Active Bond Portfolio Management

Introduction

“The models within the traditional finance paradigm assume that investors act rationally and consider all available information in the decision-making process”. Different market characteristics determine how appropriately investors will act towards different investments. Many investment markets are too unpredictable to allow the development of a consistent pattern. As Schindler further argues, “underlying all these is the theory of arbitrage, which suggests that rational investors undo price deviation away from the fundamental values quickly and maintain market equilibrium”.

Difficulties facing traditional paradigms in the bond markets have led to an emergence of the behavioral finance paradigm. As Shefrin explains, “in essence, it argues that investment choices are not always made based on full rationality, and it attempts to understand the investment market phenomena by relaxing the two doctrines of the traditional paradigm”. These two doctrines include the one that argues that agents and bond investors have failed to constantly update their beliefs and another one that argues that there is always a tendency for bond investment choices to deviate from the normative processes. Major investment management theories include the prospect theory, judgment under uncertainty which addresses overconfidence, fear of regret, representative heuristic, anchoring and adjustments, among others.

This paper explains different bond portfolio management strategies, paying more focus to active management. Different factors influence the choice of bond portfolio management strategy. Though no specific theories are addressing the choice of bond portfolio management, prospect theory in behavioral finance can be used to understand the factors that influence decisions for bond investors. The theory explains how human beings behave when assessing risks under uncertainty. The theory argues that “humans are not consistent in that they are risk-averse in gains, while in losses they are risk-takers”.

When managing bond investments, Shleifer states that “human behavior is adaptive and the biases come from the innate, quick, and mostly unconscious decisions that enable one to function in the day to day life”. Since bonds are considered as a safe investment, fear of regret as a behavior in an attempt to avoid errors, causes investors to alter their behavior and can end up making very irrational choices. This argument on its own is a good reason why those investing in bonds should have a portfolio and well organized plan for different scenarios in the market.

Bond portfolio management

Portfolio management, sometimes referred to as investment management is “the professional management of various securities (shares, bonds, and other securities) and assets such as real estate, in order to meet specified investment goals for the benefit of the investors”. Investors could be referring to institutions or individuals through direct investment contracts, or other investment schemes. Portfolio management is a large global industry worth billions of dollars and employing millions of people under financial services. This demonstrates the relevance of investment management.

Bond portfolio management is “techniques that allow managers to be relatively certain of a given promised cash stream”. The provision of bond portfolio management includes elements of bond selection, financial statement analysis, plan implementation, as well as monitoring and making adjustments. Whether passive or active, a bond portfolio management strategy must ensure diversification, stability, risks management and income management are addressed. Even though bonds are generally considered a safe investment, there are various risks associated with them. It must also allow an investor to place their investment in a bond that will have good returns. It should have a solid plan of what ought to be done should the markets change to an unexpected direct. Finally, a good portfolio must take advantage of the available rating system to know the amount of risk an investor is facing. It should also address legal challenges and other aspects related to the law of the country where one is trading such as taxes.

The process of investing in bonds can be summarized as follows;

Bonds management
Fig 1: Bonds management

As Fabozzi and fellow authors explain, “bond portfolio management is not a simple activity as it involves many complex steps” 9. The steps are broken down into various steps as discussed below;

Specification of investment objectives

To ensure maximum benefits from an investment in bonds, there need to be clearly set objectives. Successful bond portfolio management is guided by defined goals and timescale. Each objective has determined importance and a plan as to how it will be achieved. While some investors will take risks and some will do their best to minimize or avoid them, in both instances it is paramount that risks be identified in the earliest stages of the plan. The process of risk identification should also involve identifying constraints that could arise from special situations such as time horizons, liquidity and tax policies, just to mention a few.

Choosing the bond mix

According to Fabozzi, “in any investment management, the most important decision is with respect to the asset mix decision”. This step involves proper proportion of bonds in the portfolio. The proportion is determined by several factors such as risk tolerance and period allocated for different goals, among other parameters. It is in this step that a bond portfolio manager has to decide in which class a bond will be placed, as well as which bonds will be purchased in a what class.

Formulation of strategy

After choosing a bond combination, there is need to formulate a suitable strategy. Depending on the risks a manager is willing to take, the level of diversification required, and risks involved, a bond portfolio manager or the owner can decide the most suitable management strategy. Formulating a strategy further involves selection of bonds after a fundamental and comprehensive analysis of bonds an investor is interested in buying. As Beutow points out, “in case of bonds credit ratings, liquidity, tax shelter, term of maturity, and yield to maturity are factors that are considered”.

Portfolio execution

This step is one of the most significant determinants of how successful and effective will be. It involves the implementation of formulated strategy, which may include buying or selling bonds at the intended prices. It could also involve implementation of measures designed to minimize risks or ensure stability in the cash flow.

Portfolio revision and evaluation

Just like any other investment management, bond portfolio management requires constant revision and evaluation. Changes in the prices of bonds automatically change their value in the portfolio. This calls for regular changes on the portfolio to take care of fluctuations. Sell and purchase of some bonds may be necessary, and so maybe security changes. Evaluation is done from time to time to determine what is working and what is not. As Bessembinder and Maxwell explain, “ it helps the investor to realize if the portfolio return is in proportion with its risk exposure”. The author further explains that “along with this, it is also necessary to have a benchmark for comparison with other portfolios that have a similar risk exposure”.

Bond portfolio management strategies

“In order to effectively employ portfolio strategies that can control interest rate risk and/or enhance returns, you must understand the forces that drive bond markets as well as the valuation and risk management practices of these complex securities”. Investors will choose a different strategy in the way they manage their bonds based on different factors. The most significant factor that a majority of investors put into consideration is risk. Most investors will choose a risk level on the SML, and focus on having a strategy that only allows risk to that level. The second most important factor to consider is returns. Some investors will be more concerned about returns and give less attention to risks and security as is the case with young investors. A retiree on the other hand maybe more concerned about risks, security and stability as opposed to returns.

The different strategies applied by different investors can be categorized into two major categories;

Passive portfolio management

Passive portfolio management is based on the argument that bonds are a predictable and safe source of income. Investors simply buy them and hold them until they are mature. In this strategy, there are no assumptions made regarding interest rates and other market parameters. Any changes in the bond’s current value are not of big significance to the investor. Passive bond management is further divided into two strategies;

Buy-and-hold strategy

A buy-and-hold strategy is considered a lazy and traditional way of managing bonds. It simply involves buying bonds and holding them until they are matured. In this case, factors of interest include terms of maturity and quality ratings. They could also include sinking funds and coupons levels, among other factors deemed influential to the performance of the bond. According to Fabozzi, “these investors do not trade actively to earn returns, rather they look for bonds with maturities or durations that match their investment horizon”.

The new and modified buy-and-hold strategy is one in which investors practice what is not considered a half-passive strategy. The investors buy bonds but as they wait for their maturity, they are actively looking for opportunities to cash in on the bonds or trade them for better opportunities. If any desirable opportunity presents itself before the bonds mature, they are willing to engage in the activity. In some cases, when an investor’s strategy gets more aggressive, it could turn into an active strategy.

Even though a buy-and-hold strategy is considered passive, analysts argue that it still involves a lot of work. It requires a lot of research and accuracy when purchasing a bond. Treasury securities for example are considered to have lower quality than agency issues. As explained by Diebold and Canlin, “investors may also want to develop a portfolio in which coupon payments are structured with principal repayments”.

Indexing

“Indexing involves attempting to build a portfolio that will match the performance of a selected bond portfolio index”. Usually it involves a number of compromises and a selection of several indexes. The indexes are used to determine the bond’s stratification levels and the selection of securities for an investor’s portfolio. A selection is aimed at re-balancing periods and categories from which bonds are from.

Active management strategies

“Active management strategies require major adjustments to portfolios, trading to take advantage of interest rate fluctuations, and maximize returns”. Investors actively managing their bond portfolios use skills and acumen to outperform the ones using a buy-and-hold policy. This kind of bond management strategy attempts to take advantage of specific parameters in bond investments such as market timing or superior bond selection. A superior bond selection requires an investor or manager who has the ability to identify bonds that are wrongly priced and use them to gain an advantage.

There are five strategies considered active management;

Interest rate application

This strategy has for a long time been considered the riskiest bond portfolio management strategy. Its risk is magnified by the fact that the investor acts on very uncertain and hard to predict future interest rates. This strategy is mostly used by investors whose main aim is to preserve their capital when the interest rates are on an upward scale and bond prices are headed in the opposite direction. It is also commonly used in a vice-versa situation where an investor aims at receiving increased capital appreciation when bond prices increase due to reduced interest rates.

Like in other strategies, objectives should be well designed to allow for a more comprehensive plan. One way through which set objectives are met in this strategy is through the altered duration of portfolios. This is from the fact that portfolios with longer maturity periods will yield better returns in a situation where interest rates go down. The opposite outcome is expected when interest rates increase. Therefore, if different parameters point towards an increment in interest rates, then they have bond portfolios with the lowest duration.

The biggest challenge in this strategy increases from the fact that it is almost impossible to predict interest rate movements with total accuracy. As a result, a wrongly estimated movement of interest rates could lead to an unexpected situation that was not well planned for. However, since it is impossible to accurately predict interest rates, investors who decide to use this strategy are more concerned with other parameters. “Key among them is the direction of change of interest rates”. Monitoring the direction of change allows investors to make relevant changes in anticipation of a decrease or increase in the interest rate. Another important parameter that investors put into consideration is the change across maturities, as well as the magnitude. This further enables an investor to design a portfolio that allows maximum returns due to good timing, which is the third parameter.

Security duration is considered directly proportional to the effects of changes in interest rates. Those with bonds whose interest rate is expected to drop should have portfolios with high-duration securities. It is equally important to have accurate timing of the interest rates shifts. An early shift could comprise returns, while a late timing may lead to loss of prime opportunities. In this strategy, it is important for investors to analyze individual bonds within their portfolios and understand the possible outcomes for different scenarios. After putting these parameters into consideration, it is possible for an investor to calculate the relative return value analysis. This then allows the investor to graph the relationship between the current duration of individual bonds and their expected return.

Valuation analysis

In valuation analysis, the investor or bond portfolio manager targets those bonds whose computed value is higher than the current price. When such a scenario occurs, the bond is considered undervalued. These bonds’ yield to maturity is expected to be lower than the current yield to maturity. The strategy requires constant involvement of a bond’s activity, a well-informed evaluation and trading based on a comprehensive analysis. With proper analysis, investors can get rid of overvalued bonds and buy those considered as undervalued, if they are in the investor’s portfolio.

“Valuation analysis can be examined using pure discount bonds (zero-coupon) and thus determine the value of different treasuries, thus determine the default-free characteristics of any other type of bond”. The characteristics can be used to determine other parameters that could affect bond yield by incorporating different types of analysis. The most common is the regression analysis, where an investor puts into consideration the sector and coupon effect, quality rating, and sinking funds attributes, among other factors. This type of analysis further allows an investor to determine the yield for the security, which is then used to make decisions on whether to buy or sell. For example, if a bond’s expected yield is less than the yield to maturity, then an investor should buy. However, unprecedented events may alter the outcome of otherwise good decisions. For example, in the event where market risks and other factors destabilize a firm’s financial position, or in an event where there is a sudden anticipation that markets could upgrade, the outcome could be totally different.

Credit analysis

According to Shefrin, “credit analysis involves examining bond issuers to determine if any changes in the firm’s default risk can be identified”. The aim is to try and determine if firms’ ratings will be changed or not. Depending on whether an investor is managing their own bond themselves, or using a bond manager, the firm’s ratings are of paramount significance. The way firms are performing could influence traders’ attitudes in the market and even cause total shifts in the direction bonds and other securities take. The recent global economic crisis is a good example of how much firms’ rating influence market performance. As more and more economies contracted, more firms were downgraded, causing a panic among investors, as well as reduced confidence in the securities market. Such scenarios lead to reduced activity at the exchange markets and hence less returns for those investing in bonds.

To avoid being a victim of such circumstances, investors and bond portfolio managers must be able to accurately predict when and how bond ratings will change. To successfully utilize bond rating changes, investors must use available knowledge to take prompt action prior to unfavorable changes. As Schindler warns, “the market does react to unexpected bond rating changes, and it reacts quickly”. Credit analysis strategy is very dependent on a constant evaluation and updates on different events in the market. It is important for investors and hired bond portfolio managers to involve themselves with a detailed analysis of credit and other market parameters to be able to identify those bonds that will default and those that will not.

The assessment of default risk is a hard task that requires a lot of attention and experience. It has different elements categorized into systematic and unsystematic. As explained, “first individual bond issuers may experience difficulty in meeting their debt obligations, even though this could be an isolated incident, and can be diversified away”. A macro-oriented analysis may be required if market and business conditions point towards a default risk. Many investors upload bond ratings done by bond agencies and they believe they are comprehensive and accurate.

Yield spread analysis

In yield analysis, bond portfolio managers will monitor the yield in different bonds and compare their relationships. This will help them look for abnormalities or unusual trends and relationships. Like it is in every other strategy, accuracy and comprehensive information are required. This statement by Boyd and Jeffrey demonstrates how informed one needs to be to have a good yield spread analysis. The authors explain that “if a spread were thought to be abnormally high, you would trade to take advantage of a return to a normal speed. Thus you need to know what the ‘normal’ speed is, and you need the liquidity to make trades quickly to take advantage of temporary spread abnormalities”.

Yield spread analysis requires constant and accurate anticipation of any significant changes in sectoral relationships. Changes in price and yield very often influence each other and happen together. These changes may occur due to several reasons, the most significant being changing views of the creditworthiness of the market or one of its sectors and its level of sensitivity to risk. The other reasons could be changes in bonds and market valuation, characteristics of other bonds being traded, as well as the conditions of the demand and supply chain, among others. A yield spread analysis ultimately aims at investing in bonds that will have the strongest price movements, in the direction that is beneficial to the investor. Investors who manage their portfolios can hire brokerage firms who can perform specialized analysis on several parameters of interest to the investor such as the spread.

Horizontal analysis

“In this type of management, there is a simple holding period selected for analysis”. Furthermore, at the end of the period, yield structures may be considered. When making assumptions in this type of management, an investor has to be sensitive to any changes that occur in the process of implementing the strategy.

Bond swapping

As Bessembinder and fellow authors explain, “in bond swapping, investors exchange a bond to take advantage of superior ability to predict yields”. This type of active management is categorized into substitution, pure yield pickup, rate anticipation and inter-market spread swap.

Contingent immunization

In this type of management, a portfolio is managed actively for as long as desired results are forthcoming. If the case where results are unfavorable, the portfolio is many times immunized.

Characteristics of a good active bond management portfolio

Diversification

An active bond portfolio management is aimed at ensuring that the investor is in touch with the markets, trends and patterns of the bond invested in. Bonds are considered more volatile than stocks, making them a better investment when stock markets are going through a struggle. Having a portfolio that allows diversification further protects an investor when bond markets are struggling. Diversification inactive bond portfolio management can be assured by ensuring an aggressive and up-to-date consideration and understanding of various parameters such as interest rates and profit margins, among other things. It can also be achieved through comparable returns of the bond in different seasons and trends in the market.

Stability

The purpose of making a portfolio is to prepare for the future. A good portfolio must allow an investor to place their investment in a bond that will have good returns. It should have a solid plan of what ought to be done should the markets change to an unexpected direction. Because the majority of the return on bonds comes from the interest payments (like coupon payments), fluctuations in the price of a bond will have little impact on the value of the investment”. However, the interest rates have an inverse effect on the prices of the bond. The relationship between the two poses a significant challenge to investors, especially those who want to buy long-term bonds. Therefore, a good portfolio should take these factors into consideration before a decision to buy or sell. This will in turn create a sense of security in knowing there is a plan.

Consistent income

A good portfolio must ensure that payments at different intervals are utilized and invested well. Furthermore, it should have a well-laid plan on how different market trends will be managed. Even though bonds are constantly referred to as fixed-income investments, they pose risks to an investor. They can earn big losses especially when they lose value when an investor is still holding them.

Manage risks

While bonds are generally considered a safe investment, there are various risks associated with them. Interest rate risks arise as a result of the relationship between bonds prices and interest rates. The prices are inversely proportional to interest rates. For a long-term investment, bonds can be a risky investment if not well managed. A good portfolio must ensure that an investor is protected from inconsistent interest rates, by using other parameters such as market trends to the investor’s advantage. If interest rates increase, people are usually unwilling to purchase in the secondary market. This results in decreased bond prices to allow capital appreciation cover-up for the changed interest rates.

Another risk associated with bonds is the credit risk, where organizations default on their credit obligations. This can cause losses to investors if they lose the remaining value of their investment. This happens in situations where organizations go bankrupt. A good portfolio must take advantage of the available rating system to know the amount of risk an investor is facing. Government bonds are considered immune from such a risk since a government can print more money instead of defaulting. However, their rate of return is considered much lower than that of bonds issued by municipalities and even much lower compared to those issued by corporate. A good portfolio must be able to take factors that create or eliminate risks and use them to the investor’s advantage. Other risks that a good portfolio should manage include call risk and inflation risk, just to mention a few.

Legal considerations and taxes

A good portfolio must not consist of any fraudulent or illegal transaction in the plan. It should also be able to take advantage of tax-free payments for bonds where that is applicable. This is especially beneficial for those investors in the high tax bracket.

Advantages of active bond portfolio management

Maximized returns

Active bond portfolio management allows an investor to stay in touch with the markets and understand trends that influence the rate of returns for a bond. A portfolio allows the diversification of securities. According to Diebold and Canlin, a good portfolio should include bonds from at least ten issuers, all from different sectors. The same author further explains that “if you stick with highly rated debt, you’ll naturally gain exposure to some companies that tend to do well in a tough economy like health-care firms, consumer staples companies and utilities”. If diversification is well addressed in a portfolio, an investor is bound to take advantage of different parameters and make more from their investment.

A competitive position

The biggest problem in passive bond portfolio management is that investors set up a portfolio, and then totally ignore it. An active bond portfolio management ensures that an investor is actively involved in the market and regularly monitors the portfolio. This way, they are aware of when the financial health of their insurer changes. Having an active bond portfolio management ensures that investors don’t miss out on re-investing on funds from bonds that come due each year. A competitive position is created when an investor takes advantage of every situation to their advantage.

Efficient and effective allocation of scarce resources

Buying bonds is may be a hard task for a serious investor. The process involves bargaining and negotiations using factual information. In the past years, negotiations were difficult due to a lack of information on bond sales. Today, websites and expert services are offering the information to traders willingly. An investor is in a better position to negotiate when they have prices on recent trades. An active bond portfolio management ensures that an investor is well equipped with this information regularly. It is then possible to re-invest funds from bonds that are due by buying others and selling those that might end up eating on the initial investment.

Forges a link between project selection and business strategy

To establish and maintain a result-oriented active bond portfolio management, it is important to consult professional brokerages and other experts in the bonds markets. The process of making a portfolio or having an expert do it exposes an investor to useful information in the market. The information can prove vital for other projects and investments in future. Being actively involved means that an investor is part of the process, right from the initial process of bond selection, to the long-term strategy.

Achieves focus

Steps involved in developing and implementing an active bond portfolio help an investor stay focused. From setting objectives to mix selection, implementation and evaluation of the portfolio, an investor can achieve focus and effectiveness. Active portfolio management puts into consideration the time factor, ensuring that objectives are not only met, but are met in a specific time scale.

Communicates priorities

Communicating priorities ensures that an investor achieves balance in their strategy. Active bond portfolio management enables accurate objective project selection. Priorities are set through well-designed goals and objectives. When some bonds are due, the money gained from them is already planned for. If the investor wants to invest it back in bonds, there is a well-set plan to ensure that it is done in a manner that supports long-term goals.

Conclusion

Bond portfolio management is involved with analyzing bonds by looking at how a market’s behavior influences an investor’s decision-making process. It focuses on how investment decisions are made by the investors after interpreting the knowledge that they have and this acts as a basis of their actions in investment decisions. Therefore, this approach takes into account human emotion and its influence. It also deals with the inclusion of psychological and economic principles to improve financial decision-making.

Traditionally, financial paradigms have been characterized by very little activity as far as bond portfolio management is concerned. Bonds are considered a predictable and safe investment. As the bond market becomes more and more diverse, investors realize the need to manage their portfolios with more aggressiveness. Activity and interest have increased in the bonds markets as more people gather confidence to invest incorporates. Initially, more people felt safe to invest in government and municipality. Since these two issuers are less likely to default, investors did not see the need to actively manage their portfolios.

As more corporates come in with better offers, investors need to be actively involved in the bonds markets to reap the best from the investments. As a result, active bond portfolio management is becoming a common trend among investors in the bonds market. However, with the presence of highly skilled and well-qualified brokers, investors now prefer to have an expert manage their portfolios. The involvement of experts makes the markets even more vibrant and better portfolio management strategies are required. Today, different market characteristics determine how appropriately investors will act towards different investments. Many investment markets are too unpredictable to allow the development of a consistent pattern.

Furthermore, difficulties facing traditional paradigms in the bond markets have led to an emergence of the behavioral finance paradigm. Investments are no longer based on rationality but so many other parameters play a role. The recent global economic crisis revealed just how every investment and sector can be vulnerable. As a result, agents and bond investors who have failed to constantly update their beliefs and strategies in the market may end up making very little or nothing at all from them. It is also as a result of having more young investors in the market to make quick money that paradigms in the bonds markets have changed.

Bond portfolio management is today a diverse complex industry. Investors in this paper could be referring to institutions or individuals through direct investment contracts, or other investment schemes. Portfolio management is slowly growing to a global industry worth billions of dollars and employing millions of people under the financial services. The trends further illustrate the relevance of the industry. As the level of relevance grows, more information is available to investors and other stakeholders in the industry.

As discussed in the paper, there are two major types of bond portfolio strategy. Passive strategy is based on the fact that bonds are safe and are predictable investments. As a result, investors will buy and wait for them to mature. However, some investors are constantly on the lookout for opportunities to sell or buy even if they practice passive bond management strategies. In this case, an investor is only concerned with major parameters such as risk management. Passive management can be categorized into buy-and-hold and indexing strategies.

Active management on the other hand “requires major adjustments to portfolios, trading to take advantage of interest rate fluctuations and maximize returns”. Investors actively managing their bond portfolios use skills and acumen to outperform the ones using a buy-and-hold policy. This strategy attempts to take advantage of all relevant parameters in bond investments and offers specific strategies to manage specific parameters. Market trends, timing and risks all play significant roles in how the investment is managed. Active management strategy is further categorized into interest rate application, valuation analysis, credit analysis, yield spread analysis, horizontal analysis, bond swapping, and contingent immunization.

The process involves several stages such as the specification of investment objectives, choosing the bond mix, formulation of strategy, portfolio execution, revision and evaluation. To ensure maximum benefits from an investment in bonds, there need to be clearly set objectives. Successful bond portfolio management is guided by defined goals and timescale. Each objective has to determine importance and a plan as to how it will be achieved. The process of the bond mix is determined by several factors such as risk tolerance and period allocated for different goals, among other parameters. It is in this step that a bond portfolio manager has to decide in which class a bond will be placed, as well as which bonds will be purchased in what class. After choosing a bond combination, there is a need to formulate a suitable strategy, done in consideration to risks a manager is willing to take and the level of diversification required. The execution is significant and determines how successful and effective

To make it a better strategy, diversification, stability, risks management and income management must be part of the plan. While bonds are generally considered a safe investment, there are various risks associated with them. Interest rate risks arise as a result of the relationship between bonds prices and interest rates. A good portfolio must also allow an investor to place their investment in a bond that will have good returns. It should have a solid plan of what ought to be done should the markets change in an unexpected direction. Furthermore, a good portfolio must take advantage of the available rating system to know the amount of risk an investor is facing. It should also address legal challenges and other aspects related to the law of the country where one is trading such as taxes.

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