BOND INVESTMENT STRATEGIES
Did you know that bond investment may look a very plain vanilla kind of task, but it is not. Just as there are strategies in equities and derivatives, there are bond investment strategies too, where the risk reward can be defined more precisely. In bond management strategies, you take a market situation and try to earn returns by managing the returns and the risk with greater alacrity and felicity.
Some of the bonds come with strategy characteristics. For instance, convertible bonds are a kind of strategy in itself. Similarly, tax-free bonds are also a real return strategy in itself. However, we are not talking just about individual bonds. The focus will be on much larger bond portfolio management strategies. Here we look at 5 such strategies.
Table of Content
1. Ladder Strategy for Bonds
Investing in bonds is a lot beyond just finding the fixed income security with the highest yield or the lowest risk. There are strategies that minimize risk, enhance liquidity and offer diversification. We will look at the popular bond laddering strategy as the first available strategy. Bond laddering is creating a portfolio array of bonds of relatively equal amounts with staggered maturities. Laddering allows the invest to invest at regular intervals of phased maturities, minimizing interest rate and reinvestment risk.
To understand bond laddering strategy, visually construct a real ladder and how it looks when placed against a wall. Assume each rung of the ladder represents a bond. As each bond matures, you logically reinvest the principal at the current interest rates. For example, you assume that the bond ladder has bonds with maturities of 2, 4, 6, 8, and 10 years. When the first bond matures at the end of 2 years, the said money is reinvested in a bond with a 10-year maturity. This maintains the ladder that you have constructed.
Pros and Cons of a ladder strategy?
Let us look at some of the advantages of the ladder strategy.
• You don’t need to take any active view on interest rate swings. To that extent, this becomes more of a smart passive approach.
• Since your ladder has an array of bonds with different maturities available with you, this offers a consistent interest revenue stream.
• Ladder, by default, is based on churning the bond portfolio. As it matures, it provides the liquidity and the opportunity to reinvest funds.
• We talk of diversification across asset classes, but don’t focus on diversification across maturities. Laddering offers that.
• Since the strategy of laddering is largely defensive and passive in nature, it has the potential to lower the expenses involved.
Let us now turn to the disadvantages or downsides of ladder strategy.
• Laddering is more of a defensive and conservative strategy which does manage risk but does not maximize returns.
• Laddering is not the best strategy for anyone with small amounts of money to invest. Being an array strategy, laddering requires a much bigger capital of Rs25 lakhs plus.
• Some of the longer tenure bonds may have the call feature for the issuers. If the bond is called back, then the entire array of bond could get negatively impacted.
2. Bond Barbell strategy
A barbell is a weight product with a thin middle and heft at the two corners. The Bond Barbell strategy is exactly similar to that. What you do in a Bond Barbell strategy is that you create a bond portfolio whose assets are mostly concentrated in short-term and long-term bonds with few bonds in intermediate maturities. The overall combination looks like a Barbell in terms of concentration and hence the name Bond Barbell strategy.
Like the Barbell, this strategy has heavy concentration of investments at the ends of the barbell with lesser amounts or nothing in the middle of the barbell. However, what you need to remember is that this strategy has a large chunk of short term bonds. These have to be constantly traded as they mature. Hence, this strategy needs an adept trader to manage payoffs properly.
Pros and Cons of a Bond Barbell strategy?
Here are some of the advantages of the Bond Barbell strategy.
• The longer end of the yield curve is used to captures high yields from longer maturities while the shorter maturities are used to minimize interest rate risk. This normally works well in the long run.
• Like the Bond laddering strategy, the barbell strategy also offers a good diversification although the focus is more on the long end and the short end only. That is unlike the laddering strategy that also has focus on the middle end.
• Since a major chunk of the bonds are at the short end of the curve, it gives ample liquidity and flexibility so that emergencies can be easily handled.
Let us turn to the disadvantages or downside risks of the Bond Barbell strategy.
• The focus of the Barbell strategy at the short end and the long end tends to take the focus away from the intermediate maturities.
• This is a very smart and active strategy and hence it requires consistent monitoring of short-term investments to replace those that are maturing. This is very active.
• Since chunk of the investments in this Bond Barbell strategy are at the long end with long duration, this strategy is vulnerable to loss of principal on long-term investments, should the interest rates harden in the economy.
3. Bond swap strategy
A bond swap strategy entails selling one bond and immediately using the proceeds to buy another bond. The very name swap means an exchange of one bond for another. Here is how the bond swapping strategy works. You can opt to sell a bond at a certain loss and use the proceeds from the sale to buy a better-performing bond. You can write off the losses on the sale but potentially you would end up getting a better return on the purchase.
Let us look at some of the major advantages of the Bond Swap strategy. Firstly, the bond swap strategy is useful to reduce your tax liability since the losses are being written off against your existing income. This offers a higher post tax return. Bond swap strategy also offers you portfolio diversification due to the spread of bonds purchased. Typically, a swap is done ahead of anticipated rate changes. Like if you expect the rates to go up, then you can swap out of long duration bonds to reduce depreciation risk. You can also swap low quality bonds for higher quality bonds to improve credit quality.
There are some downside risks too in a Bond Swap strategy. There are tax implications like short term gains and long term gains when you constantly swap the bonds. Also, a bond swap could result in the tax break being denied by the CBDT, which is a potent risk and could change the economics of the Bond swap totally.
4. Callable Bond protection strategy
This is a very specific strategy pertaining to callable bonds. In callable bonds, there is a risk that the bonds could be called back and the high yields would cease to exist mid-way, forcing you to worry about your so called committed yields. Is there a strategy to neutralize or mitigate this risk of callable bonds. This callable bond risk happens when the bond is offering high yields and the rates fall sharply enough to trigger a call back.
If the bond is callable, you need call protection for the time frame when it becomes callable and if the interest rates are also edging lower. The first step is to find bonds that are non-callable and compare their yields to callable bonds. Invest the proceeds of the called bonds in this non-callable bond the moment it is called.
5. Passive strategies in bonds
The most common is bond indexing or just investing in a bond index instead of buying the bond per se. This works well for large institutional investors who don’t want to get into specific bond risks.
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