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Bonds are considered the ideal investment opportunity for investors with low-risk appetite. Since bonds are debt instruments, they are eligible for regular interest payments irrespective of the issuer’s profits. This makes bonds a suitable option for all those expecting low-risk stable incomes.
Though bond prices are not as volatile as stocks, there are other kinds of risks associated with bonds. Hence, knowledge of bond management strategies is crucial for all investors investing in bonds. Today’s article takes you through such strategies to manage your bond investments.
What is a bond portfolio?
Bond portfolio as a term may not be as popular as a stock portfolio. Since stocks offer better returns, maintaining a portfolio of stocks is more common as compared to bonds. Bonds are usually part of investment portfolios, but having a separate bond portfolio may not be seen often. However, it is not unheard of. Investors looking for moderate risks and returns may hold bond portfolios.
Bonds are fixed-income debt instruments which allow the transfer of capital between two parties in the form of loans. The bond issuer pays interest to the investor at period intervals for the loan lent.
A bond portfolio is a collection of investments in such bonds. It holds different varieties of bonds, offering different risk and return features. Since bonds also carry certain kinds of risk, holding the right bonds in the portfolio can help mitigate such risks.
Bond portfolio management strategies
The objective behind applying strategies to a bond portfolio is to offset one bond’s loss against another bond’s profit.
The passive approach
This approach, as the term suggests, is ideal for passive investors. It is a buy-and-hold strategy where investors invest in bonds and retain them until maturity. Unlike dynamic investors who actively track the market and sell the bonds when it is profitable, this strategy suggests holding bonds for their entire lifetime.
By the end of the maturity, investors receive their principal in full, along with all the interest payments. The passive strategy benefits investors by giving them stable income in the long term without the burden of monitoring their investments.
Investors who choose this approach follow the practice of bond laddering. They invest in different bonds maturing at different times. As they receive the principal back from one bond, they invest it in another based on the interest rates. The right balance between short and long-term bonds helps them manage the risk of interest rate changes.
The indexing approach
Similar to stock market indices like NIFTY, SENSEX and others, bond markets have indices, too. S&P BSE Indian Bond Index, Nifty AAA Corporate Bond Indices, Nifty Banking & PSU Bond Indices, etc., are examples of bond indices.
These indices reflect the performance of top bonds across different sectors in the bond market. The indexing approach uses such indices to strategise the bond portfolio of investors. Investors aim to recreate the index to generate similar returns. Since the index already goes through various calculations, this approach acts as a dependable plan for novice investors to create their bond portfolios.
For example, an investor deciding to adopt the indexing strategy may choose the Nifty Banking & PSU Bond Index. So, the investor’s portfolio will mostly contain liquid bonds issued by public sector banks having an A credit rating.
The active approach
Contrary to passive investors are active investors. Investors following this approach do not invest and remain idle until maturity. Instead, they chase profits. They take the dynamic route and sell their bonds or buy them based on interest rate fluctuations. They mainly take positions based on their speculations on future interest rates.
This approach is ideal for those with a greater risk appetite.
Immunising your bond portfolio
This approach follows a combination of active and passive strategies. Investors consider the duration of the portfolio and determine the returns they wish to earn. Accordingly, they move funds between different bonds within the given time to earn the desired results.
Importance of bond portfolio management
Bonds, though safer than equities, are risky to a certain extent. They are exposed to various kinds of risks like interest rate risks, default risks, liquidity risks, etc.
Interest rate risks are one of the most common risks for bonds. Interest rates and the value of bonds are inversely related. An increase in interest rate makes existing bonds less attractive, affecting the bond’s value. Hence, strategising the portfolio is crucial to avoid losing wealth.
Finding an investment option with zero risk exposure is seldom possible. Hence, understanding the nature of bonds and the different strategies to handle risks is important to achieve the desired level of profits.
Bond portfolio management strategy is the process of managing investments in bonds. The objective of these strategies is to maximise returns and minimise risks, mainly the interest rate risk.
Identify the investor’s objective and financial goals.
Determine the assets and amount to be invested in each asset.
Plan a portfolio management strategy.
Implement the strategy.
Evaluate the performance of the portfolio.
Bonds are low-risk investments but are not zero-risk assets. They are exposed to different risks, too, however, at a lesser degree as compared to stocks. Bond portfolio management aims to handle these risks like default risks, interest rate risks, liquidity risks, etc.
Default risk in bonds refers to the risk of the counterparty defaulting. It is the risk of bond issuers failing to pay interest periodically and repay the principal upon maturity.
Active management of a bond portfolio is suitable for investors having a high-risk appetite. These offer better returns as compared to passive strategies. A passive approach is for investors expecting low-risk and stable returns.