Evaluating the application of a portfolio optimisation approach to fixed income securities

Abstract

It is well known among institutional investors that the lack of yield is one of the top concerns with fixed income portfolios when compared to other investment returns. Virtually no asset manager applies mean-variance optimisation to fixed income securities given their fixed maturity, pricing and liquidity characteristics. The current environment for these investments is not encouraging either due to the interventions of the central banks in the capital markets to increase their balance sheet figures.

The main objective of this dissertation is to test the feasibility of applying the portfolio optimisation approach as outlined in the Modern Portfolio Theory (MPT) to a fixed income portfolio. The historical performance of bonds is analysed in relation to that of equity to assess whether reasonable justification exists upon which MPT can be rationally applied to fixed income securities. The results obtained from this analysis are satisfactory as they suggest strong belief that stocks and bonds are correlated enough to proceed with the application of MPT.

Bond funds are used to address the limitations and adjustments involved in applying this framework to a portfolio. The portfolio was constructed with thirteen bond funds from the US bond market. A bond index fund was identified in the study to serve as a benchmark for the optimised portfolio. After comparing the performance of the optimised portfolio with that of the bond index fund, it was concluded that the optimisation process produced better results. This implies that the optimisation approach as outlined by MPT, is also viable for fixed income securities when compared to an alternative passive investment strategy.