Investing in fixed income: What motivates bond investors? (Part 2 of 4)

Bond investing: Key risks and strategies to boost your portfolio

Fixed income risks

As with all investments, fixed income investments are subject to risks too. Bond prices increase when interest rates decline and decline when interest rates increase. Performance risk is a fund manager’s inability to meet their fund’s stated investment objectives. We can divide performance risks into two categories:

• Risks associated with benchmarking a specified bond index
• Risks associated with matching a liability structure

Risks associated with benchmarking a specified bond index

Tracking error is defined as “the difference between the performance of the managed bond portfolio and the performance of the pre-determined benchmark index,” where “performance” means the actual returns over the period under evaluation.

Why does tracking error occur?

Tracking error depends on the portfolio management style applied by the fund manager: active investing versus passive investing.

Under the passive investing style, the fund manager seeks to construct a miniature version of the benchmark portfolio by purchasing the latter’s constituent securities in the same proportions. If it were possible to do this at negligible or no cost, there would be very little tracking error for the passive portfolio as the returns on the constructed portfolios would nearly match the benchmark. But actually, fully replicating a bond portfolio is no mean feat for a couple reasons.

1. Most fixed income securities are highly illiquid and therefore difficult to include in a constructed portfolio
2. The transaction costs associated with a full replication strategy make it impractical to implement, as these would significantly impact the fund manager’s performance vis-à-vis the benchmark

To overcome these constraints, passive fixed income managers apply an enhanced bond indexing strategy, which seeks to match the risk factors of the benchmark by investing in a sample of bonds whose risk factors match the risk factors of the target portfolio. The risk factors include duration, cash flow distribution, sector, credit quality, and call exposure. While an enhanced bond indexing strategy can mean larger tracking errors, the lower costs incurred to implement the strategy can improve the fund manager’s performance compared to the full replication approach.

Fixed income ETFs like PZA, PVI, FLOT, and MUB are examples of exchange-traded funds (or ETFs) that track various bond indices, and investing in these funds would be an example of passive investing.

1. The PowerShares Insured National Municipal Bond Portfolio (PZA ) uses the performance of the BofA Merrill Lynch National Insured Long-Term Core Plus Municipal Securities Index as its benchmark. The index tracks the performance of long-term, AAA-rated, insured, and tax-exempt debt publicly issued by U.S. states or their political subdivisions.
2. The Invesco PowerShares VRDO Tax Free Weekly Portfolio (PVI ) tracks the Bloomberg U.S. Municipal AMT-free Weekly VRDO Index. The index comprises municipal securities issued in the primary market as variable-rate demand obligations (or VRDOs), whose interest rates reset weekly. PVI has an expense ratio of 0.25%.
3. The iShares Floating Rate Bond ETF (FLOT ) tracks the Barclays Capital <5-Years Floating Rate Note Index, which measures the performance of U.S. dollar–denominated investment-grade floating-rate notes. Securities in the index have a remaining maturity greater than or equal to one month and less than five years. With an expense ratio of 0.2%, the fund’s largest holding is Goldman Sachs FRN (GS ), an investment banking, securities, and investment management services company that comprises 1.23% of the ETF’s holdings.

Under the active investing style, the fund manager seeks to add value to portfolio performance by constructing a portfolio that’s different from the benchmark index. The fund manager attempts to do this by taking significant views on the portfolio’s risk composition, like targeting a divergent view on the portfolio’s duration and sector, for example. This can result in significant tracking error, as the portfolio may vary significantly from the benchmark index. Due to this variance, investors need to consider returns for several years in evaluating the fund manager’s performance.

In the next article of this series, we’ll discuss the factors to consider in selecting a bond benchmark. Please read on to Part 3.