Bond Investment Strategies for Smart Investors
Bonds, unlike stocks, are complex financial instruments.
Hence, you need to understand popular bond investment strategies that will help you simplify your bond investment portfolio. In the following paragraphs, we will discuss some popular bond investment strategies in detail,
What are bonds and how do they generate returns?
Bonds are instruments that enable investors to lend money to companies and governments to generate returns.
When a bond is issued, investors buy the bond and lend money to the borrower. In return, the borrower (bond issuer) promises to pay interest/coupon for the tenure of the bond and to return the investment amount (principal) after the bond matures.
All the attributes like interest rate, tenure, maturity date etc. are known at the time of bond issue. The annual return that the bond investor can expect to earn if he/she holds the bond until maturity is indicated by yield to maturity (YTM).
YTM and interest rate are measures of bond returns. Most investors get confused between the two because of how similar they seem. But they are different and we discuss the differences between the two here: What's the difference between Bond Yield (YTM) and Interest Rate?
Bonds returns can have two components:
Interest payments are the regular payments bond holders receive while they own the bond. These could have various frequencies but quarterly and semi-annual interest payments are the most common. Most investors buy bonds to get regular income.
Interest rate and bond’s face value determine how much interest will be paid out to each investor. Generally, the safer a bond is (high credit rating), the lower will be the interest rate and vice versa.
Depending on market forces and other factors, prices of bonds keep fluctuating, similar to stocks. If you sell a bond before maturity at a price higher than your purchase price, you make capital gains. This is extra return that you make over and above the interest payments.
Capital gains (or losses) are realized only if the bond's purchase price and selling price are different. If you buy a bond during its issue (first offering) and hold it until maturity, you will not realize capital gains/losses since you will be paying the face value and receiving the face value of the bond.
Reasons to invest in bonds
Bonds are less risky than asset classes like stocks and private equity. This makes bonds perfect for many scenarios.
You should invest in bonds if you are looking for:
- Higher than FD returns with only slightly higher risk
- A stable and regular income
- Short term investment options (less than 3-5 years)
- Portfolio diversification
Bonds investing strategies
Now that we understand bonds and the importance of investing in them, we can look at some bond investing strategies. These strategies are used by experienced portfolio managers and mutual funds to manage client investment portfolios.
We will have a look at the following bond investing strategies in this article:
- Hold to maturity strategy
- Bond laddering strategy
- Duration matching strategy
- Active bond investing strategy
Hold to maturity (HTM) strategy
Hold to maturity (HTM) is one of the simplest bond investment strategies.
The strategy asks you to invest in bonds and hold them until maturity. This means not making any withdrawals/redemption before the maturity date of the bond.
By holding the bond to maturity, you eliminate two types of bonds risks: interest rate risk and liquidity risk. Additionally, by holding the bond to maturity, you are likely to generate the YTM returns applicable at the time of investment.
Hold to maturity strategy has the following advantages:
- Highly predictable returns
- Passive strategy that doesn’t require constant monitoring
- Reliable strategy to plan for financial goals
- Elimination of interest rate and liquidity risks
- No capital losses if the bond purchase price was close to the face value
Hold to maturity strategy also has a couple of downsides:
- No opportunity to generate capital gains unless the bond purchase price was significantly lower than the face value
- Emergency situations may not allow you to hold the bond until maturity
- If the bond’s rating gets downgraded, you will have to hold a bond that is riskier than it was during the time of investment
Bond laddering strategy
Bond laddering is a slightly complex strategy but very helpful for certain investors. Let’s understand it.
Bond laddering strategy (BLS) asks you to break up your amount and invest it into several bonds of several tenures.
For example: If you have Rs. 1,00,000, split it into 5 parts of Rs. 20,000 each. Further, invest each part in bonds of different maturities like 1 year, 2 years, …, 5 years.
Now, as each bond matures, reinvest the amount into a 5-year (longest maturity) bond. This way, you will have a bond that matures every year (the spacing) and gets reinvested in a 5-year bond at possibly different yields.
The number of parts into which you split the amount as well as the bond maturities that you choose can be different. However, there are three conditions to make this an effective strategy:
- Split the total investment amount equally
- The spacing between maturities should be as equal as possible
- A bond should mature every X years (X is the spacing period between bonds)
Now the question is: What does this complex bond investing strategy help you achieve?
The primary idea behind this investment strategy is not to lock in a low bond yield.
Suppose you invest all your money in a 5 year bond with a yield of 7% and the very next year the issuer issues a 5 year bond with a 9% yield because the market has changed. The price of your 5 year bond will go down and you will earn a 2% lower yield.
Had you split your money into 5 parts, you would have invested only 1/5th in a 5 year bond with 7% yield. Additionally, 1/5th amount that you invested in the 1 year bond would have been reinvested into a 5 year bond at a higher yield of 9% after maturity of the 1 year bond.
But what if the bond yield fell from 7% to 5% instead of going up to 9% after a year? Well, in that case you already have a 5 year bond that yields 7%.
Basically, bond laddering strategy helps you diversify your bond portfolio across maturities. This is very similar to what happens in mutual fund SIPs (Systematic Investment Plans) where you diversify across time.
However, this is a strategy that retail investors may not be able to keep up with because of the multiple maturity and reinvestment events.
Duration matching strategy
To understand the duration matching strategy, we need to understand the concept of ‘duration’ first. There are multiple ways of looking at duration.
First, is to look at it from an interest repayment perspective. Duration is the time it takes for you to recover your investment (the bond price you paid) via the interest payments you receive from the bonds.
So, if you paid Rs. 100 for a bond and it pays back Rs. 20 as interest every year, the bond's duration is 5 years. There are no interim payments in a zero coupon bond (ZCB). So, the duration of a ZCB is equal to the bond's maturity.
Another way to look at duration is as a measure of bond price sensitivity to change in interest rate. For example, if interest rate goes up by 1% and bond price drops by 5%, the bond duration is 5 years. So, higher the duration, higher is the risk of interest rate fluctuations.
Now that we know what duration is, let’s understand the duration matching strategy.
Duration matching strategy asks you to match the duration of the bond to your investment horizon. For example, if your investment horizon is 3 years, this strategy says you should invest in a bond that has a duration of 3 years.
This is because, at duration, bond’s investment price and reinvestment risks cancel each other out. Price and reinvestment risks are the two components of interest rate risk.
Simply put, if you invest as per the duration matching strategy, you will eliminate interest rate risk. It will not matter how the interest rate has moved between the points of entry and exit if you follow this strategy which is excellent.
This is similar to the hold to maturity strategy we saw earlier. However, both eliminate different types of risks:
|Hold to maturity strategy
|Duration matching strategy
|Eliminates credit risk?
|Eliminates price risk?
|Not by itself, this strategy helps to cancel out price and reinvestment risks
|Eliminates reinvestment risk?
|Not by itself, this strategy helps to cancel out reinvestment and price risks
|Eliminates liquidity risk?
So, depending upon the dominant risk(s) in a given bond or set of bonds, you can use a suitable strategy.
Active bond investing strategy
Bond prices are inversely related to market interest rates. This means when interest rates fall, the prices of existing bonds go up and vice versa.
So, if you can predict market interest rates, you can make money in bonds. All you need to do is invest when market interest rates are high (bond prices are low) and withdraw when market interest rates are low (bond prices are high).
Simple, isn’t it? Hardly!
Even the most experienced fixed income experts are unable to time the interest rates right. This is similar to market timing in the stock markets. People can’t get it consistently right because there are too many moving parts to analyze and predict.
Yet, the active bond investing strategy exists.
Another way active strategies work is by investing in lower rated bonds that offer high yields. The expectation is that these bonds will not default and the high yield will be realized completely/mostly.
Many other methods of active bond investing exist but they are very complex and there’s little proof of them working consistently.
To sum up, the advantages of active bond investing strategy are:
- If implemented correctly, can lead to yields that may be better than returns from even riskier assets like equity
- Return maximizing strategy
But the downsides are enough to keep investors away from this strategy.
- No historical examples of investment experts being able to consistently predict interest rates
- Unlike the others we discussed earlier, this strategy doesn’t focus on eliminating risks of investing in bonds
- At best a tactical strategy and it doesn’t help in goal planning
- If the active calls go wrong, the losses could be high