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Bond Selection
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
Outline
Introduction The meaning of bond diversification Choosing bonds Example: monthly retirement income
Introduction
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
Introduction
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
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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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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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
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Constraints
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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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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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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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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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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Setup
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
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Feb.
March
May
June
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Bonds
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
Overspending
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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