Passive bond portfolio management takes advantage of the implications of bond market efficiency. Because bond markets are efficient, investors are not able to use past price and volume data or publicly available information to achieve superior rates of return. The limitations on portfolio management imposed by market efficiency preclude achieving superior rates of return by either superior bond selection or superior market timing. Investors achieve market rates of return by buying a randomly diversified bond index fund, or investors immunize the bond portfolio by taking advantage of the concept of duration.
The simplest approach to creating a bond index fund is to buy a market-weighted random selection of bonds in each of the major bond categories in the domestic bond market: Treasury bonds, federal agency bonds, corporate bonds, state and municipal bonds, and mortgage-backed bonds. This portfolio, with proper rebalancing, will provide the investor with the bond market rate of return. If the objective of the investor is narrower, a bond portfolio could be constructed to meet a specific need. For example, a bond portfolio consisting of only corporate bonds could be constructed. The rate of return for this portfolio would mirror the rate of return for corporate bonds in general. A smaller sector of the bond market, such as AAA-rated bonds, could be used to construct an index that would mirror only the highest quality bonds.
Portfolio immunization is more complex than indexation and takes advantage of bond duration to eliminate interest rate risk from the bond portfolio. When the interest reinvestment rate rises (falls), the value of the principal repayment falls (rises) and the value of the interest on interest rises (falls). A bond portfolio is immunized when the duration of the bond portfolio is equal to the duration of the liabilities hedged by the bond portfolio Thus, total interest rate change effects are offset.
An investor with multi-period obligations can take advantage of duration on a period-by-period basis. This technique is known as dedication.
The duration of the bond portfolio will vary over time. Changes in the bond portfolio duration can be rebalanced by reinvesting coupon payments or replacing longer duration bonds with shorter duration bonds.
[ Carl B. McGowan , Jr. ,
updated by David P. Bianco ]
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