To the casual observer, bond investing would appear to be as simple as buying the bond with the highest yield. While this works well when shopping for a certificate of deposit (CD) at the local bank, it's not that simple in the real world. There are multiple options available when it comes to structuring a bond portfolio, and each strategy comes with its own risk and reward tradeoffs. The four principal strategies used to manage bond portfolios are:
- Passive, or "buy and hold"
- Index matching, or "quasi-passive"
- Immunization, or "quasi-active"
- Dedicated and active
Passive investing is for investors who want predictable income, while active investing is for investors who want to make bets on the future; indexation and immunization fall in the middle, offering some predictability, but not as much as buy-and-hold or passive strategies.
Passive Bond Management Strategy
The passive buy-and-hold investor is typically looking to maximize the income-generating properties of bonds. The premise of this strategy is that bonds are assumed to be safe, predictable sources of income. Buy and hold involves purchasing individual bonds and holding them to maturity. Cash flow from the bonds can be used to fund external income needs or can be reinvested in the portfolio into other bonds or other asset classes.
In a passive strategy, there are no assumptions made as to the direction of future interest rates and any changes in the current value of the bond due to shifts in the yield are not important. The bond may be originally purchased at a premium or a discount while assuming that full par will be received upon maturity. The only variation in total return from the actual coupon yield is the reinvestment of the coupons as they occur.
On the surface, this may appear to be a lazy style of investing, but in reality, passive bond portfolios provide stable anchors in rough financial storms. They minimize or eliminate transaction costs, and if originally implemented during a period of relatively high interest rates, they have a decent chance of outperforming active strategies.
One of the main reasons for their stability is the fact that passive strategies work best with very high-quality, non-callable bonds like government or investment grade corporate or municipal bonds. These types of bonds are well suited for a buy-and-hold strategy as they minimize the risk associated with changes in the income stream due to embedded options, which are written into the bond's covenants at issue and stay with the bond for life. Like the stated coupon, call and put features embedded in a bond allow the issue to act on those options under specified market conditions.
Example: Call Feature
Company A issues $100 million in bonds at a 5% coupon rate to the public market; the bonds are completely sold out at issue. There is a call feature in the bonds' covenants that allows the lender to call (recall) the bonds if rates fall enough to reissue the bonds at a lower prevailing interest rate. Three years later, the prevailing interest rate is 3% and, due to the company's good credit rating, it is able to buy back the bonds at a predetermined price and reissue the bonds at the 3% coupon rate. This is good for the lender but bad for the borrower.
Bond Laddering in Passive Investing
Ladders are one of the most common forms of passive bond investing. This is where the portfolio is divided into equal parts and invested in laddered style maturities over the investor's time horizon. Figure 1 is an example of a basic 10-year laddered $1 million bond portfolio with a stated coupon of 5%.
Dividing the principal into equal parts provides a steady equal stream of cash flow annually.
Bond investing is not as simple or predictable as it might seem to the casual observer; there are many ways to build a bond portfolio and they each have risks and rewards.
Indexing Bond Strategy
Indexing is considered to be quasi-passive by design. The main objective of indexing a bond portfolio is to provide a return and risk characteristic closely tied to the targeted index. While this strategy carries some of the same characteristics of the passive buy-and-hold, it has some flexibility. Just like tracking a specific stock market index, a bond portfolio can be structured to mimic any published bond index. One common index mimicked by portfolio managers is the Barclays U.S. Aggregate Bond Index.
Due to the size of this index, the strategy would work well with a large portfolio due to the number of bonds required to replicate the index. One also needs to consider the transaction costs associated with not only the original investment, but also the periodic rebalancing of the portfolio to reflect changes in the index.
Immunization Bond Strategy
This strategy has the characteristics of both active and passive strategies. By definition, pure immunization implies that a portfolio is invested for a defined return for a specific period of time regardless of any outside influences, such as changes in interest rates.
Similar to indexing, the opportunity cost of using the immunization strategy is potentially giving up the upside potential of an active strategy for the assurance that the portfolio will achieve the intended desired return. As in the buy-and-hold strategy, by design, the instruments best suited for this strategy are high-grade bonds with remote possibilities of default.
In fact, the purest form of immunization would be to invest in a zero-coupon bond and match the maturity of the bond to the date on which the cash flow is expected to be needed. This eliminates any variability of return, positive or negative, associated with the reinvestment of cash flows.
Duration, or the average life of a bond, is commonly used in immunization. It is a much more accurate predictive measure of a bond's volatility than maturity. A duration strategy is commonly used in the institutional investment environment by insurance companies, pension funds, and banks to match the time horizon of their future liabilities with structured cash flows. It is one of the soundest strategies and can be used successfully by individuals.
For example, just like a pension fund would use an immunization to plan for cash flows upon an individual's retirement, that same individual could build a dedicated portfolio for their own retirement plan.
Active Bond Strategy
The goal of active management is maximizing total return. Along with the enhanced opportunity for returns obviously comes increased risk. Some examples of active styles include interest rate anticipation, timing, valuation, and spread exploitation, and multiple interest rate scenarios. The basic premise of all active strategies is that the investor is willing to make bets on the future rather than settle with the potentially lower returns a passive strategy can offer.
The Bottom Line
There are many strategies for investing in bonds that investors can employ. The buy-and-hold approach appeals to investors who are looking for income and are not willing to make predictions. The middle-of-the-road strategies include indexation and immunization, both of which offer some security and predictability. Then there is the active world, which is not for the casual investor. Each strategy has its place and when implemented correctly, can achieve the goals for which it was intended.