Investment Theory and Risk Management, + Website

A Bond Strategy

Bond managers often target a portfolio risk that is also tied to their benchmark. As we discovered in Chapter 2, a bond's duration summarizes its risk in terms of interest rate sensitivity. Bond managers who manage to a benchmark will therefore constrain the duration on their portfolio to match the benchmark duration.

Go to the companion website for more details (see Bond Strategy under Chapter 7 Examples).

The bond strategy spreadsheet in the Chapter 7 Examples workbook presents such an example. These are daily total percentage returns on the benchmark and six bond indices—Treasuries, agencies, asset-backed securities, commercial mortgage-backed securities, mortgage-backed securities, and high yield corporate credit (investment grade). We will estimate a vector of mean returns and a covariance matrix to use as arguments in our mean-variance optimization.

These daily returns span April 2006 through the close of 2010. We wish to optimize a portfolio of these six bonds having a maximum return per unit risk with no short sales and with a portfolio duration that matches the benchmark duration of 4.43 years. For perspective, we also solve the minimum variance portfolio without short sales restrictions. The covariance matrix, as before, is bordered with two rows (columns) consisting of the adding up and expected return constraints so that the basic problem looks like the ...