Issue: April/May 2006
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How to optimise returns on a bond portfolio


Bond buzzwords are so baffling it's tempting to avoid the detail and rather concentrate on the results. But in our efforts to keep it simple we might be missing out on some worthwhile opportunities to maximise bond returns. Modem bond (or fixed interest) management has many sources of added value which should be considered when constructing a bond portfolio. Perhaps these are best explored when armed with an understanding of a few of those bond buzzwords:

Bond Basics

  • Issuers of bonds are commonly government, parastatals, and more frequently, companies or corporates.
     
  • The owner of a bond has a claim against the issuer of the bond for the original loan (capital) plus interest. 
     
  • The interest rate for the bond will depend on current interest rates in the market and the risk rating of the issuer.
     
  • In general, the longer the money is to be borrowed for, the higher the interest rate on the bond. (Because more things can go wrong over time). In other words, the longer the duration of the bond, the higher the interest rate. In normal market circumstances there should be a steady increase in the interest rate paid - from short to long-duration bonds. This is Known as the yield curve.
     
  • In South Africa, bonds are quoted in yields, not prices. 
     
  • A bond issued at 8% interest a year initially has a yield of 8%. At all times the physical amount of interest paid out will be at a rate of 8%, i.e. 8c for every R1 of the bond held. But, should the prevailing market interest rates drop to 4%, the bond will become more valuable as it is paying out more than the prevailing market interest rate. The price of the bond should thus rise in order to reflect this increased value. As a general rule, when interest rates fall, the price of an existing bond increases. Similarly, when interest rates rise the price of an existing bond decreases. 
     
  • Long-duration bonds have a longer time before the capital and interest is paid and prices are therefore more sensitive to interest rate movements.

Modernised Bond Management

Bond management has traditionally been about forecasting interest rates and positioning the portfolio to take advantage of expected changes in interest rates. It focused on changing the average time to maturity (known as duration), of the bond investments in the portfolio to reflect any expected changes in the general level of bond yields. These changes might be due to inflation, interest rate forecasts or general conditions in the local and international bond market. Whilst duration is important, there are many other sources of added value that can be used in managing bonds, as shown in the diagram on the right.

Yield curve positioning is how the portfolio is invested across the different durations along the yield curve. The decision as to how much to invest along the various durations is based on forecasts of how the shape of the yield curve will change. In other words, yield curve positioning analyses whether there is a steady increase in interest rates as you move from the short term bonds towards the very long term bonds {the yield curve}, and attempts to take advantage of any anomalies in the current shape of the yield curve. Like duration management, yield curve positioning is dependent on forecasting changes in inflation and interest rates.

But other sources of value add do not have interest rates as their core driver. Some of these are:

  • The scrip lending market can be used to lend bonds for a fee.
     
  • Volatility trading uses various option strategies to make money by forecasting whether the volatility or rate of change in prices of the bond market will increase or decrease. Volatility trading does not take a view on whether the bond market is cheap or not and is thus market neutral.
     
  • Alternative strategies are varied in nature but typically will exploit very specific views, for example any mismatch between the bond yield curve and the swap curve. (A swap arises when a bond investor owns a bond with a fixed interest rate which he swaps for a floating rate)
     
  • One of the biggest growth areas in the bond market has been in credit. This refers to investments in non government-guaranteed and corporate debt. Credit bonds usually uffer higher yields than government bonds as they are riskier. The key is to ensure that credit risk is well diversified by investing in small quantities of lots of credit bonds. Large concentrated investments in the credit bonds of any single company can lead to large losses should the company fail. If a corporate bond is unable to meet its interest payment commitments, it should be of a small enough size in the portfolio to not excessively harm performance. Therefore, there should be a whole range of attractively priced credit bonds held in small quantities which collectively add to performance.
Bond Portfolio Construction

Bond mandates need to be modernised so that these opportunities can be exploited

The greater the number of opportunities available to maximise returns, the more diversified a bond portfolio becomes. The more diversified a bond portfolio, the lower the risk of the portfolio and the greater the chance of consistent outperformance.

Modem bond mandates need to be structured so that funds are not restricted to investing in too few strategies. The more restrictive the mandate, the higher the chance of excessive risk in the few permitted strategies in the hope of meeting performance targets.

Funds need to use all the potential sources of value-add in today's low return world. Widening the availability of investment opportunities optimizes bond returns, on a risft-adjusted basis. More than ever today, the risk to a client increases as the restrictiveness of the mandate increases.