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Active Bond Portfolio Management

Actively creating, structuring, restructuring, and operating a portfolio

What is Active Bond Portfolio Management?

A bond portfolio can be managed in several ways; however, the primary methods are active, passive, or a hybrid of the two. Active bond portfolio management, as the name suggests, means the portfolio manager takes an active role in the running, organizing, and management of the portfolio.

 

Active Bond Portfolio Management

 

Active Management of Funds

Active management of funds involves portfolio managers who take an active position when choosing bonds. They seek out bonds that are high performing and that they believe are more likely to surpass a benchmark index performance over time. The ultimate goal is to create and manage a fund that performs at or above the index, including identifying and investing in bonds that are undervalued. Active bond portfolio management may also involve buying bonds that hedge against market fluctuations.

 

Passively Managed Funds

Active bond portfolio management differs significantly from funds that are managed in a passive way. Passively managed funds – or index funds – are handled by a manager that simply invests in a basket of bonds that are selected to match a benchmark index’s performance.

Passively managed funds don’t actively invest in particular bonds or frequently change the bonds held in the portfolio. Instead, the funds only adjust the securities they hold if the structure of the benchmark index changes. The goal isn’t to surpass the index, but merely to match the index’s performance.

There is no overall benchmark index used for bonds in the United States. Instead, there are numerous sub-indexes for categories such as US government bonds, corporate bonds, and municipal bonds. Bloomberg Barclays Indices is the creator and manager of many of the most widely used bond indexes.

 

Advantages of Active Bond Portfolio Management

Listed below are several key advantages to the active bond portfolio management strategy:

 

1. Boost the tax-exempt income

One advantage of active bond portfolio management is the opportunity to boost the tax-exempt income within the portfolio. Municipal bonds – especially those purchased by an investor in his or her home state – are exempt from federal taxes.

The bonds are tax-exempt regardless of whether they are in an active or passively managed fund. However, with an active portfolio manager, they can be used to hedge against gains and losses in other areas of the portfolio, allowing the manager to capitalize on the income to benefit clients.

 

2. Control the holding period of the bonds

Another major benefit is the ability to control the amount of time bonds are held. All bonds come with a maturity date. Passively managed funds typically hold a bond until it matures. In an actively managed fund, however, the manager can benefit the fund’s investors by selling off bonds with a lower yield and shorter duration.

When interest rates rise, selling off such bonds boosts the yield of the portfolio overall. Generally speaking, bonds can be invested in more profitably by selling them at advantageous times that occur prior to maturity.

 

Risks of Active Bond Portfolio Management

Active portfolio management comes with risk, as well as opportunity. An actively managed bond portfolio is not guaranteed to outperform a corresponding benchmark index. If the fund manager fails to outperform the index, investors lose out on more than just the return they would’ve gotten from a passively managed fund.

In addition, they will also be out of the additional transaction fees that accompany the more frequent trading that is characteristic of actively managed bond funds.

 

Summary

The most important aspect of active bond portfolio management is the fact that the manager of the portfolio takes a head-of-the-table role in creating, structuring, restructuring, and operating the fund. When a portfolio is carefully watched and holdings are bought and sold to offset one another, hedge against risk, and ultimately boost the overall profit of the fund, investors are more likely to obtain the highest return on their investment.

However, actively managed funds come with additional risk. It is up to the individual investor to decide if they are willing to take on extra risk for the opportunity of realizing greater returns on investment.

 

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Buying on Margin
  • Momentum Investing
  • Stock Investing: A Guide to Growth Investing
  • Swing Trading

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