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Home > Asset Management Best Practice > Passive Portfolio Management and Fixed-Income Investing

Asset Management Best Practice

Passive Portfolio Management and Fixed-Income Investing

by Andrew Ainsworth

Executive Summary

  • Fixed-income securities are an important asset class that adds considerable diversification benefits to a portfolio.

  • The passive strategy known as stratified sampling allows investors to achieve benchmark returns while controlling risk and transaction costs.

  • This approach can be utilized in a tactical asset-allocation strategy, as it allows for relatively quick changes in portfolio allocations.

  • Stratified sampling allows for active bets to be integrated into the portfolio by tilting weights in response to forecasted returns.

  • The use of back-testing will ensure that actual outcomes align with expectations by adequately controlling benchmark risks.

Introduction

An allocation of investment to fixed-income assets is an important component of any diversified investment strategy. The fixed-income asset class comprises a variety of debt instruments that include government bonds, corporate bonds, municipal bonds, mortgage-backed securities, inflation-indexed debt, and convertible bonds, among others. With such a large number of securities available from which to construct a portfolio, this article reviews the stratified sampling method of replicating the returns of a benchmark portfolio in fixed-income securities. This method is of use to investors who are undertaking both active and passive portfolio management approaches.

Figure 1 shows the daily total returns of the S&P 500 and the MSCI World equity indices as well as fixed-income indices covering a broad-based global benchmark, global high yield, and world corporate debt between February 2002 and February 2012. The impact of the financial crisis is clearly evident in the figure. Interestingly, an investment made in February 2002 in either of the fixed-income indices would be worth more today than either of the equity benchmarks. In terms of risk, the standard deviation of monthly returns is considerably higher for the two equity indices—around 16%. The global broad-based index and the world corporate index have values of 6–7%. An important benefit of including fixed income in a portfolio is the diversification benefit. The correlation coefficients between the five indices are given in Table 1. The global high-yield index is more highly correlated with the equity indices than the other fixed-income indices. Either way, it is clear that fixed income should be included in a diversified portfolio.

Table 1. Correlation coefficients of monthly returns for the indexes in Figure 1, February 2002 to February 2011. (Source: Datastream)

MSCI World Equity S&P 500 BOFA/ML Global Broad FI BOFA/ML Global High Yield FI Citibank World Corporate FI
MSCI World Equity 1.000 0.973 0.264 0.755 0.466
S&P 500 0.973 1.000 0.166 0.705 0.357
BOFA/ML Global Broad FI 0.264 0.166 1.000 0.346 0.877
BOFA/ML Global High Yield FI 0.755 0.705 0.346 1.000 0.622
Citibank World Corporate FI 0.466 0.357 0.877 0.622 1.000

BOFA/ML: Bank of America Merrill Lynch; FI: fixed income

Risks of Investing in Fixed Income

Despite the lower standard deviation of returns, the recent events of the financial crisis have shown that significant risks are involved in investing in fixed-income securities. As with any financial security, expected returns will vary with risk. Before constructing a portfolio of fixed-income securities, it is important to understand the risks that an investor faces when investing in such securities.

  • Interest rate risk. There is an inverse relationship between the level of interest rates and bond prices. However, the prices of some bonds are more sensitive to changes in interest rates and are therefore exposed to greater interest rate risk. Reinvestment risk is also related to interest rate risk, as coupon payments received are reinvested at an uncertain interest rate.

  • Credit risk. This is the risk that the issuer of a bond may not make periodic coupon payments or pay back the full amount of principal at maturity. Credit rating agencies (Standard & Poor’s, Moody’s, and Fitch IBCA) provide ratings on the creditworthiness of bond issuers. These credit ratings allow investors to differentiate between bonds on the basis of the rating agencies’ assessments that an issuer will default and not meet its obligations.

  • Liquidity risk. This represents the chance that you will not be able to trade the desired quantity of a specific security when you want to trade. Bonds that are more liquid are cheaper to trade. A prime example of liquidity risk is that which occurred in certain collateralized debt obligations and mortgage-backed securities during the financial crisis.

  • Inflation risk. The chance that inflation will erode the value of investments.

  • Sovereign risk. This is related to credit risk as it represents the chance that a foreign government will not repay its debts. As the recent sovereign debt crisis has highlighted, it is an important consideration for investors in Portugal, Ireland, Greece, and Spain.

  • Currency risk. This represents the risk that a domestic investor may purchase a bond that is denominated in a foreign currency. A domestic investor faces uncertainty about the domestic currency value of the coupons and the principal paid in foreign currency.

  • Call risk. Certain bonds may allow the issuer to call the issue before maturity. This adversely impacts the investor as it introduces uncertainty as to the stream of future cash flows and limits the price appreciation of the security. Generally, these bonds are called when interest rates are low, creating reinvestment risk. Prepayment risk affects mortgage-backed securities and is related to call risk. It reflects the uncertainty surrounding the timing of cash flows to the holders of securitized loans that depend on the mortgage repayments of mortgage holders.

In order to realize a return that is in line with expectations, it is necessary for an investor to adequately monitor and manage these risks.

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Further reading

Books:

  • Fabozzi, Frank J. Bond Markets, Analysis, and Strategies. 7th ed. Boston, MA: Pearson, 2009.
  • Martellini, Lionel, Philippe Priaulet, and Stéphane Priaulet. Fixed-Income Securities: Valuation, Risk Management and Portfolio Strategies. Chichester, UK: Wiley, 2003.

Articles:

  • Blake, Christopher R., Edwin J. Elton, and Martin J. Gruber. “The performance of bond mutual funds.” Journal of Business 66:3 (July 1993): 371–403. Online at: www.jstor.org/stable/2353206
  • Boney, Vaneesha, George Comer, and Lynne Kelly. “Timing the investment grade securities market: Evidence from high quality bond funds.” Journal of Empirical Finance 16:1 (January 2009): 55–69. Online at: dx.doi.org/10.1016/j.jempfin.2008.06.005
  • Chen, Yong, Wayne Ferson, and Helen Peters. “Measuring the timing ability and performance of bond mutual funds.” Journal of Financial Economics 98:1 (October 2010): 72–89. Online at: dx.doi.org/10.1016/j.jfineco.2010.05.009
  • Huij, Joop, and Jeroen Derwall. “‘Hot hands’ in bond funds.” Journal of Banking and Finance 32:4 (April 2008): 559–572. Online at: dx.doi.org/10.1016/j.jbankfin.2007.04.023

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