Fixed Income Portfolios: Bonds

Passive management is most common when an investor wants bonds in order to receive a regular, predictable income-stream and/or return of capital invested at a known future date.

A long term ‘buy and hold’ investment portfolio may focus soley on the safest, AAA issues or it may look for yield enhancement by buying into some higher risk bonds. Whatever the investor’s credit risk and return profile, the portfolio will be assembled out of bond issues which, taken together, will minimise investment risk.

If an investor is putting money into bonds as a secure home for capital which will be needed at a known future date, investment risk can be reduced by maturity matching – picking bonds which mature and repay capital at the date the cash is needed. This nullifies interest rate and price risk.

If there is no exact time-frame for a bond portfolio to mature, or if there aren’t any bonds which are redeemed available near the required maturity date, then sophisticated portfolio management can reduce investment risk by a process called immunisation.

A portfolio of bonds is ‘immunised’ by timing individual bond cashflows ( interest payments and principal repayment) so they balance any price risk. Background interest rates create investment risk by affecting a bond in two ways.

• The relative value of the coupon payment changes when rates change
• and the market price of the bond changes to reflect the new value of its payments

So 'rates up' is bad for a bondholding. The value - in real terms- of its fixed payments goes down. But the rising rate does offer the bondholder an opportunity for gain.

If there is a coupon payment due from the bond, this cash can now be reinvested at a higher rate than before. The idea of immunisation is to create a portfolio with cashflows timed so there can always be offsetting reinvestments of cashflow made to offset bond value declines caused by changes in background interest rates.

So passive management doesn't just look for bonds with the highest yield to maturity within the chosen currency, market and risk rating. It also makes sure that the timing of future cashflows (both interest and principal repayments) maximise returns for a given risk profile.

The other way to try to maximise returns for any given risk profile is to actively manage the portfolio.