How to Use Bond Pricing Theorems to Choose Bonds
Bond investing has its advantages. Bonds typically have less volatility than stocks and generally pay higher interest rates that savings accounts. Some types of bonds are even tax-free at the federal, state and local levels. Choosing bonds can be tricky.
Selecting the wrong ones may leave you open to risk. Poorly rated bonds promise big returns, but the risk of default is higher. Bond pricing theorems can be used to effectively choose bonds while reducing some of the risk.
5 Steps to Use Bond Pricing Theorems to Choose Bonds
1. Be clear about your objectives.
Define what you want your bond portfolio to achieve. Bonds are typically chosen by investors seeking safety of principal and income. An income strategy will be more focused on stability rather than growth. As a result, higher rated bonds like those with AAA credit ratings may be well-suited because the risk of default is less likely.
2. Decide whether you will be passive or active.
Passive investors prefer doing work up front and then setting their bond portfolio on autopilot. In contrast, active investors prefer a hands-on approach where every move can be scrutinized to potentially maximize returns.
3. Familiarize yourself with the five Malkiel bond pricing theorems.
If a bond’s market price increases, then its yield must decrease. The converse is also true. If a bond’s market price decreases then its yield must increase.
If a bond’s yield doesn’t change over its life, then the size of the discount will decrease as its life shortens.
If a bond yield does not change over its life, than the size of the discount will decrease at an increasing rate as its life shortens.
A decrease in a bond’s yield will raise the bond’s price greater than the associated fall in the bond’s yield.
Price changes are greater when rates fall than they are when rates rise.
4. Use these bond pricing theorems to construct a diversified bond portfolio to minimize the some of the investment risks.
For example, theorem two states that longer maturity bonds respond more strongly to a given change in interest rates. Therefore, if your investment objective is to maintain a steady income, then you should add a percentage of shorter maturity bonds to your bond portfolio because they will be less susceptible to changes in interest rates, according to the theorem.
5. Apply your market outlook to your portfolio.
Then select the appropriate pricing theorem to guide your actions based on your market outlook. For instance, if you believe market interest rates will rise sharply in the future, then bond prices will fall accordingly. Use the above theorems to predict the bond’s behavior to choose between two bonds with similar credit ratings.
Assess your portfolio regularly. However, don’t make changes too often as they may incur transaction costs.
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