Bond portfolio management consists of strategies whose aim, generally speaking, is to minimize the amount of risk and maximize the amount of return per unit of risk. More specifically, the different strategies attempt to minimize the downside impact of the components of interest rate risk. .
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Like equities, bonds are comprised of two types of risk: Systematic and Unsystematic. Unlike equities, however, the distribution of risk is not 50:50. Bonds are comprised of 75% systematic risk and 25% unsystematic risk. Therefore, bondholders are only able to reduce their risk through research and adverse selection by 25%. The rest of their risk is determined by systematic risk, which in turn consists of purchasing power, market psychology, and interest rate risk. The increase in the distribution of systematic risk does not, however, imply that bonds are more risky than equities; in fact, the opposite is true. .
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The most general and widely known rule of thumb when dealing with bonds is to remember that when interest rates are rising, bond prices are falling, and when interest rates are falling, bond prices are rising. Hence, for the investor, an environment in which interest rates are falling is preferable to one in which they are rising. This rule is acceptable at the superficial level; however, further examination has identified two components to interest rate risk that render the situation more complex. Interest rate risk consists of both price risk and reinvestment risk. Price risk, explained earlier, deals with the price of a bond reflecting the rise and fall of interest rates. Reinvestment risk deals with the assumption that cash flows derived from the bonds being reinvested, not at the coupon rate of the bond, but at the current market interest rate. So in a situation where interest rates are rising, it is not always detrimental to hold bonds. The price of the bond may fall as a result of increasing interest rates, but the cash flows derived from the bond are being reinvested at a higher rate than that of the coupon interest rate.
