Bonds have acquired tremendous significance and managing a portfolio of bonds has become fairly complex. Bond investors may follow a variety of strategies raging from passive to active.
Many investors believe that securities at fairly priced in the sense that expected returns are commensurate with risks. Such a belief supports a passive strategy, implying that the investor does not actively try to outperform the market.
Of course a passive strategy does not mean that the investor does nothing. Even a passive investors will have to (1) determine whether bonds are suitable investment avenues for him, (2) assess risks (default risk, call risks and so on) and reasonably diversify his holdings and (3) periodically monitor his bond portfolio to ensure that his holdings match has risk preferences and objectives.
Two commonly followed strategies by passive bond investors are”: buy and hold strategy and indexing strategy.
Buy and Hold Strategy:
An investor who follows a buy and hold strategy selects a bond portfolio and stays with it. He does not churn his bond portfolio in an attempt to improve returns and/or reduce risk. Obviously such an investor chooses a bond portfolio that promises to meet his investment objectives and hence spends time and effort in his initial selection.
If the capital market is efficient, efforts to find under priced securities or to time the market may be futile. Empirical research on this issue suggests that most investors are unlikely to outperform the market. Hence, they may find an indexing strategy appealing. Such a strategy calls for building a portfolio that mirrors a well known bond index. In the US, two well known bond indices are the Shearson Lehman Index and the Salomon Brothers Index, i-BEX is a popular bond index in Index.
Immunization: A Hybrid Strategy
As interest rates tend to change over time, bondholders are exposed to interest rate risk. Interest rate risk may be split into two parts: (1) the price risk, stemming from the inverse relationship between bond prices and required rate of return and (2) the reinvestment risk arising from the rate at which interest income can be reinvested in future.
Note that price risk and reinvestment risk move in opposite directions. If the interest rate goes up it has consequences for the bond holder: (1) the price of the bonds falls, and (2) the return on reinvestment of interest income improves. By the same token, if that interest rate declines, it has two consequences for the bond holder; (1) price of the bond rises, and (2) the return on reinvestment of interest income decreases.
Can a bond holder ensure that these two opposite effects are equal so that he is immunized against interest rate risk? Yes, it is possible if the bondholder chooses a bond whose duration is equal to his investment horizon. For example, if the bondholder’s investment horizon is four years he should choose a bond that has a duration of four years if he wants to insulate himself against interest rate risk. If he does so, whenever there is a change in interest rate, losses (or gains) in capital value will be exactly offset by gains (or losses) on reinvestments.
The concept pf immunization may be illustrated with an example. An investor who has a four year investment horizon wants to invest Rs 1,000 so that his initial investment along with reinvestment of interest grows to Rs 1607.5. This means that the investor wants Investment to earn a compound return of 12.6 percent [1000 (1.126)4= 1607.5]
The investor is evaluating two bonds A and B:
Par value A Rs 1,000 B Rs 1,000
Market price A Rs 1,000 B Rs 1,000
Coupon rate A 12.6% B 12.6%
Yield to maturity A 12.6% B 12.6%
Maturity period A 4 years B 5 years
Duration A less than 4 years B 4 years
The above table shows what happens we the investors buys bond A and bond B under different assumptions about market yield. Part 1 of the exhibit shows that bond A cumulates to Rs 1607.6 if the market yield remains at 12.6 percent. Part II of the exhibit shows that bond A cumulates to Rs 1584.8 the market yield falls to 10.0 percent in year 2. Part III of the exhibit shows that bond B will produce Rs 1607.6 at end of year four if the market yield remains at 12.6 percent. Part IV of he exhibit sows the bond B will produce Rs 1608.4 at the d of year four If the market yield fails to 10.0 percent in year 2.Note that in the case if bond B it will have to be sold at the end of year 4. If the yield remains changed it will be at par, but the yield falls it will sell at a premium.
The above table it is clear that bond B whose duration equals the investment horizon, immunizes the portfolio against interest rate risk, whereas bond B, whose durations is not equal to investment horizon, does not immunize the portfolio against interest rate risk. Remember that we are talking of duration not maturity.