Bond Selection for Managed Portfolios


  • WM. Steven Smith

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      The author is from the Department of Finance, University of North Dakota. He wishes to acknowledge Robert J. Sweeney for insightful comments and to thank the anonymous referee for suggestions for improving the manuscript. The author also wants to thank Ms. Ekaterina Loukomskaia for valuable research assistance.

Wm. Steven Smith, Department of Finance, Gamble Hall, Box 7096, University of North Dakota, Grand Forks, ND 58202-7096, USA.


Abstract:  Investors in coupon bonds evaluate them based upon financial considerations such as coupon rate, time-to-maturity, callability, convertibility, and financial condition of the issuer. These investors regard promised yield as only a rough measure of the reward a bond offers to compensate them for the pure time-value-of-money and the financial risks to which they are exposed. Hence, they need a more meaningful measure of reward to facilitate comparisons among coupon bonds. The purpose of this paper is to describe an alternative heuristic approach to the task of making such comparisons. The approach produces a simple ordinal measure of reward, called the ‘indifference spread,’ that considers implicitly the potential sources of return to, as well as many of the risks associated with, investment in coupon bonds. For any coupon bond, the indifference spread method permits assessment of relative reward offered for the combined exposures to price and call risks, while also reasonably accommodating possible sale anytime prior to maturity. Once an investor (e.g., money manager) identifies indifference spreads for all bonds under consideration as of any moment in time, he/she can then draw conclusions regarding their relative values at that time based, in large part, on these spreads.