Fixed-Income Investment Strategies
Fixed-income investment strategies are a crucial part of wealth management. These strategies often involve the construction of a portfolio that is either “laddered”, “bullet”, or “barbell”. A laddered portfolio evenly distributes the bonds’ maturities and par values along the yield curve. This is in contrast to the bullet portfolio, which concentrates the bonds at a specific point on the yield curve, and the barbell portfolio, which places the bonds at the short-term and long-term ends of the curve. Despite these differences, all three portfolio types can have the same portfolio duration statistic and approximately the same change in value for a parallel shift in the yield curve.
Advantages of Laddered Portfolio
The laddered portfolio offers protection from shifts and twists in the yield curve as the cash flows are essentially “diversified” across the time spectrum. Bonds mature each year and are reinvested at the longer-term end of the ladder, typically at higher rates than short-term securities. Over time, the laddered portfolio likely includes bonds that were purchased at both high and low interest rates. This is similar to the concept of “dollar cost averaging”. Furthermore, reinvesting funds as bonds mature maintains the duration of the overall portfolio.
Convexity in laddered portfolio
Convexity is a technical term that refers to the second-order effect on the value of an asset or liability given a change in the yield to maturity. It is affected by the dispersion of cash flows, as indicated in the following equation:
$$ \begin{align*} {\text{Immunized Portfolio Convexity}} = \frac{ \left(\begin{align*} & \text{Macauley Duration}^2 \\+ & \text{Macauley Duration} \\ + & \text{Dispersion} \end{align*}\right)}{{(1 + \text{Cash flow yield})^2}} \end{align*} $$
- \(\text{Macauley Duration}^2 + \text{Macauley Duration}\): These terms account for the impact of duration on convexity. Duration measures the sensitivity of a bond’s price to changes in interest rates, and these squared and linear terms emphasize its influence on convexity.
- Dispersion: Refers to the variance of cash flows over time. A higher dispersion of cash flows increases convexity, as cash flows are spread out over a wider range of time periods.
- Cash Flow Yield: The denominator normalizes the effect of cash flow yield, ensuring that convexity is appropriately scaled for bonds or portfolios with different yields.
Comparison Across Portfolio Structures:
- Barbell Portfolio: Has the highest convexity because its cash flows are concentrated at two extremes of the timeline, leading to higher dispersion.
- Laddered Portfolio: Exhibits relatively high convexity as its cash flows are evenly distributed across the timeline. This distribution also reduces cash flow reinvestment risk compared to a barbell structure.
- Bullet Portfolio: Has the lowest convexity because its cash flows are concentrated around a single point in time, resulting in minimal dispersion.
Higher convexity (e.g., in laddered or barbell portfolios) provides better protection against interest rate changes and enhances potential price appreciation, especially in volatile markets.
Liquidity Management
The laddered portfolio is highly effective for liquidity management, especially for less actively traded bonds, like many corporate securities. A bond nearing redemption is always available, offering stable pricing due to low duration even during interest rate volatility. Maturing bonds provide cash for immediate needs, can be used as high-quality collateral for loans or repo contracts, or reinvested into long-term bonds to maintain the ladder structure.
Constructing a Laddered Portfolio Using Fixed-Maturity Corporate Bond ETFs
Wealth managers can create laddered portfolios for clients by utilizing fixed-maturity corporate bond ETFs. These ETFs are passively managed, low-cost, and designed to replicate the performance of an index of investment-grade corporate bonds maturing in a specific year. For example, a 2024 investment-grade corporate bond ETF includes bonds that mature in that year. By purchasing ETFs with staggered maturities (e.g., 2022 through 2029), wealth managers can replicate the benefits of directly holding bonds in a laddered portfolio.
Benefits of Laddered Portfolios Using ETFs
Such portfolios offer price stability for the soonest-to-mature ETFs and greater convexity compared to bullet portfolios. ETFs also provide more liquidity than directly holding bonds, enabling easier access to funds when needed. Additionally, the stratified sampling approach used by ETF managers ensures effective index tracking and cost efficiency.
Limitations and Comparison to Fixed-Income Mutual Funds
Laddered portfolios, while beneficial, have limitations. Fixed-income mutual funds offer greater diversification of default risk compared to portfolios with a limited number of corporate bonds. Mutual funds also provide better liquidity and lower transaction costs. If liquidation of the entire investment is required, mutual fund shares can typically be redeemed faster and at a more favorable price than selling individual bonds.
Practice Questions
Question 1: In fixed-income investment strategies, different types of portfolios are constructed to manage the risk and returns associated with bonds. Which of the following statements is true regarding the laddered portfolio strategy in the wealth management industry?
- The laddered portfolio concentrates the bonds at a specific point on the yield curve.
- The laddered portfolio places the bonds at the short-term and long-term ends of the yield curve.
- The laddered portfolio evenly distributes the bonds’ maturities and par values along the yield curve.
Answer: Choice C is correct.
The laddered portfolio strategy in the wealth management industry evenly distributes the bonds’ maturities and par values along the yield curve. This strategy involves purchasing bonds with different maturity dates, so that the bonds mature at regular intervals over time. This creates a ladder effect, with bonds maturing and being reinvested at regular intervals, which can help to manage interest rate risk and provide a steady income stream. The laddered portfolio strategy is often used by investors who want to balance the need for regular income with the desire to minimize interest rate risk. By spreading the maturities of the bonds across the yield curve, the laddered portfolio strategy can help to smooth out the impact of interest rate fluctuations and provide a more stable return over time.
Choice A is incorrect. The statement that the laddered portfolio concentrates the bonds at a specific point on the yield curve is not accurate. This description is more applicable to a bullet portfolio, which concentrates its bond holdings in a specific maturity range.
Choice B is incorrect. The statement that the laddered portfolio places the bonds at the short-term and long-term ends of the yield curve is not accurate. This description is more applicable to a barbell portfolio, which concentrates its bond holdings at the short-term and long-term ends of the yield curve, with little or no exposure to the middle of the curve.
Question 2: The concept of convexity is a crucial aspect of fixed-income investment strategies. Which of the following statements accurately describes the factor that affects convexity?
- Convexity is affected by the dispersion of cash flows.
- Convexity is affected by the concentration of bonds at a specific point on the yield curve.
- Convexity is affected by the placement of bonds at the short-term and long-term ends of the yield curve.
Answer: Choice A is correct.
Convexity is indeed affected by the dispersion of cash flows. Convexity is a measure of the curvature in the relationship between bond prices and bond yields. It demonstrates how the duration of a bond changes as the interest rate changes. This curvature is caused by the fact that the cash flows of a bond are distributed over time. The more dispersed these cash flows are, the greater the convexity and the more the bond’s price will change in response to a change in interest rates. This is because when cash flows are spread out over a longer period, there are more periods during which interest rates can change, affecting the present value of future cash flows. Therefore, a bond with highly dispersed cash flows will have a higher degree of convexity than a bond with less dispersed cash flows.
Choice B is incorrect. Convexity is not affected by the concentration of bonds at a specific point on the yield curve. The yield curve represents the relationship between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. The concentration of bonds at a specific point on the yield curve does not affect the convexity of an individual bond.
Choice C is incorrect. Convexity is not affected by the placement of bonds at the short-term and long-term ends of the yield curve. While the placement of bonds on the yield curve can affect their price and yield, it does not affect the convexity of an individual bond. Convexity is a characteristic of the bond itself, not of its position on the yield curve.
Glossary
- Yield Curve: A line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.
- Portfolio Duration: A measure of the sensitivity of the price of a bond portfolio to a change in interest rates.
- Macaulay Duration: The weighted average term to maturity of the cash flows from a bond.
- ETFs (Exchange-Traded Funds): Investment funds traded on stock exchanges, much like individual stocks.
- Stratified Sampling Approach: A method of sampling that involves dividing a population into smaller groups known as strata.
- Laddered Portfolio: A portfolio of fixed income securities in which each security has a significantly different maturity date.
- Convexity: A measure of the curvature in the relationship between bond prices and bond yields.
LOS 2(i): describe construction, benefits, limitations, and risk–return characteristics of a laddered bond portfolio