Why you should understand the key risks of fixed income investing (Part 7 of 7)
Investing in bonds
Besides matching the duration, convexity, and present value distribution of cash flows, there are other ways to effectively index a bond portfolio—like the db X-trackers Municipal Infrastructure Revenue Bond Fund (RVNU)—to a benchmark. We’ll go over some of the ways to do this and their applicability to different types of bonds.
While we can use the duration and present value distribution of cash flows to index portfolios containing government bonds (TLT), we need to match other factors for corporate bond portfolios (JNK).
Percent in sector and quality
The portfolio under consideration replicates the index yield by matching the percentage weights in various sectors and qualities, assuming the portfolio has covered all maturities the index tracks.
Duration contribution of the sector
Sector spreads are the difference in the yield of a non-Treasury security and a similar-maturity Treasury issue. A fund manager can minimize tracking error from the benchmark arising from changing sector spreads by matching the amount of index duration arising from each sector. This way, the manager can ensure the portfolio moves in tandem with the index for a given change in sector spreads.
Duration contribution of quality spreads
Quality spreads are the additional yield over Treasuries (TLH) or other risk-free assets required to be paid on bonds that are of lower credit quality (HYG). The fund manager can minimize tracking error from the benchmark due to changing quality spreads by matching the amount of index duration arising from each quality category (credit rating determines the quality of a bond). This way, the manager can ensure that the portfolio moves in tandem with the index for a given change in quality spreads. This risk factor takes on more importance in benchmarking high-yield bond portfolios, where quality spreads can move significantly.
In constructing a portfolio replicating an index, the number of issues comprising the portfolio are also important. If the number of issues are too few, there’s significant event risk still present in the portfolio arising from those issues that are present in the benchmark but not in the portfolio. We can calculate this risk can by estimating how much of the portfolio duration comes from the holdings of each issuer.
To learn more about managing your fixed income portfolio, check out Market Realist’s Fixed Income ETFs page.
Browse this series on Market Realist:
- Part 1 - Protect your returns by studying the key risks in bond investing
- Part 2 - Why credit risk and liability risk matter to bond investors
- Part 3 - Interest rate risk: Measure and avoid the pitfalls of duration
- Investment & Company Information