Optimize Your Bond Portfolio Through Cash Flow Matching Dedication Strategy

Summary

• The basic investment management process is the same, whether it is fixed-income portfolio management, equity portfolio management, commodities, or any other asset class portfolio.
• The portfolio manager, in discussion with the client, must agree on a suitable benchmark to evaluate the portfolio performance.
• There are two objectives of fixed income portfolio management. First is the benchmark-driven investing (BDI) and, the second is the liability-driven investing (LDI).
• Cash flow matching is the type of liability-driven investing (LDI) strategy that is designed to generate enough cash flows to successfully meet future liabilities.

Introduction

The primary goals of the investment management business are to generate enough income (return) to meet ongoing expenditures, pay-off any liabilities, and to save for future needs. The basic investment management process is the same, whether it is fixed-income portfolio management, equity portfolio management, commodities, or any other asset class portfolio. It has the five-step process: (1) setting investment objectives and constraints (drafting IPS), (2) developing the investment strategy, (3) implementing investment strategy, (4) portfolio monitoring and (5) portfolio rebalancing. The portfolio manager, in discussion with the client, must agree on a suitable benchmark to evaluate the portfolio performance.

Broadly speaking, there are two objectives of fixed income portfolio management. First is benchmark-driven investing (BDI) and, the second is liability-driven investing (LDI). The investors who fall in the first category do not have specific liability or set of liabilities. The best example is the bond mutual fund. Mutual funds have free hands to manage investors' funds because they do not have specific liabilities to meet. Portfolio managers in this class select an index of the bond market as a benchmark to gauge their investment performance. On the other hand, investors in the liability-driven investing category have liabilities that the portfolio funds need to meet. For example, pension funds have liabilities for their pensioners to pay pension amounts after the retirement of the pension plan members. The portfolio managers measure their investment performance against how effectively the portfolio is generating funds to pay out cash flows related to the liabilities (benchmark).

There are a number of investment strategies in liability-driven investing. The focus of this writing is on the "Cash Flow Matching" which is the one component of two-part "Dedicated Portfolio" theory. The other component is the "Portfolio Immunization," which is not going to be covered here.

History of Immunization (Dedicated

Analyst’s Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.