BondSquawk

March 16, 2011

The producer price index jumped by 1.6% in February, this time driven by both high energy prices and food prices. Energy prices jumped 3.3% after the 1.8% increase in the previous month. Meanwhile, foods surged 3.9% following a surprisingly weak reading in January. The increase in food prices was driven by a 48.7% surge in the price of vegetables.

Core prices (ex food and energy) posted a 0.2% increase. Core pipeline pressures picked up lately with core crude prices and core intermediate prices increasing for the seventh consecutive month. The latest report suggests that producers are passing along some of their higher input costs. The prices of certain components of core PPI such as textiles, which are directly affected by surging commodity prices, continued to increase rapidly. Men’s apparel jumped 2.3% m/m following a 0.5% increase in the month prior. Core PPI is best correlated with the core goods component in CPI. Core goods have been on a constant downward trend as of late, but there is a limit to how much further it could fall. A 0.2% increase in Core Goods CPI was seen and economists expect the reading to get firmer.

Housing starts unexpectedly fell by 22.5% in February, its biggest decline on a monthly basis in over 25 years, after rising 18.5% in January. Housing starts fell from 618k in January to 479K (annualized) in February, its lowest level since April 2009, as both single family and multi-family starts slowed. Housing permits continued to fall for a second month, declining 8.2% in February m/m.  Mortgage applications as seen in the Mortgage Banker’s Association index fell by 0.7% last week even as borrowing costs declined. The average 30-yr FRM rate fell to 4.79%, the lowest in two months, but relatively high unemployment and expectations of housing prices falling further refrain Americans from buying new houses.

Stocks fell and Treasuries extended gains amidst concerns over the after effects of Japan’s earthquake on its nuclear power plants. Treasury yields fell across the curve on increased demand for the safe haven securities. The benchmark 10-yr note traded 7 bp lower at 3.23%. The 2-yr yield fell 3 bp to 0.60%. The S&P shed 0.8% and was last seen at 1270.84 as of 11:39 AM EST. DJIA and NASDAQ were both trading a percentage point lower.

By Maulik Mody – Bondsquawk.com

March 10, 2011

U.S. government bonds gained after report today showed that the U.S. trade deficit widened in January by almost $6 billion to $46.3B. Economists had expected it to widen by roughly a billion dollars to $41.5 billion. This widening of the deficit was caused mainly as imports increased by 5.2% m/m as opposed to exports, which grew 2.7%.  The total export ex-petroleum increased by $4.8B to $19.67B.

Export of goods increased to $120B but a higher increase in imports caused the goods deficit to increase by $6B to $59.7B. The surplus in services was unchanged due to small similar increase service imports and exports.

The increase in exports of goods was due to increase in industrial supplies (10.2% m/m) and automotive vehicles and parts (13.4%). Imports considerably increased mainly in capital goods (5.3% m/m) and consumer goods (2.2% m/m).

 Among trading partners, the nominal trade balance with China deteriorated on increased imports and decreased exports. Trade balance also reduced with OPEC nations and African nations on increased imports. If the unrest in North Africa does not subside by this month, this can worsen in the coming months due to increased oil prices.

The Labor Department reported that initial jobless claims in the week ended March 5 climbed 26,000 to 397K after 371K in the previous week. Although claims came in higher than expected, it is the third consecutive reading below 400K and the second time the 4-week moving average is below 400K. The Labor Department has said earlier that “it takes a sustained improvement below 400k to have any appreciable effect on unemployment,” and this can certainly be regarded as an encouraging step towards today’s recovery.

Treasuries increased in price and stocks fell in this morning. The benchmark 10-Yr note traded 2 bp lower at 3.45%. The Long Bond was also 2 bp lower at 4.59%. The S&P retreated 1.3% to 1303.43. Oil prices also fell on concerns that slowing global recovery will reduce demand for oil. Crude price fell by around $2.8 and its April future contract was trading at 101.80.

By Maulik Mody – Bondsquawk.com

March 9, 2011

Some investors may not know where the yield of a bond is headed, or what the price appreciation will be for a particular bond if rates fall, but they have a general view about the creditworthiness of the lenders and may want to trade based on where they think spreads are headed over time. Trading a CDS for a given issue is one way of trading the corporate credit of a company.

A Credit Default Swap (CDS) is essentially an insurance that promises the holder of a corporate (or other) bond the value the face value of the bond, less the value of the defaulted debts, in the event that the issuer defaults. In return, the CDS holder pays a percentage (called spread) of the insured amount to the protection seller every year till the bond expires or defaults. These spreads move up and down with a change in the perception of the creditworthiness of the issuer among other things, hence creating trading opportunities.

Trading in CDS however is done over the counter and is not a very liquid market. This also increases transaction costs due to wide bid-offer spreads. Another way of trading corporate credit is to trade credit default swap index (CDX), which allow investors to speculate on the creditworthiness of a basket of entities or the hedge the credit risk of a portfolio. As opposed to a CDS, a CDX is a more standardized credit security hence more liquid with tighter bid-offer spreads. Just like a CDS, the spread of a CDX typically rises when investor confidence in corporate credit falls and vice-versa. An example of an a CDX for high grade bonds is the Markit CDX North American Investment Grade Index (CDX.NA.IG), which constitutes of 125 equally weighted securities from various sectors such as Financials, energy, utilities, industrial, consume cyclical etc.

So what’s making these indices move so much in the current environment?  Many different securities have been affected by the middle-east crisis and swaying oil prices, and CDX is no exception. Concerns about rising crude prices and the effects that a decrease in oil supply can have for countries and companies is causing the spreads to widen. But more interesting is the fact that these CDX spreads are moving in tandem with oil prices. Bloomberg reported last week that the correlation between the CDX and crude futures rose to 0.7, the highest so far. Correlations vary from -1 to 1 where negative 1 means that they move exactly opposite with the same magnitude, and a positive 1 indicates the two move in lockstep.

For the credit trader, this gives a good opportunity to trade CDX using the dynamics of crude futures, and for the investor, it may be a chance to bet on the general longer term trend of credit. In either case, one can expect spreads to come down to normal levels after the Middle-East unrest is over. History is evidence that oil has, on numerous occasions, settled near its pre-crisis trading levels after any crisis that has threatened the supply of oil has subsided.

March 4, 2011

The February employment report came in a little stronger than expected with nonfarm payrolls increasing 192k, in line with expectations, while the unemployment rate fell to 8.9% from 9.0% as the participation rate was unchanged. There was also a 58k upward revision to past estimates. Private sector hiring was stronger than expected with a 222k gain while the government sector let go 30k workers at the state and local level. There was some pay back from weather-related weakness in January as the construction sector added 33k after a 22k drop, while manufacturing added a robust 33k jobs after a 53k increase in January. Private service sector hiring improved to 152k from 33k and it was not reliant on temporary hiring which improved to just 16 k after a 5k drop a month prior.

Within the details professional and business services added a robust 47k while health care contributed 36k. Leisure and hospitality also added 21k after a weather-related decline of 3k in January. Overall the 3-month average for total nonfarm payrolls stands at 136k, above the roughly 110k needed to hold the unemployment rate steady. Importantly the private sector is carrying the day averaging 152k over the past three months, enough to offset the headwind from state and local governments.

Importantly for Fed policy, wage growth was flat in February after a surprisingly strong 0.4% increase leading the annual pace to return to its recent lows of 1.7% from 1.9% last month. While the unemployment rate is moving in the right direction on an apparently sustained basis, it is still elevated and downward pressure on wages remains.

Chairman Bernanke noted in his testimony before Congress last week that they will be looking at wage growth as an indicator for how much firms will be able to pass through commodity inflation into core prices. The lack of re-entrants into the labor market was also a surprise and suggests both a structural downward trend in participation owing to the retiring baby boomers and a lack of opportunity for others who have given up looking for work. The report also showed a gain of just 0.2% in aggregate hours worked as average weekly hours remained at a relatively subdued 34.2. Thus the report suggests that wage and salary growth will be solid in Q1, but probably will lag behind headline inflation. Overall the report confirms an improving trend in the labor market which will serve as an important foundation as firms and households grapple with rising food and energy prices in the months ahead.

Stocks declined this morning as investors feared that the sluggish growth in wages may fail to keep up with the rising oil prices, which will affect the cost of other commodities. Treasuries rallied across the curve, with yield at least 5 bp lower across the front end of the curve. The yield on the benchmark 10Y-y note was 5 bp lower at 3.51%. Oil continued to rise, with the April contract trading at 103.54 this morning.

March 3, 2011

Initial jobless claims dropped 20k in the week ending February 26 to 368k, the lowest level since May 2008. This was the President’s Day holiday shortened week, however, the Labor Department analyst said that there was “nothing unusual” in the data. This was the second consecutive reading below 400k, and the first time the 4-week moving average dropped below 400k reaching 389k. Recall, the Labor Department considers that “it takes a sustained improvement below 400k to have any appreciable effect on unemployment,” however, today’s reading is certainly another encouraging step for the labor market recovery.

Mr Trichet gave his most explicit signal ever that rates will rise, in April. While he said this was not the start of a series, he said that at the beginning of the last series. We expect the second rate hike in June, and no later than July.

The ECB surprised by extending the availability of 3-month fixed rate repos until June, emphasising the split between monetary policy and stability-oriented measures.

The ECB stance will stiffen expectations for a hike soon in the UK. However, consumer confidence is down sharply and weak underlying Q1 GDP would worry the Bank of England a lot given the fiscal tightening still to come.

Tensions in MENA may yet spread and disrupt oil supplies more seriously, which could have profound effects on growth and inflation. For now, however, the effect on growth might be no more than 0.5pp in the US and eurozone.

Stocks rallied higher and Treasuries fell today after the Labor Department reported that the number of people filing for unemployment declined and the service industry grew at the fastest rate in 5 years. Crude oil fell from its highest level in a year, and Gold prices also bounced off its ceiling.

By Maulik Mody – Bondsquawk.com

March 2, 2011

Stocks inched up higher and Treasuries eased after employment reports showed increased hiring in the private sector and the Fed said in its beige book that labor market is improving. Unrest in the Middle East continued to push oil prices higher. The dollar fell against other currencies while Gold climbed to an all time high.

Economic Data

The ADP employment report showed a pick-up in private sector hiring to 217k in February from an upwardly revised 189k in January. Economists had expected an increase of 180k last month. The ADP has over-predicted private payrolls by 122k over the past two months before which they under-predicted by an average 56k over the preceding six months. Hence economists at BNP Paribas expect private payrolls to have increased by 185k during February.

The Mortgage Bankers Association showed that mortgage activity in the US decreased by 6.5% for the week ended Feb 25, as both purchases and refinancing fell over 6%. The 30-year fixed mortgage rate fell 16 bp to 4.84%.

The latest Beige book reported released by the Atlanta Fed indicated that the economy is improving at a moderate pace and the labor market is stabilizing. The report covers the period from 4 January through 18 February, when high-frequency economic data were indicating improvement, especially in the manufacturing sector, while the housing market remained depressed. The Beige Book indicated that almost all districts “experienced solid growth in manufacturing production.” While “construction remained at low levels across all Districts,” retail sales increased, tourism improved and “labor market conditions continued to strengthen modestly.”

Interest Rates

Treasuries fell as yields gained across the curve on reduced demand for fixed income products after economic releases today suggested that the labor market was improving in a steadily improving economy.

The yield curve steepened, as rates in the longer end of the curve rose more than in the front end. The 2-Yr fell as its yield pushed 8 bp higher to 0.69%. The belly of the curve steepened as the yield on the 5-Yr rallied 7 bp to 2.17%. The benchmark 10-yr note fell pushing its yield 8 bp higher to 3.47%. The Long Bond also fell as its yield gained more than 8 bp to 4.56%.

Inflation expectations, as seen by the yield differential between the 10-yr Treasury and 10-yr inflation indexed bonds (TIPS), increased 5 bp to 2.47%, its highest level in a year.

Across the Capital Markets

Stocks ended slightly higher on improved economic outlook. The S&P climbed 0.2% to 1308.44, while NASDAQ gained 0.4% to 2784.07. The VIX Volatility index fell 1.5% to 20.70.

The DXY index, which measures the dollar against six major currencies, fell 0.6% to 76.651. Euro gained 0.7% against the dollar to 1.3866. The cable (GBP/USD) gained 0.3% to 1.6325, its highest level in a year.

Crude oil pushed higher amidst unrest in Libya and ended the day at 102.40 a barrel. Gold pushed to an all-time high of 1434.50.

A very good article in the WSJ that links the current riots in the Middle East to the policies adopted by the Federal Reserve to contain inflation. A must read by George Melloan:

In accounts of the political unrest sweeping through the Middle East, one factor, inflation, deserves more attention. Nothing can be more demoralizing to people at the low end of the income scale—where great masses in that region reside—than increases in the cost of basic necessities like food and fuel. It brings them out into the streets to protest government policies, especially in places where mass protests are the only means available to shake the existing power structure.

The consumer-price index in Egypt rose to more than 18% annually in 2009 from 5% in 2006, a more normal year. In Iran, the rate went to 25% in 2009 from 13% in 2006. In both cases the rate subsided in 2010 but remained in double digits.

Egyptians were able to overthrow the dictatorial Hosni Mubarak. Their efforts to fashion a more responsive regime may or may not succeed. Iranians are taking far greater risks in tackling the vicious Revolutionary Guards to try to unseat the ruling ayatollahs.

Probably few of the protesters in the streets connect their economic travail to Washington. But central bankers do. They complain, most recently at last week’s G-20 meeting in Paris, that the U.S. is exporting inflation.

China and India blame the U.S. Federal Reserve for their difficulties in maintaining stable prices. The International Monetary Fund and the United Nations, always responsive to the complaints of developing nations, are suggesting alternatives to the dollar as the pre-eminent international currency. The IMF managing director, Dominique Strauss-Kahn, has proposed replacement of the dollar with IMF special drawing rights, or SDRs, a unit of account fashioned from a basket of currencies that is made available to the foreign currency reserves of central banks.

About the only one failing to acknowledge a problem seems to be the man most responsible, Federal Reserve Chairman Ben Bernanke. In a recent question-and-answer session at the National Press Club in Washington, the chairman said it was “unfair” to accuse the Fed of exporting inflation. Other nations, he said, have the same tools the Fed has for controlling inflation.

Well, not quite. Consider, for example, that much of world trade, particularly in basic commodities like food grains and oil, is denominated in U.S. dollars. When the Fed floods the world with dollars, the dollar price of commodities goes up, and this affects market prices generally, particularly in poor countries that are heavily import-dependent. Export-dependent nations like China try to maintain exchange-rate stability by inflating their own currencies to buy up dollars.

Mr. Bernanke has made it clear that his policy is to inflate the money supply. His second round of quantitative easing—the controversial QE2 policy to systematically purchase $600 billion in Treasury securities with newly created money—serves that aim. But even for the U.S. it is uncertain that Mr. Bernanke can hold to his 2% inflation target. Oil is going up. Foodstuffs are going up. And when the Fed sneezes money, the weak economies of the world, and the poor masses who are highly vulnerable to price rises in the necessities of life, catch pneumonia.

The turmoil in Iran is reminiscent of another period when the Fed was on an inflationary binge, the late 1970s. The Iranian oil boom had brought many thousands of peasants out of the villages into the cash economy in population centers like Tehran. On top of the disorientation resulting from that change itself, Iranians were then victims of an outbreak of inflation and a sharp decline in the purchasing power of the rials in their pay envelopes. Confused and angry, they supported the clerical revolution that unseated the shah and has been a thorn in America’s side ever since.

Today’s Iranian revolt has similar causes and, if successful, could be the flip side of 1979, a nation again friendlier toward the U.S. But there is no guarantee of that, or that states now friendly, like Bahrain, will remain so after an Egyptian-style upheaval.

Indeed, it is unlikely that Americans themselves will escape the inflationary consequences of current Fed policy. Aside from the rise in oil and foodstuffs, higher prices of manufactured goods are in the offing. China’s inflation rate is hovering at 5%. MKM Partners, a research and trading firm, last November reported that an internal study at Wal-Mart, a big importer from China, showed that the huge retail chain’s prices are edging up at an annual rate of 4% a year. That recent trend showed up in last week’s consumer-price index report.

The Fed is financing a vast and rising federal deficit, following a practice that has been a surefire prescription for domestic inflation from time immemorial. Meanwhile, its policies are stoking a rise in prices that is contributing to political unrest that in some cases might be beneficial but in others might turn out as badly as the overthrow of the shah in 1979. Does any of this suggest that there might be some urgency to bringing the Fed under closer scrutiny?

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of “The Great Money Binge: Spending Our Way to Socialism” (Simon & Schuster, 2009).

February 16, 2011

The producer price index rose by 0.8% m/m in January, once again driven by high energy prices. Energy prices jumped 1.8% m/m after the 2.8% jump in the previous month. Gasoline surged 6.9% m/m. Surprisingly, food prices were not such significant driver in January, as they increased by relatively subdued 0.3% m/m. Core prices (ex food and energy) posted a 0.5% m/m increase, which was the biggest monthly increase since 2008. Core pipeline pressures picked up lately with core crude prices and core intermediate prices increasing for the sixth consecutive month. However, while producer pricing power is improving, retailers will likely still have difficulties passing higher prices onto consumer. Core PPI is best correlated with the core goods component in CPI. Core goods have been on a constant downward trend as of late, but there is a limit to how much further it could fall.

In January housing starts surged by 14.6% m/m above expectations, entirely driven by a 77.7% m/m increase in multifamily starts. Single family starts continued to decline posting a 1.0% decline in January, which followed an 8.4% m/m drop in the month prior. The strength in multifamily starts likely points to some pick up in demand for rental properties, as owners’ market continues to struggle from falling prices and surging foreclosures. Meanwhile, housing permits, the indicator of future activity, dropped 10.4%m/m, driven by a 23.8% decline in multifamily starts. Such a decline in permits likely points to a drop in starts in February. Unusually high volatility in housing starts and permits around the turn of the year also reflects builders’ attempts to get approval before the end of the year in anticipation of changes in building codes. Starts remain depressed by historical standards and confirms expectations of a prolonged and painful housing recovery.

Bond Ladders

One very popular and effective way to create a bond portfolio is to create a bond ladder.  A bond ladder consists of several different bonds with differing maturity dates. For example, if one had $200,000 to invest, they could buy $40,000 in bonds that mature in 2 years, 4 years, 6 years, 8 years, and 10 years.  This would result in a portfolio that has an average maturity of 6 years.  Another possibility is to purchase $20,000 in bonds that mature each year for the next ten years, which would create a portfolio with an average maturity of 5.5 years.

Each separate bond maturity is a “rung” in the ladder.  The bonds could be treasuries, agencies, municipals, or corporate bonds.  For bonds that are not treasuries, the ladder would most likely be invested in bonds from different issuers to diversify in order hedge againstdefault risk.

Creating a bond ladder provides investors with a number of advantages:

• Provides a steady and predictable stream of income.
• The regular maturity intervals provides ongoing liquidity.
• Because the periodic maturities allow the portfolio to purchase new bonds on a regular basis, the reinvestment risk is significantly reduced.  If interest rates rise, the maturing capital is reinvested at higher rates.  If interest rates fall, maturing capital is reinvested at lower rates, but the longer bonds in the portfolio continue to earn higher rates.
• Having the bonds mature at regular intervals also provides a hedge against interest rate risk.
• Because it is unlikely that all of the bonds in the portfolio are likely to be called at once, the ladder provides protection against early redemption or call risk.

If an investor knows that they will need access to funds in the future, a bond ladder can be created that matches their funding requirements.

Bond Swapping

A bond swap is the simultaneous sale of a bond for the portfolio and purchase of another bond from the sale proceeds.  An investor will execute a swap in order to take advantage of a market opportunity, or to adjust their portfolio for a change in investment objective or financial status.  Typical strategies for executing a swap include:

• Increasing Yield
• Increasing Quality
• Increasing Diversification
• Benefit from Changes in Interest Rates
• Call Protection
• Lower Taxes

Let’s take a look at how each objective is achieved.

Increasing Yield

Bond investors will often execute a swap to increase the yield that their portfolio is earning.   An increase in yield is often achieved by swapping to a bond with a longer maturity (assuming a positive sloping yield curve), a lower credit rating, or both.  It is important to remain cognizant of the fact that the added yield does not come for free- increasing the maturity also increases the portfolio’s interest rate risk, and decreasing the credit rating increases the credit risk.

Often the investor will enter into such a swap based on their perceptions of relative value.  It is not unusual for identical bonds with the same credit rating to trade at different yields due to the market’s current perception of differences in an industry or company’s business outlook.  For example, the prospect of high oil prices may cause investors to be concerned with the earnings impact this would have for heavy users of fuel, such as airlines; or a particular company may be considered to having a weaker product offering.  If an investor does not share the market’s view, or if they think the situation is only temporary, they may take advantage of the price discrepancy by buying the cheaper bond.

Bonds that carry credit risk will yield more than treasuries.  The difference in yield is known as the credit spread. Credit spreads change over time depending on the market’s perception of where the economy is in the business cycle. If investors feel that the economy is weakening, they will sell riskier assets and buy safer investments (this is known as a flight to quality).When this happens, credit spreads widen.  Conversely, when the investors are optimistic about the economy, they are more willing to purchase riskier assets in order to increase their return, and the credit spread will narrow.  An investor that believes the market has overreacted, and that the credit spread is exceedingly large, may take advantage of the situation by swapping into a bond with a lower credit rating.

Increasing Quality

A quality swap is a swap that is executed by selling a lower rated bond and purchasing a higher rated security.  It is essentially the opposite of a yield swap and is the result of the investor’s negative perception of the economic prospects for the issuer of a specific bond in their portfolio, the issuer’s industry, or the economy in general (they feel that the credit spread is too narrow).

Increasing Diversification

An investor may decide that their portfolio is too concentrated in a specific issuer, industry, or country.  The investor will sell some of the concentrated position and invest the proceeds in the bond of another issuer that provides greater diversification.  The concentrated position may result from a merger or other corporate restructuring, or some event may alter the investors comfort level with their exposure to the issuer, industry, or country.

Investors may also execute diversification swaps because they feel general economic or market conditions warrant increased diversification to mitigate market risk.

Changes in Interest Rates

Investors may execute swaps based on their belief that the level of overall interest rates are likely to change.  If the investor believes that rates are likely to rise, they can swap intofloating-rate, shorter term, and/or premium bonds to reduce their portfolio’s exposure tointerest rate risk. If the investor believes that rates are likely to fall, they can swap into zero coupon, longer term, and/or discount bonds to try to maximize their exposure to the expected rate change.

It is important to note that interest rate swaps are speculative in nature as the anticipated rate change may not occur, or rates may change in the opposite direction.  Also, changes in rates do not impact all maturities equally, so the swaps may not provide the desired effect.

Call Protection

An investor may choose to execute a bond swap to increase the call protection in their portfolio.  Call protection swaps generally occur in a falling rate environment when it is more likely that bonds may be called.  In this case, the investor will swap out of bonds with little or no call protection to bonds that are not callable in the near future, or into bullets.

Lower Taxes

Tax swapping is the most common form of bond swapping.  Investors will often swap out of a bond that is trading below par (or the price the investor paid for it) in order to offset a capital gain realized in the sale of another asset.

It is important to note that the IRS does not recognize a tax loss resulting from the sale and repurchase of the same or “substantially identical” security within 30 days before or after the sale date (known as a wash sale). The IRS has not explicitly defined “substantially identical,” but it is generally believed that the securities would not be considered substantially identical if the securities have different issuers, or there are substantial differences in the coupon rate or maturity.

Investors that experience an increase in their tax rate will often swap from taxable bonds to tax-free municipal bonds.  Some municipal bonds are subject to the Alternative Minimum Tax (AMT), while others are not.  Bonds that are subject to AMT will generally yield more than an equivalent non-AMT bond, therefore investors that are not subject to AMT can often improve their yield by swapping into AMT bonds.  Investors subject to AMT can save taxes by swapping into non-AMT bonds if the tax savings more than offsets the lower yield.

Tax laws change frequently and the treatment of capital gains is particularly complicated, so investors should always consult with a competent tax advisor before engaging in tax swaps.

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;
2. 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.
3. 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
4. Do you see any large expenditure in the next few years that would require liquidating part of your portfolio?
5. 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.
6. 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.
7. 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.