Part A of this paper describes the reasons for selecting corporate bonds as opposed to other types of bonds. Part D defines the benchmarks for each portfolio to compare results at the end of the investment period.
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Investing in bonds is one of the most challenging investment decisions that investors have to make. This is due to the wide variety of bonds that exist on the market in the financial services. This therefore gives the investor not only a wide range of choices but also one of which has many risks. Corporate bonds are good investment areas for financial institutions but also have inherent risks associated with them and the investor must evaluate this first before buying them (Choudhry, 2011, p. 57). In choosing the particular corporate bonds, we were guided by a number of factors. One of them is that the corporate bonds we selected have higher yields within a short time when compared to others like government bonds. Given the time period that we intend to invest in these bonds, the high risks which are always associated with high yielding bonds can be offset during the short period. We also needed a lump sum and dependable income that is steady and allows us to preserve our principal investment. All the corporate bonds we selected from financial institutions have higher rating which makes the safety of our investment guaranteed as seen through the likelihood of repayment of our principal investments and the expected annualized interest. Moreover, we chose corporate bonds as opposed to government bonds because of the diversification of sectors, the quality of credit, and the structure of bonds which are almost in tandem with our objectives for investments (Choudhry, 2004, p.33). The diversity of corporate bonds means that we have more options to choose the most dependable bonds that give better repayment of our principal investment of 20 million pounds while allowing us to market the bonds easily at the end of the one year period. Unlike the government bonds which require longer time to market, corporate bonds can be marketed easily because of their small size and the liquidity of corporate bonds in the market (Ramaswamy, 2004, p. 22).
A benchmark index is a standard which is used to evaluate the performance of a security performance or investment. Several benchmark indexes are used in the financial investments including the S&P 500, the Russell 2000 Index, and the Dow Jones Industrial Average among many other indexes. Benchmark indexes are important because they help the investor to track the performance of the bonds or stocks on selected markets. The selected benchmark index will assist us in evaluating each of our portfolios on the bond market by allowing us to track the changing values to indicate a stronger or weaker performance and thus enable us to measure our bond portfolios. Because of the variety of industries in which we have bought our bonds, we will have different benchmark indexes used in each of the industry to enable us to discern the broader performance of the market. Our result at the end of the investment period will be evaluated against the benchmark indexes set by the European Central Bank, the UK Central Bank, and the US Federal Bank. Occasionally, bond investors are supposed to choose a market index or a combination of market indexes which act as the portfolio benchmarks and helps in tracking the performance of the bonds in a given market segment (Maginn, Tuttle & McLeavey, 2010, p. 36). With our investment, there are different market segments ranging from finance to housing and will help in tracking the returns on a buy-and-hold basis. Moreover, our benchmark indexes does not attempt to determine the most attractive securities so that we are able to compare actively managed performance portfolio among the selected bonds.
Several factors may cause each of the portfolios to perform differently from the benchmark in what is known as tracking error. However, the tracking error is always positive and is equal to the annualized standard variance of monthly surplus returns (Fabozzi, Martellini & Priaulet, 2006, p. 45). The tracking error will help us to identify investment choices in the future in case we decide to invest in bonds after the period of one year. The benchmark indexes used in our portfolio management have sufficient securities for easier buying. The benchmarks we have selected for each portfolio to present an unambiguous and transparent approach, gives clear weights of securities constituted in the benchmark. It is also considered that the benchmark indexes have securities that can be purchased in the market or reflect the performance of the markets in that sector. We have also considered that the benchmark indexes selected are priced on a daily basis to allow comparison of our performance on a daily basis in the one year maturation period. Moreover, the availability of historical data relates to each of the benchmark index selected for the portfolio is important because it will help us at estimate the returns we anticipate from our investment. We also anticipate that the selected benchmark indexes have a low turnover so that it is not difficult for us to base the allocation of portfolios on the index whose composition changes frequently. More importantly are the frequent updates from the benchmark provider detailing the risk characteristics to enable the comparison of the active and passive benchmark risks facing the investment portfolios (Fabozzi, Martellini & Priaulet, 2006, p. 45).
In selecting each of the benchmark indexes for the portfolio we have evaluated the volatility tolerance and risks associated with one year investment bonds and thus all the benchmarks have high long-term returns and therefore present absolute returns for a shorter period of one year. We have also considered the liquidity of our portfolios and selected benchmark indexes with short duration while avoiding benchmarks with greater risks even with less liquidity and higher interest rates. The selected benchmarks meet the liquidity profile of our investment and thus serve as essential tools which will be useful during our investment period. Another consideration for selecting each of the benchmark has been the range and diversity of our securities and bonds. The benchmark indexes are wide enough to allow the contribution of the portfolio’s overall performance by actively managing the market forces which are likely to have negative impacts on the interest rates anticipated at the end of the year (Maginn, Tuttle & McLeavey, 2010, p. 56).
Choudhry, M. (2004).Corporate Bonds and Structured Financial Products. London: Butterworth-Heinemann.
Choudhry, M. (2011). Corporate Bond Markets: Instruments and Applications. Hoboken; John Wiley & Sons.
Fabozzi, F. J., Martellini, L. &Priaulet, P. (2006), Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies. Hoboken; John Wiley & Sons.
Maginn, J. L., Tuttle, D. L. & McLeavey, D. W. (2010), Managing Investment Portfolios: A Dynamic Process. Hoboken: John Wiley & Sons
Ramaswamy, S. (2004), Managing Credit Risk in Corporate Bond Portfolios: A Practitioner’s Guide. Hoboken: John Wiley & Sons.
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