I'd like to optimize a bond portfolio with different bond classes (government bonds, corporates, ...) and different ratings as well as maturities. Is this even possible to optimize such a portfolio? And how should I do that in practice? Suggestions or recommendations for research or similar would be very helpful. Thanks!
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4$\begingroup$ Optimization can be interpreted in different ways. What are you optimizing for? Return, risk, drawdowns? $\endgroup$– Ralph WintersCommented Apr 26, 2022 at 15:05
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3$\begingroup$ @Ralph Winters I`d like to optimize the return with constraints on e.g. duration $\endgroup$– user61695Commented Apr 29, 2022 at 11:20
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$\begingroup$ I would suggest not optimizing the portfolio in the "classical" sense (i.e. mean-variance). Conversely, your objective function should be something like the weighted OAS to Credit VaR ratio. In the CVaR calculation, you can take into account credit risk as well as the probability of migrating to worse rating notches (and default, of course). $\endgroup$– Lisa AnnCommented Sep 26, 2022 at 20:55
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$\begingroup$ @LisaAnn Why not mean-variance? $\endgroup$– SaneCommented Jul 8 at 15:02
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3 Answers
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You can use a mean variance optimizer such as Portfolio Visualizer to include different bond assets with various durations and yields, and backtest the historical returns based upon risk tolerance and return. In your case, you might want to place constraints on the assets to reflect which ones you want to give higher or lower weights to.
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Disclosure - I don't analyze, trade or study bond portfolios.
Optimizing anything (in an operations research framework) begins with specification of the objective function (e.g., "minimize cost" or "maximize return") subject to available activity choices ("decision variables") and constraints (perhaps funding requirements schedule for a pension plan).
I'd like to optimize a bond portfolio with different bond classes (government bonds, corporates, ...) and different ratings as well as maturities.
What is your
- objective function?
- permissible investments?
- constraints?
There is circa 1980's literature describing formulating an objective, choices, and constraints in the bond portfolio context. For instance
Balbás, Alejandro, and Alfredo Ibáñez. "When can you immunize a bond portfolio?." Journal of Banking & Finance 22.12 (1998): 1571-1595.
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I am not an expert but one thing I can point out is traditional optimization will be very bad, as bonds are derived from the same factors. The correlations will be far too high for it to be useful. You might want to just optimize factors (treasury, spread, rating), and probably consider 2 bonds who are exposed to the same factors as the same exact bond.
Say I have 3 AAA bonds and 5 treasury bonds. So I have a treasury factor and a AAA factor. I can write optimization as linear combination of these factor returns, and I can estimate mean factor return easily
Once I know how much I should be exposed to each factor, I can create that exposure with many combinations of the bonds.
