Fixed Income Portfolio Management
What is Fixed Income Portfolio Management?
Fixed-income portfolio management is the process of building and managing portfolios containing bonds, also known as fixed-income securities. Bondholders receive regular coupon payments at a specified interest rate until the bond matures, at which point the principal is repaid. Bonds are considered to carry lower risk compared to equities and therefore typically offer a lower expected return. Nevertheless, there are different types of fixed-income securities with a range of risk-return profiles. Investors often choose bonds to generate stable and regular income. Since bonds are highly sensitive to interest rates and inflation, fixed-income portfolio managers don’t focus on the same factors as equity portfolio managers do.
Key Learning Points
- Fixed income assets provide predictable returns through regular coupon payments and offer portfolio diversification benefits.
- Although considered to bear lower risk than equities, bond returns are vulnerable to interest rate fluctuations, default risk, and inflation, which can erode purchasing power.
- The asset class is diverse with offerings ranging from virtually risk-free government bonds to speculative high-yield corporate bonds.
- A higher allocation to fixed income typically lowers overall portfolio risk.
What is a Fixed Income Security and What Are the Different Types of Fixed Income?
Fixed income securities are debt-based instruments that offer regular coupon payments to bondholders, who receive the bond’s par (face) value at maturity. This par value is also referred to as the principal. Unlike equities, fixed income assets do not offer the opportunity to benefit from share price appreciation. Rather, they offer lower risk through a more predictable outcome. Both governments and corporations raise money to cover their needs (such as financing projects) by issuing debt securities. Bonds are generally liquid (they can be purchased and sold relatively quickly) and play a critical role in the global financial markets. Companies tap the bond market to raise more than $1tn in financing each year in the U.S. alone. ¹
Fixed-income instruments include a wide range of publicly traded instruments (such as commercial paper, notes, and bonds traded either through an exchange or over the counter) as well as non-publicly traded ones (for example, loans and private placements). Below are some of the most popular types of fixed-income securities:
Government bonds are issued by sovereign governments (for example, US Treasury bonds, also known simply as Treasuries) and are considered to be very low-risk due to their government backing. Governments raise revenue through taxation, ensuring their ability to meet their interest obligations and repay their bondholders. Some other examples of sovereign bonds include UK Gilts, German Bunds and Japanese Government Bonds (JGBs).
Municipal bonds are issued by local governments and are considered very low risk, although slightly riskier than sovereign bonds. Examples include:
- General Obligation Bonds (GO Bonds), which are typically used for financing infrastructure and other public projects like schools and hospitals.
- Revenue bonds are backed by revenue generated from a specific project or source, such as toll roads, airports or public utilities (the revenue from the project supports the repayment of the bond’s principal and interest).
- Housing Authority Bonds are issued to finance affordable housing initiatives. The proceeds are typically used for the construction, improvement, or maintenance of public housing developments. They are backed by rental income and/or state subsidies.
Corporate bonds are securities issued by companies and typically pay a higher rate of interest than do government bonds. In terms of risk, they are categorized as either investment grade or high yield (also known as junk bonds). This categorization is determined by the bond’s credit rating; BBB and above is considered investment grade while anything below is speculative.
An investment grade example is Apple’s bond, which pays a fixed interest rate of 3.25% and matures in 2030. It has a credit rating of AA+.
On the other hand, an example of a high yield bond is a J.C. Penney issue that pays 7.4% and matures in 2037. According to Standard & Poor’s, a leading credit rating agency, the company currently has a credit rating of D.
Convertible bonds can be converted into company stock, typically during pre-determined periods. This allows bondholders to exchange their bonds for a specific number of the issuer’s shares. A convertible bond offers investors an option to benefit from potential share price appreciation should they choose to convert. Because of this option, convertibles offer the potential for higher returns but also carry a higher level of risk. Typical issuers of convertible bonds are companies that may have high growth expectations but a less-than-stellar credit rating. By issuing a convertible, the company can access capital at a lower cost than through a traditional bond.
Asset-Backed Securities (ABS)
Asset-Backed Securities are instruments that are backed by various pools of assets, such as mortgages. When investors buy these securities, their overall return depends on the interest and principal payments accruing to the underlying loans. This diversifies risk and provides liquidity to lenders.
However, the level of risk for each ABS varies depending on the underlying assets.
Collateralized Debt Obligations (CDOs)
Collateralized Debt Obligations are complex debt securities, backed by pools of bonds or loans, with levels of risk varying based on the quality of the underlying assets. They are structured by bundling various types of debt, such as mortgages or corporate loans, into a single security. These are then divided into tranches with varying risk profiles (lower tranches carry more risk but usually offer higher potential returns). Payments from the underlying assets flow through the tranches, providing returns based on their priority in the payment structure (typically starting from the senior tranches, which are considered less risky and take priority in receiving interest and principal payments from the underlying assets).
The Role of Fixed Income in a Portfolio and Why Is It Important?
Fixed income is considered a defensive asset class as bonds are less volatile than stocks. They offer a source of diversification that can help reduce volatility and overall portfolio risk. Through coupon, or interest payments bonds can provide a stable stream of income, cushion against losses in a portfolio, and enhance total returns.
Fixed Income Portfolio Management Strategies
There are various fixed income strategies that allow investors to achieve specific objectives such as generating income or managing risk. Below are three popular approaches.
Laddered Portfolio is a strategy, commonly referred to as “bond ladder investing,” that involves buying fixed-income securities with various maturities (from low to high) to achieve a high level of diversification. This helps reduce risk. Moreover, as bonds mature at the shorter end of the ladder, the proceeds can be re-invested into bonds with longer maturities. This may also enhance potential return.
However, there are also risks associated with laddering, including:
- Reinvestment risk – interest rates could decline, and maturing bonds would be reinvested at lower rates.
- Liquidity risk – bonds with lower credit ratings or smaller issuances may be less liquid, making them difficult to buy or sell in the open market.
- Credit risk – laddered portfolios can be exposed to credit risk if an issuer defaults.
This strategy entails buying fixed-income securities that have the same maturity date on different dates. The approach is suitable for investors who may need a lump sum payment in the future (for example to finance a life event such as university education), as all the bonds in the portfolio will mature on the same date. Bullet portfolios are exposed to liquidity, reinvestment, and credit risks and are more sensitive to interest rate changes. If interest rates increase, the bonds become less attractive while new issues will bear higher interest rates.
This portfolio includes bonds with short-term and long-term maturities but eschews intermediate bonds. The idea behind this strategy is to pay close attention to the short-term issues (typically those with maturities of less than five years) and continue rolling them into new issues on the maturity date. The objective is to achieve the optimal risk-reward outcome, but the portfolio is nevertheless still vulnerable to interest rate, inflation, reinvestment, and credit risks.
Yield curve analysis is widely used by central banks, policymakers, and investors. The yield curve is an indicator of market sentiment and a powerful predictor of economic output and growth that shapes monetary policy and economic forecasts. In addition, it is used as a benchmark lending rates and other debt instruments such as mortgages.
The yield curve plots the interest rates of bonds with equivalent credit ratings but different maturities. The most popular comparison is between 3-month, 2-year, 5-year, 10-year, and 30-year (i.e., the short, intermediate, and long-term rates) U.S. Treasury securities. Nevertheless, a yield curve can be created for municipal bonds or a particular corporate issuer.
Generally, there are four types of yield curve:
- Normal – this is when longer-term bonds have higher yields than shorter-term bonds, creating an upward-sloping yield curve. This indicates a healthy economy.
- Steep – shows a significant difference between short-term and long-term yields, and signals anticipated economic growth.
- Inverted – short-term yields are higher than long-term yields, suggesting an economic downturn or recession.
- Flat – short-term and long-term yields are similar, suggesting uncertain future economic conditions. Sometimes the curve can appear elevated, or “humped” in the middle.
Building a Fixed Income Portfolio
Knowing where to start when constructing a fixed-income portfolio can be challenging as the asset class is large and complex. A conservative “core-satellite” approach could be a solid starting point. Investors typically focus on the “core” by adding high-quality bonds such as U.S. Treasuries and investment-grade corporate bonds, which bear low to moderate credit risk and offer diversification benefits when combined with equities. The “core” should represent a greater proportion of the overall portfolio, while the “satellite” holdings (which are more aggressive in terms of risk, with lower credit ratings and higher default rates, but higher coupons) such as high yield or convertible bonds, should be a smaller proportion. The exact allocation will be determined by the investor’s risk tolerance.
Risk Management and Performance Measurement in Fixed Income
Each fixed income portfolio has an investment objective such as capital preservation (protecting the value of the initial investment) or income generation (creating a regular cash flow by holding income generating assets). In addition to the total return, which represents the value of the securities in the portfolio along with the income distributions generated (ideally over the long-term), analyzing a portfolio’s risk and return should consider several different factors.
The duration of a bond indicates its sensitivity to interest rate changes (how much the bond price fluctuates when interest rates change). It measures interest rate risk, or how much bond prices are likely to change when interest rates move. For example, if a bond has a duration of five years and interest rates rise by 1%, the bond’s price will fall by 5%. However, actual performance may differ due to other factors that can influence bond prices.
Generally, short-term bonds mature in 1 to 3 years, “intermediate term” bonds mature in 3 to 10 years and long-term mature in more than 10 years.
A portfolio’s overall credit quality will depend on the credit quality of the underlying securities, ranging from high quality to speculative. Generally, lower quality issues can potentially deliver returns but will also likely experience greater volatility.
There are three major credit rating agencies: Standard & Poor’s, Moody’s and Fitch. They use a letter scale system to reflect their view of the relative credit risk of a bond, with the highest being AAA and those in default being assigned C and D ratings.
In the simplest terms, a bond’s yield is the return it generates. There are several different types of yield.
Coupon yield is the annual interest rate specified at the bond’s issue. For example, a bond issued with a par value of $1000 will pay $50 in interest annually if the coupon rate is 5%. The terms coupon rate and coupon yield can be used interchangeably.
Current yield is dependent on a bond’s market price and coupon rate. When the bond price changes, the yield changes. It is calculated by dividing the annual coupon income by the bond’s market price. This is the yield that the investor will receive if they buy a bond and hold it for one year.
When bonds are traded in the secondary market, they may sell at a discount (trading lower than the par value) or at a premium (trading above par). When interest rates rise and bond prices fall, current yields rise since the denominator of the equation declines.
Yield to Maturity is the estimated total return an investor earns on a bond if they hold the security until it matures. It is the overall amount of interest that the investor earns over the holding period. It is essentially an internal rate of return calculation; it is the discount rate at which the present value of all future cash flows (interest and principal) is equal to the bond’s current price.
Bond Fixed Income Portfolio Risks
There are a number of different risks that an investor in a bond portfolio is exposed to. Typically, higher risk means higher reward, so a bond portfolio manager can manage exposure to these risks in an attempt to generate higher returns for their portfolio. The main risks that a portfolio manager has to manage include:
Interest Rate Risk
When interest rates increase, the value of bonds can decrease. However, not all bonds react in the same way to changes in interest rates, so portfolio managers can manage their exposure to this level of risk.
When a portfolio manager receives cash flows from their bonds held in their portfolios from coupons or from bonds reaching their maturity date, this money then needs to be reinvested. At the start of an investment horizon, an assumption can be made of the level of reinvestment return that can be achieved, and this is included within the yield to maturity calculation. However, the yield to maturity assumes that cash flows can be reinvested at that yield. If interest rates decrease, then the level of return that can be earned on reinvested cash flows will decrease.
Identifies the risk that a borrower might not make the necessary coupon or principal repayments as they are scheduled to do, but also incorporates the fact that if the risk of that increases, there may be a decrease in the market value of a particular bond. So credit risk doesn’t just capture the risk of default, but also the reduction in market value. If the perception of risk increases.
Fixed income bonds generate a fixed rate of return for an investor. So if inflation is higher than a portfolio manager anticipated, the level of real return after inflation has been accounted for will decrease within a portfolio.
If you invest in overseas bonds denominated in a different currency, then there is a risk that the foreign currency may depreciate in value, which leads to a reduction in the value of that bond in your domestic currency.
Identify which of the following bonds is the most sensitive to interest rate risk assuming a 0.5% change in interest rates.
To find the potential percentage change in price with a change in interest rates, we need to first calculate the current price of the bond (assuming a par value of 100).
Then we need to find the price adjusted to a 0.5% increase in the interest rate and then calculate the percentage change (price after change/previous price – 1). The same should be applied to the calculation assuming a 0.5% decrease in the interest rate.
Then, use the same formula (price after change/previous price – 1) to find out the percentage change. Longer maturities have the highest sensitivity to changes in the interest rate.
Access the fixed-income portfolio management workout to practice this and other fixed-income portfolio management calculations in full.
Overall, fixed-income securities can help investors increase diversification and lower volatility while enjoying stable income. While investors may consider employing different strategies and selecting different types of debt securities to achieve their desired risk-reward outcome, fixed-income portfolio management requires in-depth knowledge of credit risk and duration management. There are many different products from which investors can choose, but portfolio construction and ongoing management will ultimately depend on the investor’s risk profile, time horizon, and desired level of income.