portfolio management- chapter 13

8/3/2019 Portfolio Management- Chapter 13

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Chapter 13

Bond Selection

Prof. Rushen Chahal 1

Prof. Rushen Chahal


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To preserve their independence, we must not let ourrules load us with perpetual debt. We must make

our election between economy and liberty, orprofusion 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

I

nterest rate risk



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Default Risk

Default riskrefers 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 riskfor consumers

Rating agencies such as S&P and Moodys

function as credit bureaus for credit issuers



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Default Risk (contd)

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 itsinterest rate risk



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Dealing With the

Yield Cu

rve (contd)

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 andinterest 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 Premiu

m 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 Premiu

m (contd)

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 bondscategorically from a portfolio

Avoid making extensive use of a single callablebond 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 listspecifies 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 (contd)

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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PeriodicIncome

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 bondportfolio that matches a particular investment

horizon

E.g., assemble securities to fund a specific set ofpayment 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

RetirementI

nc

ome The problem

Unspecified constraints

Using S&Ps 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 (contd)

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 (contd)


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 (contd)

Characteristics of the fund:

Quarterly dividends total $3,001 ($12,004annually)

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 dont want to choose CC-rated bonds

You dont want the longest maturity bonds you

can find



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Using S&Ps 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&Ps

Bond Guide (contd)



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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 (contd)


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 $4005,000 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 bonds 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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Bonds

Security 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

$100,000Englehard 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


portfolio management- chapter 13

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