What proportion of cash, bonds, and equities should be held?
What is the appropriate risk vs reward balance that we should aim for?
What is the appropriate risk vs reward balance that we should aim for?
How many assets are required to reap diversification benefits?
Should we invest in domestic or foreign assets? Should they be hedged?
What is the time horizon of our investment? How much liquidity is required?
How should the weightings of the assets held be determined?
Which sectors should we invest in? Corporate or government?
How often should adjustments be made to the portfolio holdings?
This post will seek to answer the above questions and in the process develop a strategy for the construction of a fixed income portfolio for a hypothetical client. Since our client is at retirement age, they have requested a portfolio entirely composed of fixed income assets. Investing in government bonds would certainly be a minimal risk strategy, however to better match the risk profile of the client it has been decided to invest instead in corporate bonds. Relative to equities bonds yield returns with much lower volatility so such a portfolio will naturally be low risk. The risk tolerance of the investor was measured as slightly-below average, but not extremely low. For this reason, 90 per cent of the portfolio will be comprised of investment grade bonds (rated BBB+ or greater) and 10 per cent of the portfolio will be comprised of high yield bonds (BBB or lower).
The next decision to make is how many assets to hold within the portfolio. Dbouk & Kryzanowski (2010) examine the diversification benefits associated with different-sized portfolios of bonds using various metrics. They examine the marginal diversification gains by industry sector, credit ratings, and maturity. In general, they find that the optimal portfolio size is about 40 bonds with associated diversification benefits of about 80%. For this reason the portfolio will be constructed by selecting 40 different corporate bonds.
Research by Liu (2012) investigates whether US investors can achieve diversification benefits by adding international corporate bonds to their portfolio. His findings show that such an approach can significantly reduce portfolio volatility and increase Sharpe ratio, reducing risk by as much as 82.4 per cent. Based on these findings the portfolio to be constructed will be diversified among British, American, Australian, Canadian, European, and Japanese corporate bonds. The bonds purchased will be issued in foreign currency, and as such appropriate currency hedges will be employed (to be discussed further in a later post).
Next, we must consider the appropriate time horizon of our investment portfolio and the liquidity requirements of the client. The client has indicated that they may require access to some portion of the funds after 5 years. For this reason, at least half of the bonds selected for the portfolio will have maturities of approximately 5 years.
The weighting strategy of the portfolio will follow a simple 1/N strategy, whereby equal allocation values are maintained for each asset. While this simple portfolio strategy does not optimize with respect to any return information, it is easy to implement and not subject to any bias. DeMiguel, Garlappi, and Uppal (2009) show that across a large class of sample based mean variance portfolio allocation models, no model consistently out performs the 1/N naive portfolio allocation strategy in out of sample performance.
Finally, it is worth considering the industry sectors chosen for investment. The focus of the diversification strategy employed so far is primarily geographical with some consideration given to choosing bonds of different maturities. As such, sector diversification has been deemed of lesser importance. However, where possible bonds from a range of different sectors have been selected for each country.
The portfolio was constructed using the PRTU function in Bloomberg.
Here is a breakdown of the bonds chosen by country, maturity, and industry:
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