To the casual observer, bond investing would appear to be as simple as buying the bond with the highest yield and holding onto it until it reaches maturity. While this works well when shopping for a certificate of deposit (CD) at the local bank, it doesn't work in the wider world of debt investing.
A number of options are available for 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
- Owning a bond portfolio can generate steady income, but bond prices are sensitive to interest rate changes.
- An active approach requires staying ahead of interest rate moves.
- An immunization approach reduces the impact of interest rate changes on a portfolio's value.
The 4 Bond Management Strategies
Passive investing is for investors who want predictable income.
Active investing is for investors who want to make bets on the future.
Indexation and immunization fall in the middle. They offer some predictability, but not as much as a passive strategy will produce.
Passive Bond Management Strategy
The passive buy-and-hold investor is looking to maximize the income-generating properties of bonds. Buy and hold involves purchasing individual bonds and holding them to maturity.
To the passive investor, bonds are a safe, predictable source of income. The cash flow can contribute immediately to the investor's income or can be reinvested in other bonds or other assets.
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.
A Stable Anchor
On the surface, this may appear to be a lazy style of investing. 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.
A passive strategy works 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 investor's 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 issuer to act on those options under specified market conditions.
Example of a 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%. Due to the company's good credit rating, it is able to buy back the bonds at a predetermined price and reissue them at a 3% coupon rate. This is good for the lender but bad for the borrower.
Bond Laddering in Passive Investing
Bond laddering is one of the most common forms of passive bond investing. The investor divides the portfolio into equal parts, then buys bonds that mature on different dates. Each maturity date represents a "rung" on the ladder, which is the investor's entire time horizon.
As the bonds reach maturity, the proceeds are reinvested at the currently available rate. This strategy reduces the impact of fluctuation in bond rates.
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 each year.
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 each has its 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 Bloomberg 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 the original investment and the periodic rebalancing of the portfolio to reflect changes in the index.
Immunization Bond Strategy
The immunization strategy has some of the characteristics of both active and passive strategies. It seeks to match the duration of assets and liabilities (such as discounted future cash flows required by the portfolio) to protect against interest rate fluctuations.
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 immunization strategy potentially gives 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, the instruments best suited for this strategy are high-grade bonds with remote possibilities of default.
Eliminating the Variables
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.
The duration strategy is commonly used 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.
A pension fund might use an immunization strategy to plan for cash flows for an individual's retirement. The same individual could build a dedicated portfolio independently.
Active Bond Strategy
The goal of active management is maximizing total return. Along with the enhanced opportunity for returns comes increased risk.
Some examples of active styles include interest rate anticipation, timing, valuation, 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 for the potentially lower returns a passive strategy offers.
What Is a Bond and Why Would I Invest in Them?
A bond is essentially an IOU. When a corporation, a government, or some other agency wants to raise a sum of money, it might issue a round of bonds. Investors buy the bonds in return for a set amount of interest, usually paid in installments. When the bond reaches its maturity date, the issuer returns the original sum invested.
High-quality bonds represent a reasonably safe alternative for the investor. "High-quality" means the bonds come with a rating of BBB- or better from one of the three major bond rating agencies.
The return the investor will get is known up front. The rating indicates that the company is extremely likely to pay the interest and return the principal.
Are Bonds a Good Investment When Inflation Is High?
When inflation rises, the interest rates on newly-issued bonds typically will increase in order to remain competitive.
The same trend, however, causes the value of existing bonds to decrease on the secondary bond market. The existing bonds cannot compete with newer, higher-paying bonds.
That is why it is often said that bond prices are inversely related to interest rates.
Price fluctuations in the secondary bond market have no impact on the value of bonds being held to maturity by investors.
Can I Lose Money Investing in Bonds?
An investor is highly unlikely to lose money on bonds as long as the bonds are investment quality, meaning they are rated BBB- or better.
That is the reason that investors prize bonds. They provide a steady, reliable income with little chance of a loss of principle.
The risk in bonds lies in the potential for missed opportunities. If an investor buys a one-year bond that pays 3.9 percent interest in March and new bonds issued four months later pay 4.3 percent, the investor has missed an opportunity for a better return.
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.