By Odhiambo Ocholla
Growth in the bond market has been remarkable in recent years, besides attracting more players. As the capital market gets sophisticated and given the impressive volume of bonds traded at the secondary market, it is important for the investors to understand some of the bonds trading strategies.
Investment in the bond market was until recently a preserve of institutional investors because of lack of awareness and high minimum capital required for investments. The minimum amount required to invest in a Treasury bond is Sh50,000.
But now various unit trust firms offering bond funds have revised their minimum entry capital making and it is affordable to majority of investors. Strategies for bond investing range from a buy-and-hold approach to complex tactical trades involving views on inflation and interest rates.
As with any kind of investment, the right strategy for investors will depend on their goals, time frame and appetite for risk. Bonds can help investors meet a variety of financial goals such as: preserving principal, earning income, balancing the risks of stock investments and growing assets.
Bond Investment Strategies
Active traders are looking for short-term profit and an active bond portfolio will hold issues across the most volatile maturity bonds to get that profit. Bonds have a significant aspect of many investment strategies.
However, after deciding how much to allocate to bonds as part of the initial asset allocation process, investors still need to decide which bonds to actually invest in. Choices at each stage will depend on whether the portfolio is to be actively or passively managed.
Active management involves trading bonds, so they would not be held in a portfolio for very long. An active portfolio seeks to profit from bond price changes created by interest rate fluctuations.
So a portfolio must focus on the most liquid bonds with high trading volumes and bond issues which are about to change in value.
Active management of fixed income portfolio looks to earn investment returns by buying and selling in anticipation of price changes which can be caused by changes in interest rates (investment risk).
Passive management is a ‘buy and hold’ strategy, so there is not so much need for liquidity. This gives passive portfolios a wider choice of securities than actively traded portfolios.
Portfolio returns whether from an active or passively managed portfolio will be compared against a benchmark index. Portfolios which are actively managed tend to focus on the most liquid issues and these happen to be the Treasury bonds.
Passive management is most common when an investor wants bonds to receive a regular, predictable income-stream and/or return of capital invested at a known future date. A long term ‘buy and hold’ investment portfolio may focus solely on the safest Government Treasury bonds issues.
With more time to maturity, long-term bonds are more vulnerable to changes in interest rates. If you are a buy-and-hold investor, however, these changes will not affect you unless you change your strategy and decide to sell your bonds
Managing Interest Rate Risk
Bond prices move inversely to interest rates. And because interest rate risk varies depending on maturity, bonds of different maturities respond differently to changes in interest rates, so changing the shape of the yield curve.
If a trader believes that the yield curve is either too steep or too flat, then a profitable trade would be to go short (sell) in bonds of one maturity, and go long (buy) in another maturity.
There are many different strategies, which bond traders can employ, but the underlying aim is always the same in an active strategy.
Buy-and-hold investors can manage interest rate risk by creating a "laddered" portfolio of bonds with different maturities, for example: one, three, five and ten years.
A laddered portfolio has principal being returned at defined intervals. When one bond matures, you have the opportunity to reinvest the proceeds at the long-term end of the ladder if you want to keep it going.
If rates are rising, that maturing principal can be invested at higher rates. If they are falling, your portfolio is still earning higher interest on the long-term holdings.
