Question

Armed with your basic understanding of bonds and bond markets, your task is, mostly based on external research (outside your book and the material provided in this class) to explain what is the best bond investment strategy going forward, considering the recent large macro event, which is the end of QE and an expected rise in interest rates (accelerated post Trump election win). Keep in mind that you can't simply say I would invest in bonds or I will not invest in bonds. Similar to many bond fund managers, just like myself, you have no option. You have been given billions of dollars in money from investors to invest in the bond market and you can't sit idle, you must go out there and invest it in the bond market. But at the same time, you must be aware of the fundamental trends in the bond market and not blindly invest, but have an appropriate strategy that is customized to the anticipated trends. What I'm looking for here is not much of an individual bond picks, "I'm going to invest in IBM bond or I will invest in Amazon bond" but what bond features should you be looking for that best fits the current bond environment. The big clue here is "duration", so get to know that concept from your book and any other research material. Based on what you find, tell me what's the bond investment strategy you would develop and what features will you focus on when creating the bond portfolio.

Answer 1

A. CRITERIA FOR PORTFOLIO DECISIONS AND FACTORS THAT INFLUENCE PORTFOLIO DECISIONS

Emphasis is on identifying the collective importance of all investor’s holdings. Each portfolio has to be tailored to the particular needs of its owners. The strategies are required to be moulded to the unique needs and characteristics of the portfolio owner. The risk can be reduced by diversifying the portfolio. Since risk and returns are related, the important decision to make is the amount of risk, which is acceptable. Following criteria should be considered:

1. Investor’s Characteristics
2. Liquidity needs
3. Tax considerations
4. Safety of Principal
5. Assurance of Income
6. Investment Risk
7. Interest Rate Risk
8. Business and Market Risk

B. STEPS IN CREATING SOUND PORTFOLIO

This is an ongoing process and following steps are taken:

1. Specification and quantification of investor objectives, constraints and preferences in the form of policy statement.
2. Determination and quantification of capital market expectations for the economy, market sectors, industries and individual securities.
3. Allocation of assets and selection of individual securities.
4. Performance measurement and evaluation of the portfolio to ensure that investor’s objectives are attained.
5. Monitoring the performance and responding to changes in investor objective constraints and capital market expectations.
6. Rebalancing the portfolio whenever necessary.

C. FORMULATION OF PORTFOLIO STRATEGY

After choosing certain asset mix the next step is to formulate an appropriate strategy for the same. There as two strategies available: Active strategy and Passive strategy. Investment professionals follow an active strategy and are aggressive investors who want to earn superior returns after adjustment for risk. There are four key points of active strategy:

(1) Market timing: This involves departing from the normal asset mix to reflect one’s assessment of the prospects of various assets in near future.

(2) Sector rotation: This concept can be applied to both stocks and bonds. When applied to stocks it involves shifting the weightings for various industrial sectors based on their assessed outlook. Whereas when this concept is applied to bonds it involves shift in the composition of the bond portfolio in terms of quality, coupon rate, term to maturity, etc.

(3) Security selection: Security selection involves search for under-priced securities. In case of stocks you can employ fundamental or technical analysis to identify the stocks that can give superior returns while in case of bonds you can choose bonds that offer highest yield to maturity at a given level of risk.

(4) Use of a specialized concept: Another way to get superior returns is applying specialized concepts like growth stocks, out of favor stocks, asset-rich stocks, technology and cyclical stocks.

The passive strategy is based on the assumption that capital market is quite efficient with respect to available information. Therefore getting superior returns through active strategy is considered fruitless. Passive strategy calls for two things. First, creating a well-diversified portfolio at pre-determined level of risk and holding it unchanged over a period of time, unless it becomes inconsistent with the investor’s risk-return preferences.