Bond Portfolio Management: A Beginning

Understanding the inverse relationship that a bond’s yield to has to its price is just the beginning. Several bonds, with many different rates of interest and various and different maturity dates are assembled into a bond portfolio. A bond portfolios can be made up of just a few thousand dollars to billions of dollars. Because of economy of scale and the way bonds trade, larger portfolios in the hundreds of millions gives the portfolio manager the best opportunity to keep trading costs down. Bonds, unlike stocks, are traded on a net basis. There are no commissions. Traders that make a market buy bonds on the bid side and sell them on the asked side of the market. To make things more interesting, keep in mind that the market is constantly moving. That means yields and prices are moving all the time.

US Treasury notes and bonds are rated AAA by the rating companies. As such they carry the lowest rate of interest as you would expect from the best and strongest credit. If you draw a line and connect the dots on a piece of graph paper representing interest rates (on the vertical axis) and maturity dates (along the horizontal axis) of US Treasuries from a one year maturity to a 30-year maturity, you will have created a line that is referred to as a yield curve. Many years ago a book was written by two men, Sidney Homer and Martin Leibowitz and titled Inside the Yield Book. The book was first published in 1972, a few years after I got my start in the bond business. I actually read some of the book some 30 plus years ago, but for some reason, I always remember the title as “Inside the Yield Curve.” When I first got into the bond business, before there were calculators that could compute a bond’s price, there were basis books that you looked up the price of a bond. All you needed was a maturity date, and an interest rate, usually referred to as the coupon rate, and the yield to maturity and you came to a page with columns of numbers representing prices. With these three pieces of information, you could look up the price of a bond given its coupon rate, maturity date in years and months and a yield to maturity.

All of this is held together by the mathematical relationships that time, present value, future value and compound interest have to each other. The yield curve is constantly moving as prices change, yields change and therefore the yield curve changes. The US Treasury yield curve represents the base line for interest rates because they are considered the safest and strongest debt instrument that trades in the market. All other bonds trade at higher interest rates and this difference between the US Treasury yield and a corporate or asset-backed bond's yield is called the spread. Spreads are referred to in basis points. One hundred basis points equals one percent, and 25 basis points is equal to one quarter of one percent. One strategy employed by bond portfolio managers is to watch the spread between various classes of bonds. For example, the spread between AAA rated US Treasuries and AA rate corporate bonds can be charted. The AA rated corporate bonds will normally trade at a spread of so many basis points, a higher interest rate, to the yield on US Treasuries of the same maturity. However, there are times when the spread with narrow and the portfolio manager may choose to sell his AA corporate bonds and buy US Treasuries. Then when the spread between US Treasuries and AA rated corporate bonds widens and gets back to a more normal spread, the trade is reversed and the Treasuries are sold and corporate bonds are purchased. There are any number of relationships between classes of bonds that can be followed and charted. When a pick up in yield or quality can be achieved and thus a gain for the portfolio can be taken, and a trade is executed.

There are numerous strategies to managing a bond portfolio, but the important thing to remember is that bond portfolios today are actively managed. Pension funds, foundations, endowment funds and mutual funds invested in bonds are all actively managed on a daily basis. That is why when there is a “meltdown” and no bond traders are making a market for a particular class of bonds, there is a serious crisis of confidence throughout the whole bond market.


There are computer programs today that help bond portfolio managers manage their portfolios. In the late 1970’s and early 1980’s, I felt lucky if I could get a portfolio printout by maturity and not alphabetically. In those days, computer programs that could simulate what a bond purchase or sale would do to a bond portfolio under various interest rate scenarios going forward were rare. Today, the use of the computer and bond management software can take a lot of the guessing out of managing, but all the computers in the world can not save a portfolio manager that does not think first and act second. Because a bond portfolio is just a mass of numbers, it can reduced to an average weighted coupon (interest rate), an average weighted maturity (total days to maturities divided by the par value of the portfolio) and a weighted cost, market value and yield to maturity. Knowing all these numbers, the portfolio manager can reduce the bond portfolio to a virtual bond, which then can be tested against various interest rate scenarios going forward. In other words, the effect one bond trade will have on the whole portfolio can be simulated before the actual trade is completed.

I will stop here for today and let those that have never read anything like this before digest what I have written. The management of bond portfolios is going on around the world. There are some very bright people involved in this business, but brightness is not everything. Besides a knowledge of bond management techniques and strategies, there is the outside world in which all the trading and math calculations take place. Being able to read trends and understand current events, both political and economic, is essential to remaining one step a head of the crowd. Because, when things move, they move quickly and not everyone can get through the door at the same time. Stay tuned.