A bond portfolio might look like the safest bet to investors, and some might think that it is a risk-free investment option, but this is not true. While bonds are safer as compared to equity investments, they still carry some amount of risk and hence require planning and management. Effective bond portfolio management strategies can help yield higher returns and reduce the risk considerably. There are various bond portfolio strategies and different types of bonds that can be used to maximize returns and minimize risk. Including the right types of bonds in your portfolio can help you diversify your bond portfolio to earn maximum returns. This article talks about the various bond portfolio management strategies that you can implement.
What is a Bond Portfolio?
A bond portfolio is a group of investments predominantly composed of bonds. Bind portfolios are also known as fixed income portfolios as the bonds provide income in the form of coupons. Bonds are a better option when compared to savings bank accounts as they provide higher returns, and the risk can be minimized with a well-balanced and diversified bond portfolio. A bond having a 5% interest rate and a face value of $2000 when trading at its par value will yield $100 every year to the bondholder as a fixed income. If the value of the bond increases above $2000, it will provide further income to the bondholder.
Effective Bond Portfolio Strategies
However, bond management might look simple, but the wide variety of bonds available makes it integral to select the right bond portfolio management strategy. All the portfolio management strategies have their own risks and rewards.
A passive investing strategy or a buy-and-hold investment strategy is a strategy where the investor aims at maximizing the returns by holding them to maturity. Bonds are predictable in nature, and a passive investor is looking to earn maximum returns without having to worry about the future direction of interest rates and the bond value. The full coupon amount is received on the maturity of the bond at par value. The passive investment strategy is a great way to ensure the stability of income in times of financial crisis. It eliminates all types of costs, including transaction costs.
Bond laddering is one of the most popular passive investment strategies. In this type of strategy, the investment is divided into equal portions and invested within the investment horizon of the investor.
Indexing strategy aims at creating a portfolio that can give returns similar to a targeted bond index. The inventors invest in specific bond indexed like Barclays Capital Aggregate bond index. The performance of the bond index is measured by the total returns over the investment horizon. Indexing strategy provides the investors with more control over the investments and allows them to manage their bond portfolio. The transaction costs in the case of bond index investment. It also helps the investors eliminate the risk of poor performance by the bond managers. Indexing is a quasi-passive investment strategy that is similar to the buy and hold strategy but has more flexibility. The indexing strategy focuses on replicating or mimicking the bond index, and therefore a larger portfolio is required in this type of strategy.
Bond immunization strategy is a combination of both active as well as passive investment strategies. It helps eliminate the risk of interest rate fluctuations. The investment horizon of the investor is matched with the duration of the portfolio to make the investments immune to any interest rates risk. This strategy focuses on achieving the desired amount of return by investing with a target to earn a specified sum by the end of a certain period. Immunization strategy is also known as duration matching strategy and is based on the principle of matching the change in the value of the portfolio with the returns from reinvesting the portfolio cash flows.
The active bond strategy focuses on maximizing the total returns from the bond portfolio. Unlike passive management strategies and immunization strategies, the active bond portfolio management strategy does not aim to eliminate risk and focuses on the total returns. The investors following an active strategy have a higher risk tolerance than passive investors and are willing to take the risk of anticipating the future direction of the interest rates. In this type of strategy, the investor selects some of the bonds rather than following the entire bond index to gain higher returns. Active bond portfolio strategy requires constant tracking and analysis by the investor or the portfolio manager. There are different types of active strategies. Let us look at some of them.
Anticipating Interest Rates
Interest rate anticipation strategy involves anticipating the future change in interest rates and the value of the bond. Any change in interest rates has a greater effect on the value of long-term bonds. Holding long-term bonds at a time when the interest rate is falling can yield high returns and vice versa. The relationship between interest rates and bond value is inverse in nature.
Sector rotation strategy involves increasing or decreasing the weight of a particular bond in the portfolio depending on the various industry or sector-related factors. Portfolio managers generally compare the performance of their portfolio against the targeted index.
Security selection strategy involves analyzing the fundamentals and credit risk of the bond. It analyzes the possibility of earning payments throughout the term of the bond. Statistical methods are used to conduct the credit analysis of bonds.
Despite the risks associated with an investment in bonds, the above strategies can help minimize the risks and maximize the returns at the same time. You can select the most suitable bond portfolio management strategy for yourself on the basis of your investment horizon, investment amount, and risk tolerance. If you have a very low-risk tolerance, you can opt for a passive or immunization strategy, and if you have a comparatively higher risk tolerance, an active strategy would be a better option.