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Bonds

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Fixed income assets (e.g., bonds) are often added to a portfolio to lessen its volatility.  Another benefit from including bonds in a (otherwise all equity) portfolio is the improved riskreturn characteristics resulting from the less than perfect correlation of bonds with equities and other assets.

Manoj V. Athavale and Terry L. Zivney, "Now is Always the Best Time to Buy Bonds," Journal of Financial Planning, August 2005, pp. 56-61.  This outstanding paper suggests that it makes sense to buy bonds when you need them, even if that happens to be in a rising interest rate environment.  "... financial planners would better serve their clients by helping them define their investment time frame and helping them understand the role of bonds in their portfolio, and discouraging speculation on the direction and magnitude of interest rate changes."

Dale L. Domian and William Reichenstein, "Performance and Persistence in Money Market Fund Returns," Financial Services Review, 1997 Vol 6, pp. 169-183.  This paper confirms strong persistence in money market mutual funds due principally to the almost perfect negative correlation of expenses and performance.  The paper strongly supports the prudence of a strategy of selecting money market funds by cost (i.e., choosing no-load funds with the lowest expense ratios).

Dale L. Domian, Terry S. Maness, and William Reichenstein, "Rewards to Extending Maturity: Implications for investors," Journal of Portfolio Management, Spring 1998, pp. 77-92. This paper confirms that short term bonds offer superior risk-adjusted returns to those offered by longer term bonds.  "The average term premium appears to rise very sharply as maturity lengthens through about one year, continues to rise through about three years, remains essentially flat from. about three through fifteen years, and falls thereafter."  "The greatest reward to risk is realized for extending maturity through the shortest end of the bond market. In fact, most of the average reward to extending maturity probably occurs by the time maturity reaches one year."

Eugene F. Fama and Robert R. Bliss, "The Information in Long-Maturity Forward Rates," American Economic Review, September 1987, pp. 680-692. This paper suggests that long forward interest rates have significant power in predicting future spot interest rates.  "The 1-year forward rate calculated from the prices of 4- and 5-year bonds explains 48 percent of the variance of the change in the 1-year interest rate 4 years ahead."  In other words, the market is fairly efficient at anticipating future interest rates.

Amy K. Edwards, Lawrence E. Harris, and Michael S. Piwowar, "Corporate Bond Market Transaction Costs and Transparency," Journal of Finance, June 2007, pp. 1421-1451. "Our results show that corporate bonds are expensive for retail investors to trade.  Effective spreads in corporate bonds average 1.24% of the price of representative retail-sized trades ($20,000). ... Corporate bond transaction costs are much lower for institutional-sized transactions."  This paper confirms the prudence of using bond funds instead of individual bonds -- due to the much higher transaction costs associated with retail-size trades.

Eugene F. Fama and Robert R. Bliss, "The Information in Long-Maturity Forward Rates," American Economic Review, September 1987, pp. 680-692.  This paper suggests that long forward interest rates have significant power in predicting future spot interest rates.  "The 1-year forward rate calculated from the prices of 4- and 5-year bonds explains 48 percent of the variance of the change in the 1-year interest rate 4 years ahead."  In other words, the market is fairly efficient at anticipating future interest rates.

Roberto C. Gutierrez, Jr., "Book-to-Market, Equity, Size, and the Segmentation of the Stock and Bond Markets," Texas A&M Working Paper, April 11 2001 (85kb).  This paper suggests that book-to-market ratio and market capitalization have explanatory power for the cross section of corporate bond returns, just as they do for stocks.

Delroy Hunter and David P. Simon, "Benefits of International Bond Diversification," Journal of Fixed Income, March 2004, pp. 57-68 (1mb). This paper finds that, during the period 1992 to 2002, there was benefit to diversifying a bond portfolio overseas, but only if you hedged the currency risk.

Antti Ilmanen, "Does Duration Extension Enhance Long-Term Returns?," Journal of Fixed Income, September 1996, pp. 23-36. "The main conclusion is that duration extension does increase expected returns at the front end of the [yield] curve ... and for durations longer than two years, no conclusive evidence exists of rising expected returns."

Antti Ilmanen, Rory Byrne, Heinz Gunasekera, and Robert Minikin, "Which Risks Have Been Best Rewarded?: Duration, equity market, and short-dated credit risk," Journal of Portfolio Management, Winter 2004, pp. 53-57. This outstanding paper looks at what return enhancing strategies are most "worthwhile" for bond investors: extending duration, changing from bonds to stocks, and decreasing credit quality.  It finds that the highest increase in risk adjusted returns comes from extending duration from treasury money market to the 1 to 3 year range, and from increasing credit risk from zero (Treasuries) to investment-grade corporates.  This paper supports a strategy of using short-term investment grade corporate bonds as the (non-inflation indexed) bond component in your portfolio.

Alexander Kozhemiakin, "The Risk Premium of Corporate Bonds," Journal of Portfolio Management, Winter 2007, pp. 101-109. "If investors are concerned primarily with generating the best risk-adjusted returns, the shape of the risk premium curve will promote investment-grade bonds.  ... This also implies that 1) ensuring proper diversification and 2) reducing transaction costs are of more importance in managing investment-grade portfolios than a detailed credit analysis of individual bonds."  This paper supports the idea that concentrating on investment grade bonds (i.e., rather than on lower-quality debt) seems prudent for most investors.

Burton G. Malkiel, "Expectations, Bond Prices, and the Term Structure of Interest Rates," Quarterly Journal of Economics, May 1962, pp. 197-218. This seminal paper laid out clearly some of the principal phenomena affecting bond pricing.

Craig McCauley, "The Case for Global Fixed Income," Global Investor, October 1996, pp. 29-31. "... presents a compelling case for US investors to substantially increase their exposures to international fixed income markets (on a fully hedged or unhedged basis), and to maintain a permanent exposure to this asset class."

Robert C. Merton, "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, May 1974, pp. )449-470 (1.58mb. This paper suggests that corporate bonds can be modeled as riskless bonds (i.e., Treasury bonds) plus a put (i.e., an option to sell the stock) that bondholders issue to the owners of the company’s stock.  As the company's prospects become better, the stock's price increases, which causes the value of the put to decrease (which is good for the bondholders who issue the virtual puts), which causes the value of the bond to increase, which causes the yield on the bond to decrease.  On a separate line of thought, as the company becomes riskier, the value of the put increases (which is bad for the bondholders who issue the virtual puts), which causes the value of the bond to decrease, which causes the yield on the bond to increase.  This is how high-yield bonds get to be high-yield bonds.

Eugene A. Pilotte and Frederick Sterbenz, "Sharpe and Treynor Ratios on Treasury Bonds," Journal of Business, January 2006. "Most striking is our finding that reward-to-risk ratios vary inversely with maturity and are incredibly high for short-term bills. Apparently investors would do much better engaging in highly leveraged investments in bills instead of purchasing long maturity bonds or common stocks."  This paper provides additional support for the prudence of keeping bond durations short.

Tom Potts and William Reichenstein, "Predictability of Fixed Income Fund Returns," Journal of Financial Planning, November 2004. This paper finds that relative bond fund returns are somewhat predictable.  For funds with similar duration and credit worthiness, the difference in returns is likely to be similar to the difference in expense ratio.  The gross returns for Intermediate-Term bond funds were consistent (over five year periods, but less so for shorter periods) with the yield on five year treasuries at the beginning of the period.  The gross returns for Long-Term bond funds were consistent (over ten to twenty year periods, but less so for shorter periods) with the yield on twenty year treasuries at the beginning of the period.

William Reichenstein, "Bond Fund Returns and Expenses: A Study of Bond Market Efficiency," Journal of Investing, Winter 1999, pp. 8-16 (488kb).  This paper finds a strong persistence in bond fund performance.  It suggests this is due to the strong negative correlation between a bond fund's expenses and its performance.  In other words, this paper suggests that selecting bond funds by price (i.e., no-load funds with the lowest expense ratios) is an extremely prudent strategy.

V. Vance Roley and Gordon H. Sellon, Jr., "Monetary Policy Actions and Long-Term Interest Rates," The Federal Reserve Bank of Kansas City Economic Review, Fourth Quarter 1995, pp. 73-89 (142kb). This excellent paper describes, theoretically, how bond yields respond to changes in the Federal Funds Target rate — and why.

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