Bond Investment Strategies to Optimise Your Performance
By Acceler8now.com Bond Investing Team, August, 2007
Bond investing requires, you would expect, strategies for success, unless you do not aim to achieve specific objectives. But you do, because that is why you are investing, in the first place. Since you don't control the market and the variables that affect it, you obviously need an approach that aims to safeguard your interest and meet the investment goals you set. How do you develop a personal investing strategy for the bond market? Here is a guide, which may assist you.
Clarify Your Goal and Timeframe
This step is basic. You need to know why you want to include bonds in your portfolio. It could be income, a lump-sum payment at a future date, your risk psychology, overall portfolio diversification or whatever. Especially in markets where you have a diversity of bond features, that definition of purpose will help qualify investment options you want to consider for acceptance.
Decide Your Exposure
What level of investment are you looking at? This should tie in with your portfolio asset allocation where you have defined the proportional investment in this asset class. Set a figure of what you will commit.
Trade or Hold?
While there may no hard and fast rule pigeonholing you into either option, you need to be clear in your mind whether you intend to actively trade or buy and hold. Both positions require different approaches, since, obviously, a trader has a more compelling need to track the market. When you buy and hold, you save yourself that trouble of closely chasing market trends - aftera ll, you'll get your money at maturity - but you also lose the potential to possibly grab some capital gains that the market could throw up. Buy and hold will serve you if the idea is to keep your principal intact to a future date and/or to earn a steady stream of income. In that case too, a callable bond that can truncate that process, will not be attractive. You will therefore be interested in the quality ratings of bonds, their coupon rates, maturity and, going by the last statement, any call features. You need high quality, low default-risk holdings and you want higher coupons. On the other hand, if you want to play the market for gains, you need to wear trading shoes. Trading requires serious interest rates analysis, especially as to determining the direction and change-scope of interest rates, because of their impact on bond prices. A trader will also keep analysing bond values, like the value stock investor, to find where bond under-valuation may be present as this offers investment opportunity. Similarly, credit analysis of issuers will help determine those that their default-risk status may shift, meaning that expected resultant price movements can be taken advantage of. Obviously, trading is a more involved process, but this is justified on the expectation of gains that generate higher returns than when you hold. Active trading supports a total return strategy where you target income (from coupon payments) as well as capital appreciation (gains), in the hope that both exceed the former if you should hold to maturity. And if you want the best of two worlds, you marry the two strategies.
Specific Instruments or a Fund
This is another important strategy decision to take. You could choose to buy specific bonds for your portfolio, especially if you are comfortable with reading the bond market. Another available option, which will suite a beginner, is to identify a bond fund to invest in. Bond fund here refers to a managed fund (bond mutual fund), investing in bonds, which an investor can buy into, indirectly investing in bonds. So, instead of owning specific bonds with definite maturity dates, you own units of the fund (whose value can appreciate) and share in the earnings of the fund. Such funds enjoy the benefit of professional management, spare you the trouble of following the market and most likely, offer better diversification as the fund is likely to invest in more issues than you will. Naturally, the overhead costs of the business eat into the earnings, just as the fund manager can choose to take more risk than you would and possibly lose some money. So, decide whether to run your show or settle for a professionally managed fund.
Income Versus Quality
Your strategy will also define a relationship between income expectation and asset quality. Higher bond quality translates to lower yield and vice versa. This factor is perhaps superfluous in a market environment like ours that currently offers only government bonds, usually of low relative yield, but if you have to buy in other markets, you need to take a position on the income-risk trade-off continuum.
Long or Short
What kind of maturities will work best with your investment plan? Bonds are short, intermediate or long-term and these maturities have implications for bond pricing and yield. Longer-term bonds will provide opportunity for higher coupons and that's because you face higher risk over a longer bond term. Something could go wrong with the issuer, for instance, over a long stretch. Or, are you expecting to use your funds much sooner, in which case a short or medium term holding will better match your requirement.
Portfolio Strength
Diversification is an important reason for bond investment. That objective calls
for a purposeful spread of your bond portfolio. In effect, portfolio management would dictate a holding of a set of carefully chosen bonds as against, for example, investing exclusively in one. What factors influence your selection? Different issuers instead of one, for instance. Different classes to balance income and quality (some Federal Government, some corporate). Different maturities to spread the risk and cash inflow. While bondholding should be part of the overall portfolio structure to manage risk, ensuring further diversification of the bond portfolio goes further in advancing that goal.
Ladder for Interest Risk Management
Laddering will stack bond maturities so that you have holdings that mature at set intervals. You could have some bonds maturing every half yearly, yearly, each two years, etc. This puts you in fund at those intervals since the principal is received. More importantly, you spread the interest risk.  Check what would happen if all your bonds matured in a single year of low interest rate. Hold your funds and possibly spend them or re-invest at the low current rate? When you stagger maturities, only a fraction will mature in a period. Though if rates are attractive you'd wish you had more funds free for reinvestment, but a spread approach balances out extremes. Related strategies are barbell and bullet. With barbell, you target the maturity extremes of short and long. Long maturities aim to capitalise on the higher yields that they attract while the shorts help you come into funds to re-invest if good market opportunities arise. Bullets target a coinciding maturity, with bonds bought at various times being to the same maturity date. This will matter, for instance, if there is a project to execute with the proceeds.
Tax Management
If you are aiming to rein in on the tax liability on your earnings, then bonds that enjoy a tax advantage will be the core of your strategy. The Government bonds will fit that bill as the FGN bonds are interest-free.
Obviously, there are many factors that would matter to different bond investors. As would be expected, various preferences do conflict, requiring a trade-off. In the end, you only seek to optimise your performance, given your preferences. As with all investing, it's important to hone your strategies as you embark on bond investing. That ensures that the positions you take are in tune with your investment objectives.
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