Bonds are one of the safest securities a person can add to their investment portfolio, and they give investors a fixed income stream despite market volatility.
Potential investors may think that bonds are a type of ‘buy and forget’ investment, however, there are several strategies they can use to boost income from bonds.
The most popular approaches are passive in nature. They require a smart delegation of capital to bonds with different maturities, such as bond laddering and the barbell technique. However, active bond management strategies open up opportunities for bigger profits.
Here are some active management techniques fund managers use to outperform the market with bonds.
Managers select bonds issued by companies with low credit ratings but have the potential for great improvement. Once a bond candidate is found, the managers will purchase the risky bond based on their prediction that the company’s value, as well as the bond’s price, will increase.
If they make a correct prediction, they can benefit from either owning a high coupon bond for the full term or selling the bond at a premium.
Market and macroeconomic analyses
Some managers trade bonds to take advantage of shifts in supply and demand when prices move. This way, they can sell at a premium when demand is high but supply is low, or buy at a discount when supply is high but demand is low.
Managers also search for bonds that may benefit from price increase and favourable coupon rates based on economic conditions and global growth.
Active managers can focus their lending or bond investment in specific sectors depending on the current economic outlook. Their selections are usually based on how certain sectors historically performed in similar circumstances.
For instance, active managers can focus on the technology sector while snubbing properties and real estate one cycle, then pull out from technology to focus on the mining industry when conditions turn in its favour.
Rolling down the yield curve
This strategy relies on timing the sale of a long-term investment as its market value increases and earnings from it decrease. For this to work, long-term interest rates should be lower than short-term ones.
Think of rolling down the yield curve this way: portfolio managers understand that long-term bonds increase in value and decrease in yield as maturity closes in, so to maximise profits, they sell the bond once its value has increased and the yield to maturity becomes smaller. For example, selling a 10-year bond on the seventh year.
The bondholder would benefit by selling the bond at a premium and, at the same time, they already gained a sizeable CIP from it.
However, the strategy’s profitability would still depend on the condition of interest rates in the market. If overall interest rates rise, holding shorter term bonds to maturity would still be more profitable than attempting to roll down the yield curve.
Active management may seem aggressive to some investors, especially in the case of bonds, but managers also employ active risk management strategies to help reduce exposure to the market forces.
This requires balancing risky strategies with more secure investments, and it is really necessary that fund managers stay active in monitoring their portfolio to ensure minimal loss.
Thinking of applying active management strategies?
Investor should keep in mind that It is very important for active managers to always be aware of market and economic movements to curb losses.
Active bond management requires a lot of hard work, so consider seeking professional advice before applying any technique.
This information has been sourced from PIMCO and Investopedia.