A variety of bond investment strategies are possible, depending on the investor's resource, risk preference, tax status, investment horizon, income and liquidity needs. Two broad classes of bond investment strategies may be identified: passive and active. A passive investment strategy is one in which the investor seldom trades securities, but rather purchases and holds them until maturity or the investment horizon is reached. An active strategy is one where the investor frequently trades from one security to another in an effort to achieve superior performance.
Active versus passive strategies
An active strategy is usually only appropriate when the investor has insights that will grant superior performance to that of other investors. For example, an investor who expects interest rates to fall should purchase long-term low coupon bonds in order to take advantage of the expected increase in bond prices. The seller of the bonds, an active trader, must have some different belief about future interest rates. Otherwise, this potential seller will keep the bonds and make a profit. The investor who does not have superior insights should probably avoid an active strategy, which incurs transactions costs that can lower returns dramatically. Several academics have studied this question of whether or not an active trading strategy can pay off for the investor.
A passive strategy is more appropriate for the investor who does not have superior return-forecasting ability. This investor must identify personal needs such as horizon, degree of risk aversion and need for liquidity, and then choose the portfolio that best meets those needs. Any trading of the portfolio should be done only in response to changing needs over time. An example of this strategy: the investor attempted to keep the duration equal to the horizon in order to ensure predictable wealth as of the horizon date.
A bond investor typically needs to identify the appropriate investment horizon, the wealth required on the horizon date, how much risk to undertake and the liquidity required in the intervening period. After these needs have been identified, the investor must choose between two types of strategies: a passive strategy, and an active strategy.
A passive strategy involves purchasing those securities that most closely meet the investor's needs. Subsequent trading is kept to a minimum, and is undertaken primarily to keep the characteristics of the portfolio in line with changing needs. If liquidity is important, the investor may follow a strategy of holding only short-term securities or perhaps a barbell or laddered portfolio. The investor who is concerned about safeguarding the principal may choose only high quality bonds or a portfolio consisting of bonds issued by a wide variety of borrowers. The investor who requires a known amount of wealth at some future date may follow an immunization strategy of keeping the duration of the portfolio equal to the investment horizon.
Under an active trading strategy, the investor continually trades securities for other securities promising higher returns. Many such "swaps" are possible. An arbitrage swap is the trading of one security for an identical security trading at a lower price. The interest rate forecast swap involves prediction of future interest rate movements: the investor swaps into securities that will provide a higher return when interest rates actually move. Relative value swaps involve the exchange of a security that is overpriced relative to other securities on the basis of quality, coupon or other features for one of the properly priced or underpriced securities.
An active strategy can lead to superior returns to a passive strategy, but only if the investor has above-average ability to forecast the returns of particular securities or groups of securities. It is not certain that this ability to forecast has ever been demonstrated.
