35.1 Passive Management Strategy

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1 NPTEL Course Course Title: Security Analysis and Portfolio Management Dr. Jitendra Mahakud Module- 18 Session-35 Bond Portfolio Management Strategies-I Bond portfolio management strategies can be broadly classified into passive management, semi active management and active management. The basis of classification of bond management strategies is the nature of inputs required. Passive management is an approach which does not rely too much on forecasts about future whereas active management relies too much on forecasting. The frequency of forecasts and the number of variables that are forecasted are high in case of active management. Semi-active management falls in between these two approaches. This session discusses about the passive and semi-active strategies and the next session discusses about the active management strategies Passive Management Strategy Passive management places less emphasis on expectations. That, is most of the key inputs are known at the time of investment analysis itself. Three widely used strategies of passive management are buy-and-hold, bond laddering and indexing. (1) Buy-and-Hold Strategy One of the simple investment strategies is to identify a security with the desired characteristics and hold it till maturity or redemption and reinvest the proceeds in similar securities. This strategy is known as buy-and-hold strategy. Buy-and-gold investors do not trade actively with the objective of increasing their returns. They buy the bond with a maturity or duration close to their investment horizon to reduce price and reinvestment risk. When a security is held till maturity, price risk is eliminated and the return on the security is controlled by the coupon payments and reinvestment rate. Therefore, cash flows over life of the security are determined by the coupon payments received and reinvested. An important thing is buy-and-hold approach is identifying bonds with attractive yield and maturity profiles. The investors has to choose carefully from the available bonds based on the analysis of quality, coupon level, term to maturity and important indenture provisions such as call, sinking fund features, etc. Though management of the portfolio is passive, bonds are selected based on a careful analysis. 1

2 Buy-and-hold strategy is suitable to income maximising investors such as pensioners, bond mutual funds, endowment funds, insurance companies, etc. The objective of these investors is to maximise yield over the investment horizon. In some cases, following active bond management strategies may be difficult because of the market impact of large cash flows of large funds. Another feature of buy-and-hold approach is its low level risk. As we have already seen the main source of risk for bonds, interest rate risk, can be limited to reinvestment risk. Price risk is eliminated under buy-and-hold strategy because the security is held till maturity and price realized would be the same as expected. This also makes the buy-and-hold strategy attractive to risk adverse investors. Therefore, buy-and-hold strategy will be suitable to investors with the objective of maximising income with minimum risk. (2) Bond Ladder Strategy Another form of buy-and-hold passive strategy of bond portfolio management is bond laddering. Bond laddering involves investing in bonds with several maturity dates instead of a single time horizon as in the case of simple buy-and-hold strategy. This process of bond management is called laddering because of the various rungs of investment established over the maturity ladder. (3) Indexing Strategy Another form of passive management is indexing strategy. Under this strategy, a bond portfolio is formed with the objective of replicating the performance of selected index. Performance is measured in terms of total return realized over the investment horizon. Sources of total return over the investment horizon are change in portfolio value, coupon interest received and reinvestment income. Once it is decided to pursue an indexing strategy, the next step is to select a bond index to replicate. There are a number of bond indexes to choose from. Various factors such as investor s risk tolerance, investor s objectives, and constraints imposed by regulators guide the decision on appropriate benchmark index. If the investors risk tolerance is low, then the index should include more of government securities than corporate bonds. This is because corporate bonds expose the investor to credit risk whereas government securities do not have credit risk. The objective of the investor has a major influence on selecting an appropriate index. If the objective is to maximise variability of total returns, he may be biased towards choosing an index with a lower variability. On the other hand, if the investor has strong expectations about the directions of interest rate, selection of index may be biased towards an index, which 2

3 is expected to yield maximum returns. If the objective of the investor is to meet certain future liability, then choosing an index with the duration of the liability may be prudent. Another important consideration in choosing an index is constraint on acceptable investments imposed by regulators, as in the case of financial institutions like banks, insurance companies, etc. These constraints may be in the form of limits on exposure to sectors, quality, etc. In such a case, choice of the index may be influenced by regulatory constraints. Indexing Methodologies After selecting an appropriate index, comes the construction of portfolio that will tract the index. The portfolio should be constructed in such a way as to maximize the tracking error. Tracking error is the deviation of the performance of the portfolio from that of the index. Tracking error can be caused by: (i) transaction costs in construction of the index; (ii) differences in the composition of the indexed portfolio and the index itself; and (iii) discrepancies between prices used by the organization constructing the index and transaction prices paid by the index manager. One way to construct the portfolio is to invest in all the issues in the index in the same proportion as in the index. This can eliminate the tracking error resulting from differences in the composition of index and the portfolio. But this will increase tracking error resulting from transaction costs. Another way to construct the portfolio is to invest in a sample of issues. This can substantially reduce the transaction costs and thereby tracking error resulting from transaction costs. But tracking error caused by the composition of the portfolio will increase. Therefore, it is a trade-off between the tracking errors resulting from transaction costs and composition. This needs to be kept in mind while constructing portfolio. Three popular methods of constructing a portfolio to replicate an index are (i) the stratified sampling or cellular approach; (ii) the optimization approach; and (iii) the variance minimization approach. Stratified Sampling or Cellular Approach This is the most simple and flexible approach of constructing a portfolio. Under this approach, the index is divided into subsectors or cells. This division can be based on various characteristics such as sector, term to maturity, duration, coupon, credit rating, call features etc. Suppose that a fund manager stratifies the index based on the following characteristics: 1. Duration (2 cells) (i) Up to 5 years (ii) More than 5 years 2. Crediting rating (4 cells) (i) Triple A 3

4 (ii) Double A (iii) Single A (iv) Triple B 3. Sectors (2 cells) (i) Corporate (ii) Treasury Total number of cells for the index is equal to 2 x 4 x 2 = 16 After stratifying the index cells, securities are selected so as to represent each of these cells. Securities are selected from each of these cells in such a way that the selection is representative of the particular cell. The proposition of investment in each cell depends on the percentage of the cell s market value in the index. For example, if 25 percent of the market value of the index is made up of triple A issues, then 25 percent of the indexed portfolio should be composed of triple A issues. Optimization Approach A more disciplined and quantitative extension of cellular approach to construction of a portfolio is optimization approach. Under this approach, the money manager seeks to construct an indexed portfolio that will match the requirements as under the cellular approach and satisfy a few other constraints and also optimize a specific objective function. Objective function can be maximization of yield, maximization of convexity or maximization of expected total return. This approach requires mathematical programming. If the objective function is linear, linear program is used and if the objective function is a quadratic function, quadratic programming is used. Variance Minimization Approach This is complex approach to portfolio construction. The objective of this approach is to maximise the expected return of the indexed portfolio while minimizing the variance of tracking error in the construction of the portfolio. A quadratic program consisting of three components, an objective function, a set of constraints and a universe of securities, is solved to construct the indexed portfolio. III Semi-active Management Strategies Apart from earning a steady flow of income from bond investments, many bond portfolio managers may require an investment to take care of a future liability. The objective of such investors is to accumulate the present value of investment over the investment horizon. This funding objective may be required by a person who needs to build wealth through investment so as to provide money for retirement, education of children, etc. Many 4

5 large institutional investors, such as pension funds and insurance companies, must accumulate money in order to fund future liabilities. Two popular portfolio strategies that bonds to accumulate value are (i) dedication, and (ii) immunization. (1) Dedication Dedication is a strategy in which the objective is to create and maintain a bond portfolio that has a cash flow structure that exactly or closely matches the cash flow structure of a stream of current and future liabilities that must be paid. There are at least two approaches that can be used to contrast a dedicated portfolio: pure cash matching and cash matching with reinvestment. Pure Cash Matching The most conservative of the dedicated portfolio strategies is that in which a bond portfolio is constructed in such a way that the cash flows (coupons, principal payments, and any principal payments through call features) exactly match the required payments for a stream of liabilities. In the strictest sense, the portfolio would not be needed to help fund the liability payments. Thus, assuming that the future liability stream is known with some degree of certainty, the portfolio, once constructed, would need little monitoring. The easiest way to implement this approach is through dedication with zeros, i.e., purchase of zero coupon bonds whose maturities coincide with the dates on which money would be needed. However, because maturity dates for zero coupon securities may not exactly match liability payment dates, it may be difficult, if not impossible to do so. The dedication strategy will need to reply on some amount of reinvestment income to supplement the portfolio coupon and/or principal cash flows. Cash Matching with Reinvestment An alternative approach to portfolio dedication is to construct a portfolio such that the cash flows plus expected reinvestment income provide the anticipated funds at the time when payments are required. This method provides greater flexibility in the choice of securities, because, now, the maturity of the bonds does not have to match with the dates at which funds are required. However, the manager faces the risk that the reinvestment returns, when combined with coupon and principal repayments, may be insufficient to meet the needs. As a result, a conservative estimate of the future reinvestment rate is usually made so as to protect against a potential shortfall. (2) Immunization A major concern of bond investors who use bonds as an investment vehicle to accumulate value is that future reinvestment rates may change, thus affecting the realised 5

6 yield, and consequently, the accumulated value. The realized accumulated value may be insufficient to pay-off the required liability that the portfolio was intended to fund. The effect that changes in interest rates can have upon a bond s total returns is interest rate risk. This interest rate risk has two components: price risk and reinvestment risk. Price risk is the uncertainty about return from selling the bond at some time in the future. Reinvestment risk is the uncertainty about return from reinvesting the coupon income received over the holding period. The changing interest rates have opposite effect on these two components of interest rate risk. When interest rate increases, return from reinvestment increases but return from selling the bond decreases. A decline in the interest rate has the opposite effect. In maturity matching the price risk is eliminated since uncertainty about the selling price of the bond is removed by holding the bond till maturity; however, reinvestment risk is not eliminated. Using the concept of duration, we can immunize the portfolio from the changing interest rates and can lock promised YTM or accumulate a targeted wealth. Conditions for Immunization Three main conditions that are necessary to assure multiple liability immunization, in case of parallel shifts, are (i) the present value of the liabilities should be equal to the present value of assets; (ii) the duration of the assets should be equal to the duration of the liabilities; and (iii) the convexity of assets in the portfolio should be greater than the convexity of the liabilities. Questions and Answers 1. What are the different types of Bond Portfolio Management Strategies? Ans. Alternative Bond Portfolio Strategies: Passive portfolio strategies: Buy and hold, Indexing. Buy and hold strategy simply involves buying a bond and holding it until maturity. Bond investors would examine such factors as quality ratings, coupon levels, terms to maturity, call features and sinking funds. Indexing involves attempting to build a portfolio that will match the performance of a selected bond portfolio index Semi-Active Management Strategy: It refers to bond portfolio management techniques that are used to service a prescribed set of liabilities. It can be Pure Cash 6

7 Matched Dedicated Portfolios 9 conservative approach) or Dedication With Reinvestment or can be both. Active management strategies: Potential sources of return from fixed income portfolio: Coupon income, Capital gain, Reinvestment income. Fundamental active strategies includes, Interest rate expectations strategy, Yield Curve strategies, Valuation analysis, Credit analysis, use of Bond swaps Matched-funding techniques: Horizon matching. It is a combination of cash-matching dedication and immunization. Important decision is the length of the horizon period 2. Write a short note on Immunization. Ans. The immunization technique attempts to derive a specified rate of return during a given investment horizon regardless of what happens to market interest rates. Conditions for Immunizations: The Present value of the liabilities should be equal to present value of assets Duration of assets should be equal to duration of liabilities Convexity of assets in the portfolio should be greater than the convexity of liabilities Immunization Strategies: Components of Interest Rate Risk: Price Risk, Coupon Reinvestment Risk Immunization is neither a simple nor a passive strategy. An immunized portfolio requires frequent rebalancing because the modified duration of the portfolio always should be equal to the remaining time horizon (except in the case of the zero-coupon bond) 1. Explain Indexing Strategy of Passive portfolio management. Ans. 7

8 Its objective is to construct a portfolio of bonds that will equal the performance of a specified bond index. Performance is measured in terms of total return realized over the investment horizon Advantages of Indexing Strategy: Poor and inconsistent performance of active bond portfolio mangers Lower transaction cost Degree of control exercised by the investor Factors affecting the Selection of the Index: Investor s Risk tolerance, Investment Objectives and Constraints imposed by the regulator. Indexing Methodologies: Methods of Construction: Stratified sampling or Cellular Approach,Optimization Approach, Variance Minimization Approach Utmost care must be taken to minimize the tracking error caused by : Transaction costs in construction of the index, Differences in the composition of the indexed portfolio and the index itself, Discrepancies between prices used by the organization constructing the index and the transaction prices paid by the index manager 8