaching retirement.  The advantage is that it lowers the price risk because the investor is less likely to have to sell an investment at a loss.

Active Portfolio Management

Active portfolio managers are attempting to outperform the benchmark.  This is often very difficult to achieve, especially considering the higher transaction fees that result from increased trade activity.  It is the strategy that presents the highest potential return, but the risk is also higher.  Active managers do not believe in the efficient market hypothesis, or they believe that markets are not significantly efficient.

Relative Value Strategies

Relative value (RV) strategies attempt to take advantage of temporary price anomalies between different bonds.  In other words, the spread between the two bonds is exceedingly large, and the manager expects the spread to return to normal.  The anomaly may be in a credit spread, a yield spread, or a maturity spread.

Aggressive managers will usually go long the cheap security and short the expensive bond.  These trades are usually made market neutral by weighting the long and short position by the price sensitivity of each bond (see How Traders Establish Strategic Curve Trades section in Bond Trading 201).

An investor can also take advantage of relative value anomalies by swapping out of an expensive security in their portfolio into a cheap on (see the Bond Swapping section in Fixed Income Portfolio Management 102).

Market Timing Strategies

Market timing involves attempts to correctly anticipate changes in interest rates.  Traders use a number of methods to try to forecast interest rates and structure trades to profit from their forecasts (see Bond Trading 102).

Reactive Strategies

While market timing strategies involve anticipated changes in market prices, reactive strategies respond to changes in market prices.  Momentum strategies follow trends by getting into markets that are in a trend, and exiting when the trend changes.  Traders use statistical methods to identify trends.  These methods will be explored in future lessons.

With duration-based mean reversion strategies the manager will extend the average duration of the portfolio (by selling short-duration securities and buying long duration securities) as interest rates rise, and shorten the average duration as interest rates decline.

 
 
 

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