Bond investments seem the perfect way to obtain easy income. Some investors believe all they need to do is buying the bond with the highest yield. However, building a portfolio in this sector isn’t as easy as it seems for outsiders. First of all, there are too many options available, and if you don’t know which is what, you may miss out or choose the one that is less suited to your purposes.
Besides, each strategy has its own risk and reward tradeoffs, and it’s better to be prepared and know what to expect.
If you want to invest in bonds, that you should know about four principal strategies that investors use for managing bond portfolios. These are:
- Dedicated and active
- Passive, or “buy and hold”
- Immunization, or “quasi-active”
- Index matching, or “quasi-passive”
Active investing is for those investors who want to make bets on the future. On the other hand, Passive investing enables one to have a predictable income. Immunization and indexation offer some predictability but not as much as passive or buy-and-hold strategies. Let’s discuss each of them for better understanding.
Active Bond Management Strategy
Investors choose this strategy when they want to maximize total return. However, with increased profit comes increased risk. Some examples of active trading styles include interest rate anticipation, valuation, timing, and spread exploitation, as well as multiple interest rate scenarios.
Choosing any type of active strategy means that the trader is willing to bet on the future instead of settling with the potentially lower returns offered by a passive strategy.
Passive Bond Management Strategy
If an investor wants to maximize the income-generating properties of bonds, then they usually prefer the passive buy-and-hold strategy. In this case, bonds are assumed to be predictable and safe sources of income.
Investors purchase individual bonds and hold them to maturity. They can use cash flow from the bonds to fund external income needs or reinvested in the portfolio into other bonds or asset classes.
When employing a passive strategy, investors have no assumptions about the direction of future interest rates. Furthermore, changes in the current value of the bond because of the shifts in the yield are not important.
While it may seem a lazy style of investing, in reality, passive bond portfolios provide stable income in rough financial storms. They are secure and quite profitable in the long-term. They eliminate or minimize transaction costs. And if an investment has relatively high-interest rates, it would have a decent chance of outperforming active strategies.
Immunization Bond Strategy
This strategy has the characteristics of both passive and active strategies. Immunization in its purest form implies that you invest in a portfolio for a pre-defined return for a specific period of time regardless of changes in interest rates or other outside influences.
Similar to the buy-and-hold strategy, high-grade bonds with remote possibilities of default are the best-suited instruments for this strategy.
However, if investors use the immunization strategy, they may have to give up the upside potential of an active strategy for the assurance that their portfolio will achieve the desired return.
Indexing Bond Strategy
Analysts consider Indexing to be quasi-passive by design. If an investor wants to build a bond portfolio so that risk and return characteristics were closely tied to the targeted index, this strategy is the best choice.
This strategy has several characteristics of the buy-and-hold, but it also offers some flexibility. For instance, an investor can structure a bond portfolio to mimic any published bond index.
This strategy works well with a large portfolio because of the number of bonds required to replicate the index. However, before choosing it, you should consider the transaction costs.
As you see, all four strategies have various aims. So, you should consider carefully which one suits you best before picking out one.