Bond Portfolio Management
What is a bond portfolio?
This article will explain the basics of proper Bond Portfolio Management.
Bond portfolios contain a variety of investment bonds issued by various different corporations and governments. People often establish
bond portfolios with the intention of using bond interest payments as supplemental income. When you establish a bond portfolio, you can either concentrate on buying certain types of bonds or diversify your portfolio with a mixture of government, corporate and mortgage-backed bonds.
Bonds fall into four main categories:
- Government bonds,
- Municipal bonds,
- Corporate bonds and
- Mortgage bonds.
What is bond portfolio management?
Bond Portfolio Management is a technique or strategy used by Investors or Wealth management Companies to actively or passively manage & diversify the bond portfolios of their clients depending on their risk profile & return requirements.
Effective bond portfolio management involves basically timing the bond market knowing when to enter/exit, and the right proportion of low yield/ high yield bonds.
Basic Bond Selection Criteria
Bonds are rated by credit agencies according to their quality i.e. risk of default. Although Bonds are considered as safe investment assets, the measure of safety or ‘Credit Rating’ is basically just the likelihood of the bond issuer not paying back the money to the bond holder, for any reason.
This is why bonds issued by some entities are classified as ‘junk bonds’ while others with lower risk of default are relatively higher returns are classified as ‘Investment grade’ bonds.
- Many investors are wary of junk bonds due to the heightened default risk, but other investors are attracted to the bonds because of the high interest rates junk bonds pay.
- Many investors keep a mixture of conservative low yield bonds and high yield high-risk bonds.
- A conservative investor will have a maximum exposure to AAA+ bonds, which may not give the best yield but are considered safe while an aggressive investor may have a huge proportion of High yield junk bonds and a balanced investor will have an equal proportion of high yield & good credit quality bonds.
Bond portfolios and Corporates
Corporates or SMEs (Small – Medium Enterprises) rely on cash flow to expand their businesses. So they often have a huge chunk of cash put aside kept for capital expenditures. While having reserve cash is good, investing the money in ‘Safe’ assets that give higher returns than the banks is better than keeping the money in the bank.
Building a proper Bond portfolio is an avenue to get leverage on their investment in fixed income products at the same time maintaining quick access to the money.
Fixed income Securities
Unlike a variable-income security, where yield changes based on some underlying measure such as short-term interest rates, the yield of a fixed-income security is known in advance. That's why bonds are also known as “fixed-income” investments, they are intended to provide you a steady payout or yearly income.
Benefits of investing in Fixed Income Securities
- These securities are very safe in nature - Since the risk is low, the returns are also very low. Investors who are looking to diversify into safe avenues should invest in these. Safety with low volatility is the main feature of these products.
- The coupons (fixed yield percentage) serve to offer a regular income at very low risk - These become ideal for risk-averse investors, for example, people who have retired.
- Such products are available for different maturities, so an investor can buy one by timing the exit of his investment from the instrument when he needs the money.
- Such instruments are very liquid - In case money is needed very urgently by the investor, these can be converted into cash immediately.
An example of a fixed-income security would be a 5% fixed-rate government bond where a $1,000 investment would result in an annual $50 payment until maturity when the investor would receive the $1,000 back. Generally, these types of assets offer a lower return on investment because they guarantee income.
What is leverage?
Leverage is using borrowed money to increase your investment buying power. Where an investor with $10,000 that does not use leverage can buy $10,000 worth of bonds, an investor who uses leverage can buy $20,000 worth of bonds or more, with that same $10,000.
People use leverage to try an increase the profit potential of their investments. Leverage is however a double-edged sword: Just as additional buying power that comes with leverage increases your profit potential, it increases your loss potential by the same amount.
Do’s and Don’ts
DO’s of Bond Portfolio Management
- Diversify bond holdings to include non-Dollar based issues to hedge your portfolio partially against Dollar exchange rate losses
- Diversify bond holding to include some emerging market sovereign issues where country credit worthiness is rising.
- Lean toward intermediate-term or short-term bond funds to minimize losses when rates eventually rise.
- Maintain a spread of both credit quality and duration, but with a bias away from long-term debt and toward higher quality credit bonds.
DON’Ts of Bond Portfolio Management
- Don’t own individual long-term bonds, because rates must rise, which cause the value of your interest stream will be lower than expected.
- Don’t buy intermediate or long-term Treasuries, which will lose their safe harbor appeal as stock markets recover, and which will decline as major foreign buyers demand higher rates (lower prices) due to a weak Dollar foreign exchange and inflation prospects.
- Don’t own individual bonds unless you are certain you can hold them to maturity.
- Don’t remain entirely in cash which is a guaranteed purchasing power loss in the event of possible continued Dollar declines, while earning next to zero cash flow.
So in summary Bond Portfolio Management is not difficult to do, but as with all investments, professional advice should be taken when structuring. If you have more questions, please feel free to comment using the forms below this article. I will be happy to help you with your Bond portfolio management queries.