1. Bond Portfolio Management Strategies 03/02/09

2. 2 Bond Portfolio Management Strategies What is a bond portfolio investment style? What are some passive and active bond management strategies?

3. 3 Portfolio 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).

4. 4 Passive 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.

5. 5 Passive 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.

6. 6 Active 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 fundamentals

7. 7 Active 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.

8. 8 Active 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.

9. 9 Active Portfolio Strategies Interest-rate anticipation Bullet strategy Investment is concentrated on intermediate-term bonds. This strategy will outperform in a yield- steepening environment.

10. 10 Active 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.

11. 11 Active 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 * X5 Where 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.

12. 12 Active 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.

13. 13 Active 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.

14. 14 Active 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.

15. 15 Active 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.

16. 16 Readings RB 19 (pgs. 757-770)