Fixed Income Portfolio Optimization: More Than Just Filling Holes or Allocating Bonds

The bond market contains 100,000+ available bonds for purchase on a given day. As portfolio managers are trying to determine the ideal securities for each portfolio, their options are endless. Add to that the extensive amount of data and analytics that goes into selecting a bond, and portfolio managers have begun to become data processors instead of investment strategists. This has left portfolio managers trying to hunt with a spear – far from the easiest way to catch prey. Through the emergence of some technology, portfolio managers upgraded to a bow & arrow by using generics and allocation to find the right securities. However, we’re now bringing the rifle so PMs can hyper-target the exact bonds they need for their portfolios.

In this blog, you can explore how optimizing portfolios has evolved and what it means to be a true portfolio optimizer – and what does not count. Finally, you can compare the different methodologies for choosing bonds for your accounts.

Evolution of portfolio optimization for bond managers

Portfolio optimization has evolved substantially over time. It began as an allocation tool. With an Excel spreadsheet and a couple (or perhaps several) cups of coffee, you could produce an allocation tool that placed bonds into portfolio(s), so long as they didn’t have a negative impact.

Then, investment teams tried to quantify where gaps existed within portfolios using generic securities. Once you knew where the holes were, then you could find actual bonds to fill them. While this method may lead you to buy a single bond that fits specific characteristics, what if the most optimal solution was actually a combination of two or three bonds that you could buy across your portfolio(s)?

The next chapter of optimization, especially in managing fixed income SMAs, is having the ability to set your preferences and then process every potential outcome when searching for the most optimal bonds for a portfolio. This enables PMs to focus on unique portfolios, while the tool accounts for unique rules and bond-level characteristics, so you can execute with clear pre-trade visibility.

Imagine running an optimization on live executable bonds so you can invest your portfolios in the most optimal way. Advanced portfolio optimization in fixed income is the invention that will ensure firms remain relevant in the future.

What is a fixed income portfolio optimization tool?

Let’s debunk the myths. People automatically think of optimization engines as opaque black boxes, but those types of tools don’t benefit anyone. An optimizer should simply take all the criteria and rules you have for each portfolio and run through thousands of calculations to find the optimal investments available in the market. And it should do this across all your accounts in one shot.

As a PM, you need to be able to set your preferences to get your desired outcome while allowing technology to optimally size positions, control portfolio risk, and adhere to unique client requests. But it shouldn’t require you to guesstimate or spend hours sorting through the endless possibilities. This is precisely why we designed an optimizer that’s transparent and flexible to user inputs.

By using IMTC’s Optimizer, you’re getting trade recommendations based on a data science approach. Our system’s ability to synthesize thousands of data points from dealer inventory, internal firm preferences, and unique client needs, while being able to set priorities and goals, means you’re able to implement your best ideas and client requests – fast.

Investment teams focusing on fundamental factors (e.g., yield, spread, liquidity, CTD) and quantitative factors (e.g., environmental impact or the ability of an issuer/obligor to survive a global pandemic) will find IMTC’s optimization tool dramatically reduces the time it takes to make precise investment decisions.

Comparing methodologies for choosing bonds in a portfolio

The investment process for managing fixed income SMAs is dependent upon the technology the team utilizes. Explore the benefits, pitfalls, and processes for each type of portfolio optimization.

1. The allocation method

Does your process for determining bonds look similar to this?

1. Pre-set portfolios to users desired:
   1. IPS/client preferences
   2. Portfolio positioning
2. Filter daily inventory by types of bonds you typically purchase:
   1. Assess by size offered as you need larger offerings in order to allocate the bond to multiple accounts
3. Find the best bond in the market while accounting for other considerations, including:
   1. Determining relative value
   2. Asking if I like the credit
   3. Assessing how liquid the bond is
4. Allocate bond equitably via rankings:
   1. Come up with score by a management style which has weightings to rank portfolio needs
   2. Include portfolios with positive scores, which can be produced even if there are negative inputs based off weightings
   3. Use ranking to allocate bonds over other portfolios
5. Test the bond against other rules and guidelines, such as:
   1. Would I be overweight a specific state or obligor?
   2. Are there any unique client requests that stop me from purchasing this bond?
6. Repeat steps 1-4
   
   
   

2. The generics + allocation methodology – “filling holes”

Does your process for determining bonds look like this?

1. Pre-set portfolios to users desired:
   1. IPS/client preferences
   2. Portfolio positioning
2. Use holdings vs. ideal weights and determine where you are most underweight. For example, I am underweight the:
   1. 5-7 year duration bucket
   2. AA
   3. General Obligation Sector
3. Filter for daily inventory:
   1. View all 5-7 years, AA, GO bond
4. Find the best bond that accounts for all considerations, including:
   1. Fitting the right characteristics
   2. Determining relative value
   3. Checking if the credit is approved – what does the analyst think
   4. Assessing how liquid the bond is
5. Test bond for individual portfolio rules, such as:
   1. Would I be overweight a specific state or obligor based off portfolio rules and current holdings?
   2. Are there any unique client requests that stop me from purchasing this bond?
6. Allocate bond equitably across accounts:
   1. Determine if portfolio is in need of the bond over other portfolios
      
      
      

3. Using optimization method

Does your process for determining bonds look like this?

1. Pre-set portfolios to users desired:
   1. IPS/client preferences
   2. Portfolio positioning
   3. Relative value
   4. Credit research
   5. Liquidity preferences
2. Set the optimization preferences to rank priority of, choosing to:
   1. Maximize yield/spreads
   2. Reduce tracking error
   3. Minimize duration drift
3. Synthesize all available bonds in coordination with pre-set rules and ranking of priority to allocate best fit bonds to portfolios, while ensuring:
   1. Portfolio level trades are in compliance
   2. Moves the portfolio into ideal positioning
   3. Maximizing the portfolios’ taxable equivalent yield
4. Allocate bonds based off need (if original position size is no longer available)

Outcomes of using robust portfolio optimization software

By using an optimizer, you increase your investable market and ability to find the bonds that most optimally reflect your best thinking, while maximizing the taxable equivalent yield.

Users can then rely on a tool to find best execution, increase liquidity by buying bonds that are already held in the portfolio, and synthesize the entire market to purchase the best bond for one portfolio, also giving you the ability to purchase odd-lots. Optimization engines complete all these steps so quickly that it enables users to manage more AUM and/or portfolios and provide a more extensive solution to their clients.

The customized offerings and new strategies that end clients are looking for are much easier to produce. With an optimization tool that can synthesize both buys and sells concurrently, you can now tax-loss harvest for all your SMAs throughout the year or take a more active approach to changes in the market. The ability to lower the account minimums allows asset managers to manage more of their own assets rather than farm them out to ETFs and mutual funds.

How can an optimizer help you?

• Outperform on accounts
  • Generating swap ideas
    • Ability to tax-loss harvest at scale
    • More active bond management where you maximize tax-equivalent-yield (active bond ladders)
  • Purchase odd-lots
  • Purchase “matchers” (bonds already held in account)
  • Respond to more BWIC’s/RFQ’s
  • Guarantee best execution
    
    
• Scale your firm
  • More customized offerings and different strategies
    • Model portfolios
    • State-focused
    • Blended account of taxable and tax-free
    • Cross-over accounts for IG and HY
  • Lower account minimums
  • More portfolios without adding headcount
    
    

Want to see our Optimizer in action? Schedule a demo today.