Bond Portfolio Strategies

1
Bond Portfolio Strategies

• Passive management strategy
• In a passive strategy the investor seeks out
  bonds with attractive yield characteristics and
  holds them until maturity The key to this
  strategy is to choose investments whose maturity
  is close to the investors investment horizon

2
Bond Portfolio Strategies

• Passive management strategy
• Many investors choose a modified buy and hold
  approach where they plan on holding bonds until
  maturity but make modifications based on market
  conditions
• An attractive alternative to buy and hold for
  many individual investors is bond index funds
  These funds are managed to mimic one of the bond
  indexes.

3
Bond Portfolio Strategies

• Active bond management strategies
• The purpose of active bond management is to earn
  yields above those required for the riskiness of
  the portfolio

4
Bond Portfolio Strategies

• Active bond management strategies
• 1. Interest rate anticipation
• One way to earn abnormal returns is to benefit
  from increases in bond prices
• Bond prices increase when interest rates fall
• If you can forecast interest rates you can earn
  high capital gains by buying high duration bonds
  right before an interest rate fall
• For interest rate strategies it is important to
  choose liquid, high quality bonds so the strategy
  can be more easily employed

5
Bond Portfolio Strategies

• Active bond management strategies
• 2. Selecting undervalued bonds
• Based on bond characteristics, you determine if
  the bond is overvalued and undervalued.
• Must assign correct yield costs to the various
  characteristics Default risk, maturity, coupon,
  etc.

6
Bond Portfolio Strategies

• Active bond management strategies
• 3. Credit analysis
• Bond yields increase (decrease) when bonds are
  downgraded (upgraded).

7
Bond Portfolio Strategies

• Active bond management strategies
• High yield issues
• Analyzing the prospects of companies that issue
  high yield bonds can allow for superior returns
  if investors can pick the winners from these
  companies
• Average default rates on high-yield issues is
  between 30-40

8
Bond Portfolio Strategies

• Potential areas of analysis of high yield issues
• 1. What is the firms competitive position in
  terms of cost and pricing?
• 2. Cash-flow to cash requirements
• 3. Liquidity value of assets
• 4. Quality of management
• 5. Degree of financial leverage
• 6. Analysis of credit score (Z-score)
• Profitability
• Stability of profitability
• Debt service capabilities
• Cumulative profitability
• Capitalization levels
• Firm size

9
Bond Portfolio Strategies

• Matched funding techniques
• 1. Immunization strategies
• Bond immunization strategies are meant to lock in
  a certain yield regardless of changes in interest
  rates.
• Two components of interest rate risk
• - price risk
• - reinvestment risk
• If interest rates increase the price of a bond
  falls but the amount at which interim interest
  payments can be reinvested increases
• Immunization has to consider these tradeoffs

10
Bond Portfolio Strategies

• Matched funding techniques
• 1. Immunization strategies
• An investor can immunize a portfolio by setting
  the duration of the portfolio equal to the
  investment horizon.
• If the duration and the investment horizon are
  equal price and reinvestment risk will offset
  each other exactly and the bond portfolio will be
  immunized.
• The problem with immunization strategy is that
  durations of coupon bonds change when interest
  rates change.

11
Bond Portfolio Strategies

• Contingent Procedures
• Contingent Immunization
• Allows for active management subject to
  constraint of immunization
• Must be willing to accept a cushion, earn less
  than expected

12
Bond Portfolio Strategies

• Bond investment and efficient markets
• 1. Studies on ability to predict changes in
  interest rates
• Can't be done consistently
• 2. Bond rating changes
• -- Do affect yields, may contain useful
  information

13
Equity portfolio Management

• Passive vs. Active management
• 1. Passive management
• Generally regarded as a buy-and hold strategy.
  Generally, you are trying to achieve the
  risk/return level of a predefined index.
• Passive management focuses on management of risk
  and return.
• Passive management assumes market efficiency

14
Equity Portfolio Management

• Passive vs. Active management
• 2. Active management
• Assumes the ability to outperform, on a
  risk-adjusted basis, some market benchmark.

15
Equity Portfolio Management

• Passive management strategies
• 1. Indexing
• Indexing is creating a portfolio to match the
  risk/return characteristics to match those of a
  predefined market benchmark.

16
Equity Portfolio Management

• Passive management strategies
• Strategies for indexing
• 1. Full Replication
• -- Match index completely
• -- High transaction costs, due to changing
  weights of index
• -- Reinvestment of dividends
• 2. Sampling
• -- Attempt to replicate index with fewer
  securities
• -- Goal is to minimize "tracking error"
• -- Can sample based on industry/firm
  characteristics
• -- Can sample based on quadratic programming

17
Equity Portfolio Management

• Passive management strategies
• 2. Minimizing unsystematic risk
  (diversification)
• Attempt to hold a portfolio that contains only
  systematic risk
• Unsystematic risk is considered to be firm
  specific risk that can be diversified away
• Systematic risk is related to common market
  factors and can not be diversified away. Market
  efficiency would contend that only systematic
  risk is important.
• Studies have shown that a naïve diversification
  strategy can eliminate all unsystematic risk with
  as few as 12 securities.

18
Equity Portfolio Management

• Passive management strategies
• 3. Manage risk and return
• Create portfolios to earn a fair return for your
  given level of risk, recognizing that higher
  returns mean higher risk
• Can manage total risk, generally measured by the
  standard deviation of the portfolio's returns
• Can manage systematic risk, generally measured by
  beta.

19
Equity Portfolio Management

• Active management strategies
• Keys to successful active management
• -- Consistency
• -- Minimize transactions costs
• -- Research
• -- Markets must not be efficient

20
Equity Portfolio Management

• Active management strategies
• 1. Taking advantage of speculative bubbles
• The key to a successful strategy is to realize
  when the stock/industry enters the bubble and
  when the bubble is going to burst.

21
Equity Portfolio Management

• Active management strategies
• 2. Using cyclical patterns in stocks
• You can use the fact that one sector is
  experiencing a run-up due to a speculative bubble
  to search for bargains in another sector.
• An example is value stocks versus growth stocks.
  Generally, when value stocks do well growth
  stocks do poorly.
• The advantage of using cyclical patterns is that
  they can be invested in using mutual funds,
  thereby minimizing costs.

22
Equity Portfolio Management

• Active management strategies
• Using the life-cycle approach to investing
• Some believe that all stocks go through some type
  of life-cycle.
• For example stocks may begin as growth stocks,
  become value stocks, become stalwarts, become
  slow growers, experience a turn-around, and then
  begin as growth stocks again.
• The key to using the life-cycle approach is
  investing in the security when it is in the phase
  that you desire, i.e. value.

23
Asset Allocation Strategies

• Asset allocation refers to the process whereby
  investors decide how much money to invest in the
  assets they have chosen
• Asset allocation can be viewed independently from
  asset choice

24
Asset Allocation Strategies

• 1. Integrated asset allocation
• Examines capital market conditions and investors'
  objectives and constraints separately
• Choose an optimal portfolio, for the given market
  condition, that offers the best chance of meeting
  the investors' objectives and constraints

25
Asset Allocation Strategies

• 2. Strategic asset allocation
• Uses historical information to generate
  "efficient frontiers" given a particular set of
  assets that the investor has chosen
• Portfolios on the "efficient frontier" offer the
  highest return for a given level of risk.
• Based on the investor's risk preference, a
  portfolio on the efficient frontier is chosen

26
Asset Allocation Strategies

• 3. Tactical asset allocation
• Move in and out of assets based on their
  perceived value
• A way to enhance portfolio value
• 4. Insured asset allocation
• Move into risky assets as portfolio value
  increases
• Move into less risky assets as portfolio value
  decreases