Fixed Income Portfolio Strategies — the ground floor

What a fixed income portfolio is

Fixed income instruments are debt instruments. They pay a coupon (interest) and return the principal at maturity. Their returns are more predictable than equity. Investors like them mainly to match their own liabilities and for stable returns.

A portfolio built from such securities is a fixed income portfolio. The workbook's examples: Government Securities, Corporate Bonds, Debentures, Commercial Papers, Certificates of Deposit, Treasury Bills and Tri-Party Repos (TREPS).

A few big-picture points from the workbook:

• Fixed income has lower risk than equity.
• Globally, fixed income investments are bigger than equity investments.
• Large institutions — sovereign funds, endowments, pension funds, insurers, banks — keep a large share in fixed income.
• Governments are the largest borrowers through fixed income markets. The money builds roads, power, defence, ports, schools, hospitals and farms.

Passive strategy 1: Buy and Hold

Identify the bonds, buy them, and hold till maturity. The aim is to lock in the yield at purchase, whatever happens to prices later.

The workbook's example: ₹1,00,000 invested on 01/01/20 in a 5-year bond paying 8% semi-annually. Every six months a coupon of ₹4,000 arrives, and on 31/12/24 the investor receives ₹1,04,000 (last coupon plus principal). Market yields wander from 8% down to 5.50% over the period. It does not matter. The investor still gets the originally contracted 8%.

What Buy and Hold gives you:

• Returns exactly as expected, with no negative surprises
• No speculation on interest rates
• No price risk, because there is no sale before maturity
• Low transaction costs
• Predictable cash flows — which is why large institutions use it

What it does not remove: reinvestment risk. The coupons must be reinvested at whatever the yield is on the day they arrive. That is because YTM assumes coupons are reinvested at the YTM till maturity.

A portfolio version works the same way — every bond is held to maturity. Mutual fund Fixed Maturity Plans follow this philosophy. To avoid cash-flow losses, high-quality bonds are preferred.

Passive strategy 2: Bond index funds

Indexing means holding the same or similar securities as the benchmark, in the same weights. The manager only mimics a pre-defined index.

Why use bond index funds? The workbook gives five reasons:

• Portfolio mandate — the client wants a specific benchmark. Example: a global endowment putting 5% into Indian fixed income.
• Management fee — very small, because there are few decisions to make.
• Ease of replication — index rules already handle liquidity, size, weight, issuer and rating.
• Availability of choice — sovereign, corporate, long-duration G-Sec, commercial paper indices, and more.
• Liquidity risk mitigation — an ETF can mirror an index. The workbook's example: Bharat Bond ETF.

A good benchmark is explicit, transparent and unambiguous, made of tradable securities, and has daily prices publicly available.

Choosing the benchmark

Selecting the right benchmark is the first step in passive management. The two guideposts are the investment objective and the risk appetite.

Tracking error

Tracking error is the difference between the portfolio's performance and the benchmark's. Lower is better. A large one means the index is hard to replicate, or the manager is slow to react.

Six genuine causes:

• Costs — expenses and transaction costs reduce NAV; the index has none.
• Similar but not the same security — often because the index bond is illiquid.
• Weight difference from the index.
• Illiquid securities with wide bid-ask spreads.
• Regulatory limits on concentration — the index may be heavy in one issuer; the fund cannot be.
• Cash in hand — for liquidity, flows, or odd lots (for example ₹4 crore in cash when the lot size is ₹5 crore).

Passive strategy 3: Immunization

Immunization protects the portfolio's return against future interest-rate moves. It deals with both interest rate risk and reinvestment risk.

The simple way: buy a zero-coupon bond maturing exactly when the liability falls due. No coupons means no reinvestment risk, and holding to maturity means no price risk. At 10% for 10 years, a zero-coupon bond with face value ₹10,00,000 costs ₹3,85,543.30 today.

Zero-coupon bonds of long tenure are rare now, because they are risky for issuers. A simple bank fixed deposit behaves like one — except it is not tradable.

The portfolio way: build a bond portfolio whose Macaulay Duration equals the liability horizon. Then two effects cancel:

• If rates fall, bond prices rise, but coupons are reinvested at lower yields.
• If rates rise, bond prices fall, but coupons are reinvested at higher yields.

For a zero-coupon bond, Macaulay Duration equals maturity. That is why it is theoretically the best immunizing asset.

Note the workbook's own twist. It lists immunization as a passive strategy, then says immunization is "not a passive strategy like Buy and Hold" — every time rates change, duration must be re-adjusted to match the remaining horizon. Know both statements.

Active strategies: interest-rate driven

Active managers deliberately deviate from the benchmark to beat it. They must still keep in mind the fund's objective, regulatory and internal guidelines, the validity of their rate assumptions, and the cost of being wrong.

The most common active strategy is managing duration based on rate forecasts.

• Directional call — expect rates to rise? Cut duration. Expect rates to fall? Increase duration.
• Barbell — when rates could move sharply either way. Concentrate at both ends, with little in the middle. The workbook's example: 40% short, 40% long, 20% mid.
• Bullet — buying zero-coupon bonds with a bullet payment is itself an active strategy.
• Floaters — the coupon resets periodically, so the floater's duration is at most the time to the next reset, even if maturity is long.
• Maturity extension — when rates are stable and low, long bonds give higher yield on a normal rising curve. But price sensitivity is high.
• Roll down — on a rising curve, a bond's yield falls as it ages, so its price rises. You earn coupons and price gain.
• Buying convexity — more on this in L2.

The workbook's duration buckets (which it says SEBI also uses when categorising debt funds): Long — Macaulay Duration more than 7 years; Mid — 3 to 7 years; Short — less than 3 years.

The three S's of the yield curve

• Shift — the whole curve moves up or down in parallel.
• Slope — how steep or flat it is.
• Shape — its curvature, measured through convexity.

Credit analysis

Credit (default) risk belongs to corporate bonds. Rating agencies rate each issue separately. The workbook says that in India it is mandatory to obtain a credit rating before issuing any bond or commercial paper.

Riskier issuers pay more. If a 5-year government bond yields 8%, a AAA corporate might yield 9%, and AA 10%. The extra yield is the credit yield spread. Sovereign bonds are free from credit risk.

Managers do not rely only on ratings. Their own research uses the four Cs — Capacity, Collateral, Covenants and Capital — to estimate probability of default and loss given default.

A put option embedded bond lets bondholders sell the bond back to the issuer, who must buy. Holders give up some yield for this right.

Credit funds come in two main types:

• Optimising yield and credit quality — most common; investment grade. If AA+ is the minimum, the manager balances AAA and AA+. Pooled products (CLOs, asset-backed securities) are rated higher than their individual loans and often yield more than similar-rated plain bonds.
• High yield / junk bonds — very low rating, speculative grade. Managers prefer short-dated papers with good earnings visibility and study recovery in liquidation.

Challenges: sharp deterioration in credit quality that ratings miss; poor diversification (in India the financial sector dominates the corporate bond market); and higher tail risk.

Yield spread analysis

Term spread is the difference in yield between two maturities. Example: 10-year G-Sec at 6.0% minus 2-year G-Sec at 4.3% = 1.7%. Spreads widen in uncertainty and recession (investors want bigger risk premiums) and narrow in confidence and expansion.

Global fixed income

Investors look across borders for relative value (regional differences in credit cycles and pricing) and an illiquidity premium (emerging markets are less liquid). The key job is assessing country risk. The main risks are economy risk, legal risk and currency risk — the last hedged with currency swaps.

Derivatives for bond portfolios

• Interest Rate Swap — exchange fixed-rate payments for floating-rate payments (say 3-month MIBOR) on a notional principal.
• Swaption — the holder has the right but not the obligation to enter a swap; the seller has the obligation and charges a premium.
• Futures — standardised, exchange-traded agreement to buy or sell a bond later at a price fixed today.
• Forward contract — like futures, but OTC and not standardised.
• Credit Default Swap — the buyer pays a premium for protection against a credit event (default, rating downgrade, bankruptcy). Like insurance on a bond.
• Cross currency swap — OTC exchange of floating payments in one currency for floating payments in another, usually with initial and final exchange of principal.

Protective put on bonds: raises the mean return and cuts off the left tail of the return distribution. The seller often adds a cap and/or floor.

Asset-liability management: insurance and pension funds have liabilities of 20–40 years. Long bonds are scarce and volatile, so the duration mismatch is uncompensated risk. The simplest fix is immunization — minimising the duration gap using options, futures and swaps.

Beyond the book

The workbook warns that credit ratings may not reflect a sudden collapse. Indian investors saw this with IL&FS in 2018, whose highly rated paper was downgraded to default within weeks. In April 2020, Franklin Templeton wound up six Indian debt schemes after lower-rated holdings became hard to sell — the "poor diversification" and "tail risk" challenges in real life.