Bond investors can choose from many different investment strategies,
depending on the role or roles that bonds will play in their investment
portfolios.
Passive investment strategies include buying and
holding bonds until maturity and investing in bond funds or portfolios
that track bond indexes. Passive approaches may suit investors seeking
some of the traditional benefits of bonds, such as capital preservation,
income and diversification, but they do not attempt to capitalize on
the interest-rate, credit or market environment.
Active
investment strategies, by contrast, try to outperform bond indexes,
often by buying and selling bonds to take advantage of price movements.
They have the potential to provide many or all of the benefits of bonds;
however, to outperform indexes successfully over the long term, active
investing requires the ability to form opinions on the economy, the
direction of interest rates and/or the credit environment; trade bonds
efficiently to express those views; and manage risk.
Passive strategies: Buy-and-hold approaches
Investors seeking capital preservation, income and/or diversification may simply buy bonds and hold them until they mature.
The
interest rate environment affects the prices buy-and-hold investors pay
for bonds when they first invest and again when they need to reinvest
their money at maturity. Strategies have evolved that can help
buy-and-hold investors manage this inherent interest-rate risk. One of
the most popular is the bond ladder. A laddered bond portfolio is
invested equally in bonds maturing periodically, usually every year or
every other year. As the bonds mature, money is reinvested to maintain
the maturity ladder. Investors typically use the laddered approach to
match a steady liability stream and to reduce the risk of having to
reinvest a significant portion of their money in a low interest-rate
environment.
Another buy-and-hold approach is the barbell, in which money is invested
in a combination of short-term and long-term bonds; as the short-term
bonds mature, investors can reinvest to take advantage of market
opportunities while the long-term bonds provide attractive coupon rates.
Other passive strategies
Investors seeking
the traditional benefits of bonds may also choose from passive
investment strategies that attempt to match the performance of bond
indexes. For example, a core bond portfolio in the U.S. might use a
broad, investment-grade index, such as the Barclays Capital U.S.
Aggregate Index, as a performance benchmark, or guideline. Similar to
equity indexes, bond indexes are transparent (the securities in it are
known) and performance is updated and published daily.
Many
exchange-traded funds (ETFs) and certain bond mutual funds invest in the
same or similar securities held in bond indexes and thus closely track
the indexes’ performances. In these passive bond strategies, portfolio
managers change the composition of their portfolios if and when the
corresponding indexes change but do not generally make independent
decisions on buying and selling bonds.
Active strategies
Investors that aim to
outperform bond indexes use actively managed bond strategies. Active
portfolio managers can attempt to maximize income or capital (price)
appreciation from bonds, or both. Many bond portfolios managed for
institutional investors, many bond mutual funds and an increasing number
of ETFs are actively managed.
One of the most widely used
active approaches is known as total return investing, which uses a
variety of strategies to maximize capital appreciation. Active bond
portfolio managers seeking price appreciation try to buy undervalued
bonds, hold them as they rise in price and then sell them before
maturity to realize the profits – ideally “buying low and selling high.”
Active managers can employ a number of different techniques in an
effort to find bonds that could rise in price.
- Credit analysis: Using fundamental, “bottom-up” credit analysis, active managers attempt to identify individual bonds that may rise in price due to an improvement in the credit standing of the issuer. Bond prices may increase, for example, when a company brings in new and better management.
- Macroeconomic analysis: Portfolio managers use top-down analysis to find bonds that may rise in price due to economic conditions, a favorable interest-rate environment or global growth patterns. For example, as the emerging markets have become greater drivers of global growth in recent years, many bonds from governments and corporate issuers in these countries have risen in price.
- Sector rotation: Based on their economic outlook, bond managers invest in certain sectors that have historically increased in price during a particular phase in the economic cycle and avoid those that have underperformed at that point. As the economic cycle turns, they may sell bonds in one sector and buy in another.
- Market analysis: Portfolio managers can buy and sell bonds to take advantage of changes in supply and demand that cause price movements.
- Duration management: To express a view on and help manage the risk in interest-rate changes, portfolio managers can adjust the duration of their bond portfolios. Managers anticipating a rise in interest rates can attempt to protect bond portfolios from a negative price impact by shortening duration, possibly by selling some longer-term bonds and buying short-term bonds. Conversely, to maximize the positive impact of an expected drop in interest rates, active managers can lengthen duration on bond portfolios.
- Yield curve positioning: Active bond managers can adjust the maturity structure of a bond portfolio based on expected changes in the relationship between bonds with different maturities, a relationship illustrated by the yield curve. While yields normally rise with maturity, this relationship can change, creating opportunities for active bond managers to position a portfolio in the area of the yield curve that is likely to perform the best in a given economic environment.
- Roll down: When short-term interest rates are lower than longer-term rates (known as a “normal” interest rate environment), a bond is valued at successively lower yields and higher prices as it approaches maturity or “rolls down the yield curve.” A bond manager can hold a bond for a period of time as it appreciates in price and sell it before maturity to realize the gain. This strategy has the potential to continually add to total return in a normal interest rate environment.
- Derivatives: Bond managers can use futures, options and derivatives to express a wide range of views, from the credit-worthiness of a particular issuer to the direction of interest rates.
- An active bond manager may also take steps to maximize income without increasing risk significantly, perhaps by investing in some longer-term or slightly lower rated bonds, which carry higher coupons.
