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Chapter 13

Bond Selection

Prof. Rushen Chahal

Prof. Rushen Chahal

To preserve their independence, we must not let our rules load us with perpetual debt. We must make our election between economy and liberty, or profusion and servitude. - Thomas Jefferson

Prof. Rushen Chahal

Introduction The meaning of bond diversification Choosing bonds Example: monthly retirement income

Prof. Rushen Chahal

In most respects selecting the fixed-income components of a portfolio is easier than selecting equity securities There are ways to make mistakes with bond selection

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The Meaning of Bond Diversification

Introduction Default risk Dealing with the yield curve Bond betas

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It is important to diversify a bond portfolio Diversification of a bond portfolio is different from diversification of an equity portfolio Two types of risk are important:
Default risk Interest rate risk

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Default Risk
Default risk refers to the likelihood that a firm will be unable to repay the principal and interest of a loan as agreed in the bond indenture
Equivalent to credit risk for consumers Rating agencies such as S&P and Moody s function as credit bureaus for credit issuers

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Default Risk (cont d)

To diversify default risk:
Purchase bonds from a number of different issuers Do not purchase various bond issues from a single issuer
E.g., Enron had 20 bond issues when it went bankrupt

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Dealing With the Yield Curve

The yield curve is typically upward sloping
The longer a fixed-income security has until maturity, the higher the return it will have to compensate investors The longer the average duration of a fund, the higher its expected return and the higher its interest rate risk

Prof. Rushen Chahal

Dealing With the Yield Curve (cont d)

The client and portfolio manager need to determine the appropriate level of interest rate risk of a portfolio

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Bond Betas
The concept of bond betas:
States that the market prices a bond according to its level of risk relative to the market average Has never become fully accepted Measures systematic risk, while default risk and interest rate risk are more important

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Choosing Bonds
Client psychology and bonds selling at a premium Call risk Constraints

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Client Psychology and Bonds Selling at A Premium

Premium bonds held to maturity are expected to pay higher coupon rates than the market rate of interest Premium bond held to maturity will decline in value toward par value as the bond moves towards its maturity date

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Client Psychology & Bonds Selling at A Premium (cont d)

Clients may not want to buy something they know will decline in value There is nothing wrong with buying bonds selling at a premium

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Call Risk
If a bond is called:
The funds must be reinvested The fund manager runs the risk of having to make adjustments to many portfolios all at one time

There is no reason to exclude callable bonds categorically from a portfolio

Avoid making extensive use of a single callable bond issue

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Specifying return Specifying grade Specifying average maturity Periodic income Maturity timing Socially responsible investing

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Specifying Return
To increase the expected return on a bond portfolio:
Choose bonds with lower ratings Choose bonds with longer maturities Or both

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Specifying Grade
A legal list specifies securities that are eligible investments
E.g., investment grade only

Portfolio managers take the added risk of noninvestment grade bonds only if the yield pickup is substantial

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Specifying Grade (cont d)

Conservative organizations will accept only U.S. government or AAA-rated corporate bonds A fund may be limited to no more than a certain percentage of non-AAA bonds

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Specifying Average Maturity

Average maturity is a common bond portfolio constraint
The motivation is concern about rising interest rates Specifying average duration would be an alternative approach

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Periodic Income
Some funds have periodic income needs that allow little or not flexibility Clients will want to receive interest checks frequently
The portfolio manager should carefully select the bonds in the portfolio

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Maturity Timing
Maturity timing generates income as needed
Sometimes a manager needs to construct a bond portfolio that matches a particular investment horizon E.g., assemble securities to fund a specific set of payment obligations over the next ten years
Assemble a portfolio that generates income and principal repayments to satisfy the income needs

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Socially Responsible Investing

Some clients will ask that certain types of companies not be included in the portfolio Examples are nuclear power, military hardware, vice products

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Example: Monthly Retirement Income

The problem Unspecified constraints Using S&P s Bond Guide Solving the problem

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The Problem
A client has:
Primary objective: growth of income Secondary objective: income $1,100,000 to invest Inviolable income needs of $4,000 per month

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The Problem (cont d)

You decide:
To invest the funds 50-50 between common stocks and debt securities To invest in ten common stock in the equity portion (see next slide)
You incur $1,500 in brokerage commissions

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The Problem (cont d)

Stock 3,000 AAC 1,000 BBL 2,000 XXQ 5,000 XZ 7,000 MCDL 1,000 ME 2,000 LN 4,000 STU 3,000 LLZ 6,000 MZN Total Value $51,000 50,000 49,000 52,000 53,000 49,000 51,000 47,000 49,000 43,000 $494,000 Qrtl Div. $380 370 400 270 0 370 500 260 290 170 $3,010

Payment Month Jan./April/July/Oct. Jan./April/July/Oct. Feb./May/Aug./Nov. March/June/Sept./Dec. -Feb./May/Aug./Nov. Jan./April/July/Oct. March/June/Sept./Dec. Feb./May/Aug./Nov. Jan./April/July/Oct.

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The Problem (cont d)

Characteristics of the fund:
Quarterly dividends total $3,001 ($12,004 annually) The dividend yield on the equity portfolio is 2.44% Total annual income required is $48,000 or 4.36% of fund Bonds need to have a current yield of at least 6.28%

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Unspecified Constraints
The task is meeting the minimum required expected return with the least possible risk
You don t want to choose CC-rated bonds You don t want the longest maturity bonds you can find

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Using S&P s Bond Guide

Figure 13-1 is an excerpt from the Bond Guide:
Indicates interest payment dates, coupon rates, and issuer Provides S&P ratings Provides current price, current yield

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Using S&P s Bond Guide (cont d)

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Solving the Problem

Setup Dealing with accrued interest and commissions Choosing the bonds Overspending What about convertible bonds?

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You have two constraints:
Include only bonds rated BBB or higher Keep the average maturities below fifteen years

Set up a worksheet that enables you to pick bonds to generate exactly $4,000 per month (see next slide)

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Setup (cont d)
Security 3,000 AAC 1,000 BBL 2,000 XXQ 5,000 XZ 7,000 MCDL 1,000 ME 2,000 LN 4,000 STU 3,000 LLZ 6,000 MZN Equities Price $51,000 50,000 49,000 52,000 53,000 49,000 51,000 47,000 49,000 43,000 170 $1,060 $530 $494,000 $1,420 290 170 $1,420 $1,060 $530

Jan. $380 370



April $380 370



$400 $270 370 500 260 500

$400 $270 370 260 290

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Dealing With Accrued Interest and Commissions

Bond prices are typically quoted on a net basis (already include commissions) Calculate accrued interest using the mid-term heuristic
Assume every bond s accrued interest is half of one interest check

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Choosing the Bonds

The following slide shows one possible solution:
Stock cost: $494,000 Bond cost: $557,130 Accrued interest: $9,350 Stock commissions: $1,500

Do you think this solution could be improved?

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Security $80,000 Empire 71/2s02 $80,000 Energen 8s07 $100,000 Enhance 61/4s03 $80,000 Enron 65/8s03 $90,000 Enron 6.7s06 $100,000 Englehard 6.95s28 Bonds subtotal Total income Price $86,400 82,900 105,500 84,500 97,200 100,630 Jan. $3,000 $3,200 $3,370 $2,650 $3,010 $3,470 Feb. March April May June

$557,130 $3,000 $3,200 $3,370 $2,650 $3,010 $3,470 $4,420 $4,260 $3,900 $4,070 $4,070 $4,000
Prof. Rushen Chahal 37

The total of all costs associated with the portfolio should not exceed the amount given to you by the client to invest The money the client gives you establishes another constraint

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What About Convertible Bonds?

Convertible bonds can be included in a portfolio
Useful for a growth of income objective People buy convertible bonds in hopes of price appreciation Useful if you otherwise meet your income constraints

Prof. Rushen Chahal