The second approach requires greater skill and effort, but it provides the route to higher
returns. It allows the investor to choose the mix of bonds which provides the highest
YTM while still achieving the target quality level.
Thus the bond portfolio selection problem has three aspects:- The portfolio duration must equal the duration of the outflows.
- The average quality of the portfolio (in terms of the credit rating) must not fall
below the acceptable level. - Within these two constraints, the high yielding bonds must be chosen to
maximize the YTM of the portfolio
All this does not eliminate the need for active management of the bond portfolio.
Duration matching eliminates the interest rate risk, but it is a continuous process rather
than a one shot activity. There are several reasons why the duration of a portfolio may
change:
- Duration wandering is a phenomenon in which as time passes, the duration of
a portfolio changes slowly. - Large changes in interest rates can change the duration.
- Normal trading activity in the portfolio may change its duration.
To take care of all these factors, it is necessary to recompute the portfolio duration at
frequent intervals. Whenever a substantial discrepancy is found, steps must be taken to
rebalance the portfolio to achieve the desired duration.
Finally, Just as in the case of equity portfolios we can shift the beta temporarily to exploit
our forecast of market trends, we can temporarily change the duration of our bond
portfolio to take advantage of our forecasts of interest rate trends. If we expect interest
rates to rise, we must switch towards low duration assets. Conversely, a switch to high
duration assets is mandated if we expect interest rates to fall.