Bond Portfolio Management StrategiesSlide 2Portfolio Management StrategiesPassive Portfolio StrategiesSlide 5Active Portfolio StrategiesSlide 7Slide 8Slide 9Slide 10Slide 11Active Management StrategiesSlide 13Slide 14Slide 15ReadingsBond Portfolio Management Strategies03/02/092Bond Portfolio Management Strategies•What is a bond portfolio investment style?•What are some passive and active bond management strategies?3Portfolio 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).4Passive 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.5Passive 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.6Active 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 fundamentals7Active 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.8Active 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.9Active Portfolio Strategies•Interest-rate anticipation•Bullet strategy•Investment is concentrated on intermediate-term bonds.•This strategy will outperform in a yield-steepening environment.10Active 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.11Active 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 * X5Where 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.12Active 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.13Active 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.14Active 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.15Active 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.16Readings•RB 19 (pgs.