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Chapter 13

Bond Selection

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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

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

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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

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The Meaning of Bond Diversification

Introduction Default risk Dealing with the yield curve Bond betas

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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

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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

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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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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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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 Value Qrtl Div. Payment Month

3,000 AAC $51,000 $380 Jan./April/July/Oct.

1,000 BBL 50,000 370 Jan./April/July/Oct.

2,000 XXQ 49,000 400 Feb./May/Aug./Nov.

5,000 XZ 52,000 270 March/June/Sept./Dec.

7,000 MCDL 53,000 0 --

1,000 ME 49,000 370 Feb./May/Aug./Nov.

2,000 LN 51,000 500 Jan./April/July/Oct.

4,000 STU 47,000 260 March/June/Sept./Dec.

3,000 LLZ 49,000 290 Feb./May/Aug./Nov.

6,000 MZN 43,000 170 Jan./April/July/Oct.

Total $494,000 $3,010

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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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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 Price Jan. Feb. March April May June

3,000 AAC $51,000 $380 $380

1,000 BBL 50,000 370 370

2,000 XXQ 49,000 $400 $400

5,000 XZ 52,000 $270 $270

7,000 MCDL 53,000

1,000 ME 49,000 370 370

2,000 LN 51,000 500 500

4,000 STU 47,000 260 260

3,000 LLZ 49,000 290 290

6,000 MZN 43,000 170 170

Equities $494,000 $1,420 $1,060 $530 $1,420 $1,060 $530

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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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BondsSecurity Price Jan. Feb. March April May June

$80,000 Empire 71/2s02

$86,400 $3,000

$80,000 Energen 8s07

82,900 $3,200

$100,000 Enhance 61/4s03

105,500 $3,370

$80,000 Enron 65/8s03

84,500 $2,650

$90,000 Enron 6.7s06

97,200 $3,010

$100,000 Englehard 6.95s28

100,630 $3,470

Bonds subtotal $557,130 $3,000 $3,200 $3,370 $2,650 $3,010 $3,470

Total income $4,420 $4,260 $3,900 $4,070 $4,070 $4,000

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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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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