4 strategies for managing bond portfolios

To casual observers, bond investment seems to be as simple as buying the highest yielding bonds. Although this works well when buying a certificate of deposit (CD) at a local bank, it is not that simple in the real world. There are many options when constructing a bond portfolio, and each strategy has its own risk and return trade-offs. The four main strategies used to manage bond portfolios are:

  • Passive, or “buy and hold”
  • Index matching, or “quasi-passive”
  • Immunity, or “quasi-active”
  • Focused and positive

Passive investment is suitable for investors who want to obtain predictable returns, while active investment is suitable for investors who want to bet on the future; indexation and immunity are in the middle, which provides some predictability, but it is not as good as buy and hold or passive strategies .

Passive bond management strategy

Investors who buy and hold passively usually want to maximize the income-generating characteristics of bonds. The premise of this strategy is to assume that bonds are a safe and predictable source of income. Buying and holding involves purchasing individual bonds and holding them to maturity. Cash flow from bonds can be used to fund external income needs, or the portfolio can be reinvested in other bonds or other asset classes.

In a passive strategy, no assumptions are made about the direction of future interest rates, and any change in the current value of the bond due to changes in the yield is not important. The bond may initially be purchased at a premium or discount, assuming that the full face value will be received at maturity. Compared with the actual coupon yield, the only change in total return is the reinvestment when the coupon occurs.

On the surface, this may seem like a lazy investment method, but in reality, passive bond portfolios provide a stable anchor in the turbulent financial storm. They minimize or eliminate transaction costs, and if initially implemented in a period when interest rates are relatively high, they have a great opportunity to surpass active strategies.

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One of the main reasons for their stability is that passive strategies are best suited for very high-quality, non-redeemable bonds, such as government or investment-grade companies or municipal bonds. These types of bonds are very suitable for buy-and-hold strategies because they minimize the risk of income stream changes due to embedded options, which are written into the bond contract issued and held for life. As with required coupons, the call and bear characteristics embedded in bonds allow the issuance to take action on these options under certain market conditions.

Example: Call function

Company A issued 100 million US dollars of bonds to the public market at a coupon rate of 5%; the bonds were all sold out at the time of issuance. There is a redemption feature in the bond contract. If the interest rate drops enough to reissue the bond at a lower current interest rate, the lender is allowed to redeem (recall) the bond. Three years later, the current interest rate is 3%. Because the company has a good credit rating, it can repurchase the bonds at a predetermined price and reissue the bonds at a coupon rate of 3%. This is good for lenders but bad for borrowers.

The bond ladder in passive investment

Tiered bond investment is one of the most common forms of passive bond investment. Here, the investment portfolio is divided into equal parts and invested in a stepped maturity within the investor’s time frame. Figure 1 is an example of a basic 10-year stepped $1 million bond portfolio with a required coupon rate of 5%.

year 1 2 3 4 5 6 7 8 9 10
Main 100,000 USD 100,000 USD 100,000 USD 100,000 USD 100,000 USD 100,000 USD 100,000 USD 100,000 USD 100,000 USD 100,000 USD
Coupon revenue 5,000 USD 5,000 USD 5,000 USD 5,000 USD 5,000 USD 5,000 USD 5,000 USD 5,000 USD 5,000 USD 5,000 USD
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figure 1

Divide the principal into equal parts to provide a stable and equal cash flow every year.

Bond investment is not as simple or predictable as ordinary observers might seem. There are many ways to build a bond portfolio, and each method has risks and rewards.

Indexed Bond Strategy

The index is considered quasi-passive by design. The main goal of indexing a bond portfolio is to provide return and risk characteristics closely related to the target index. Although this strategy has some of the same characteristics as passive buying and holding, it has a certain degree of flexibility. Just like tracking a specific stock market index, the structure of a bond portfolio can mimic any published bond index. A common index imitated by portfolio managers is the Barclays US Aggregate Bond Index.

Due to the size of the index and the number of bonds required to replicate the index, this strategy is suitable for large investment portfolios. People also need to consider not only the transaction costs associated with the original investment, but also the periodic rebalancing of the portfolio to reflect changes in the index.

Immune conjugation strategy

This strategy has the characteristics of both active and passive strategies. By definition, pure immunity means that the investment portfolio invests in a certain return within a certain period of time, without any external influences, such as changes in interest rates.

Similar to indexation, the opportunity cost of using an immunization strategy may give up the upside potential of an active strategy to ensure that the investment portfolio will achieve the expected expected return. Like the buy-and-hold strategy, according to the design, the most suitable tool for this strategy is high-grade bonds with the possibility of long-range default.

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In fact, the purest form of immunity is to invest in zero-coupon bonds and match the maturity date of the bond with the expected cash flow date. This eliminates any changes in returns related to cash flow reinvestment, whether positive or negative.

The duration or average lifespan of a bond, usually used for immunization. Compared with maturity date, it is a more accurate indicator of bond volatility prediction. Insurance companies, pension funds, and banks often use duration strategies in institutional investment environments to match the time horizon of their future liabilities with structural cash flows. This is one of the most reasonable strategies that individuals can use successfully.

For example, just as a pension fund uses immunization to plan cash flow when an individual retires, the individual can also build a dedicated investment portfolio for their retirement plan.

Active bond strategy

The goal of active management is to maximize total returns. As the opportunities for returns increase, so too does the risk. Some examples of positive styles include interest rate expectations, timing, valuation, and spread utilization, as well as multiple interest rate scenarios. The basic premise of all active strategies is that investors are willing to bet on the future, rather than accepting the potentially lower returns that passive strategies may provide.

Bottom line

Investors can use a variety of bond investment strategies. The buy-and-hold approach is attractive to investors seeking income but unwilling to make predictions. Intermediate strategies include indexation and immunization, both of which provide a certain degree of safety and predictability. Then there is the active world, which is not suitable for casual investors. Every strategy has its place, and if implemented correctly, it can achieve its expected goals.

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