How to build a bond portfolio and choose the safest bonds

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A bond investment portfolio must balance the maximization of profits with the reduction of risk: to evaluate each bond to invest in and optimize the set of bonds it is necessary to know returns and volatility.

build a bond portfolio

The main factors that determine the yield of the bonds and the risk are security liquidity, risk of default (issuer risk) and time to maturity (duration). I have already dealt with these factors extensively in articles Bonds are fixed income investments: maturity, duration and risks and How to calculate bond yield and risk, so here I make only a few hints, to introduce the main theme of the article: how to build a good bond portfolio.

Evaluate the bonds portfolio risk

Security liquidity: the more liquid a security is, the faster it can be converted into currency without significant price concessions. Consequently, a non-professional investor should purchase unlisted bonds or stocks because that there is no transparent and detectable price on a daily basis. Furthermore, in the event of a sale, the counterparty willing to pay the requested price may even be missing. The so-called liquidity risk of the investment would be too high.

Bond issuer risk: a distinction must be made between government bonds from developed economies, government bonds from emerging countries, bonds issued by companies with “stable” profits and balance sheets (Corporate Bonds with investment grade rating) and bonds issued by companies with non-brilliant balance sheets (Corporate High Yield Bond with low rating).

One way to evaluate issuer risk is to refer to the rating, used by specialized agencies to classify the reliability of both government and corporate issuers, built on the basis of their riskiness with regard to current and future balance sheet data.

Risk in terms of volatility: it must be measured using the standard deviation, with the same residual maturity of the securities around 5 years.

bonds volatility
Data 2013-17

Evaluating the bonds to put in the portfolio based on the rating is certainly an important method for detecting the default risk, but one must be careful because sometimes the rating agencies modify the judgments too late compared to market conditions.

The risk expressed by historical volatility, on the other hand, provides a clearer quantitative measure of how much the initial capital invested can oscillate by investing in the various alternatives.

The issuer risk of the portfolio should not exceed 2-3%, which would advise a non-professional saver not to buy bonds from individual companies or emerging countries (where the issuer risk is very high), but managed savings instruments (Etf, Funds or Sicav), which in themselves already have a very low issuing risk, since they are extremely diversified.

How to estimate the yield of bonds in the portfolio

Estimating expected returns is the problem with all portfolio simulations because each method has different pros and cons. A reasonable starting point for estimating the bond portfolio yields is the difference in the long-term historical average yields of the individual types of bonds compared to the risk-free yields, i.e. what is called historical yield spread. Over 50 years of data embrace every possible macro-economic scenario and therefore they can be trusted to carry out the simulations.

The graph shows the historical yield spreads of the market in the period 1954-2008, for homogeneous maturities. It can be reasonably estimated that inflation-linked bonds for which sufficiently long historical data are lacking can have a spread of around 2%.

yield spreads

Bond portfolio: correlation between risk, return and types of bonds

Risk and return of the various asset classes are not perfectly correlated, therefore, when taking on greater risks, it is not always possible to expect an increase in the return proportionally. Vice versa, it is not said that by reducing the risk to a minimum, returns are also minimal.

risk return ratio

The construction of a bond portfolio is not easy because, in addition to assessing risk and return of each bond, it is necessary to evaluate the correlation between the different types of bonds that are to be included in the portfolio.

The correlation index expresses the relationship between two variables to highlight whether each value of the first variable corresponds with a certain regularity to a value of the second. It is not necessarily a cause and effect relationship, but simply the tendency of one variable to vary according to another.

Positive values of the correlation index correspond to movements in the same direction between the variables considered (in our case, between two types of bonds) and vice versa negative values correspond to movements in the reverse direction. Data near zero indicate independent movements between the variables.

For bonds, the 5-year correlation is considered to be a sufficiently stable quantity over time and therefore usable for making reasonable estimates in the construction of portfolios. You can use an online correlation calculator, the data to be entered are the returns of two different types of bonds (series of at least two years, to have statistically significant values): so you will see which bonds are related to each other, or inversely related.

Broadly speaking, to reduce risk the bond portfolio should have a composition based on inversely related bonds, on the contrary to maximize profits it should have a composition based on related bonds.

But it is a theoretical hypothesis, which in reality should be corrected. By inserting the yield, risk and correlation data in an investment portfolio optimizer (online or downloadable tool), it will be possible to obtain the range of efficient investment portfolios, i.e. those portfolios that maximize the return, for each level of risk required by the investor. Once you have chosen the strategic portfolio suitable for your risk appetite, however, the work is not finished: despite being a good starting point, this must then be monitored based on the performance of the economic cycle and the trends of the underlying components.

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