By Hrishikesh Menon. Edited by Arjun Chandrasekar.
Overview
All liquid assets have various investment strategies, even bonds. Bonds may seem like a “boring” investment and it is meant to have low returns compared to other assets but the right bonds are important assets to include in a strong investment portfolio and for that, you need the right bond strategy.
Bonds Recap
Bonds are a type of debt security. They are used by governments and corporations to borrow money from investors. Bonds have 3 components: the face value, the coupon rate, the maturity date. The face value is the principal amount that is needed to purchase the bond. The coupon rate is the annual rate of interest the bond investor can expect to receive as long as they hold it. Finally, the maturity date is the date when the bond’s final interest payment and principal will be paid back to the buyer. A fixed-rate bond’s value depends on the interest rates. If the interest rates hike, the bond value will decrease. If the rate goes down, the bond value would go up.
Passive Bond Strategies
- Buy and Hold: Bonds have relatively low returns and passive investors use that to their advantage by buying and holding high rated, low coupon rate, stable bonds to maturity to maximize income. Buy and hold bond investors do not worry as much about interest rate fluctuations in the future. This attitude is similar to that of value stock investors who do not consider the price movements of the stock and only focus on the company’s intrinsic value and whether it is undervalued.
- Ladder Strategy: Another common passive bond strategy is laddering. This is when you divide the principal payment equally over time. For example, you have a $100,000 you want to invest into bonds and have a steady cash flow so you decide to ladder it and invest $10,000 semiannually for 5 years at a coupon rate of 5%. You would receive $1,000 every year in coupon income which becomes your steady cash flow. These strategies are great for conservative investors who are just looking for some steady income but bonds can also be used for aggressive investors, mostly institutions, who look for high returns.
Active Bond Strategies
While passive strategies may not focus on changes in interest rates, credit ratings, or yield curves, active strategies do. Most active strategies involve derivatives on bonds, mostly swap contracts. A swap contract is an exchange of cash flows (or interest rates in this case) of the underlying security.
- Rate Anticipation Swaps: The first type of bond swaps are interest rate anticipation swaps where you would sell a group of fixed rate bonds to the counterparty for a purchase of floating rate bonds which would adjust according to the interest rate movement. To evaluate which durations would optimize profit, investors use Horizon analysis or also called Total Return analysis.
- Yield Curve Shifts: when strategies are used to make profit off yield curve movement. The ladder strategy can be used here as well. Another strategy is called the Bullet strategy where you would buy bonds with 1 maturity date. This strategy depends on where you predict the shift will occur: upwards or downwards. If upwards, you would buy short-term bonds and if downwards, then long-term bonds are the way to go. A way to hedge against a shift in either direction is to implement the Barbell strategy where you would buy short and long-term bonds.
- Credit Strategies: Most investors tend to favor high quality bonds due to its high creditworthiness. Active bond portfolios, however, tend to risk bond default (when the payments cannot be made by the issuer) by buying high yield bonds. When interest rates are low, there is a higher demand for high yield bonds but when interest rates hike, investors move towards high quality bonds. A way to profit in both situations is to buy a quality swap contract where you short sell the bonds you think will decline and buy the bonds that you think will increase in value. This strategy is profitable no matter the interest rate movement since it is reliant on the quality spread of the bonds.
Conclusion
Bonds are debt securities used by corporations and governments to borrow money. A rule of thumb is that the interest rate and bond value are inversely proportional. Some passive bond strategies are the classic buy and hold or laddering. Some active bond strategies are rate anticipation swaps, Bullet strategy, Barbell strategy, quality swaps, etc.
