If I were a Bond fund Manager with a mid term view

We were told by our Bond's Professor (can somebody say shaken not stirred) to imagine we were bond fund managers with a mid term view.

This is what our bond fund would look like:

Bond Portfolio Strategy

a) Investment objective

The objective of the bond portfolio recommended in this paper (Excalibur US Bond Portfolio) seeks to earn better returns than that of an identified benchmark index fund. Excalibur would achieve higher returns through the use of an index plus strategy. The Portfolio seeks current income, with capital appreciation and growth of income, by investing at least 20% of its net assets in bonds of governments and government agencies, 75% in corporate bonds issued in the US and the rest of it in cash. The asset-mix will be a diversified portfolio of fixed income instruments of varying maturities.

b) Benchmark

The benchmark index for Excalibur will be the PIMCO Total Return Fund (Bloomberg Code: PTTRX US, refer to Appendix A) where its objective is maximum total return, consistent with preservation of capital and prudent investment management. The Fund invests at least 65% of its assets in a portfolio of investment-grade fixed income instruments of varying maturities. The annualized 5 year return is 8.29%. .

c) Strategy

Excalibur will be adopting an index plus strategy with 20% invested in PIMCO’s top 10 holdings to achieve preservation of capital, the remaining 75% holdings will be actively managed, leaving behind 5% in cash. The Portfolio seeks to achieve alpha through active management in the selection of corporate bonds. Given various analysts’ calls that 2011 would potentially be the year where equities outperform bonds, it is essential to identify areas of alpha to outperform a pure capital preservation portfolio, e.g. PTTRX US.

The actively managed Excalibur will take the form of a bullet portfolio with majority of the holding held in medium term corporate bonds. While the US Bond market is divided into six sectors; namely, U.S. Treasury, agency, municipal, corporate, asset-backed securities and mortgage sector. In lieu of the Portfolio restriction to invest in high grade bonds (A rating and above), there will not be any asset-backed securities and mortgage sector in the bond holdings.

The reasons for adopting such a strategy are as such:

i. Existence of a Sweet Spot

Research conducted by the Excalibur research department reviews that there exist a sweet spot in the middle term range in specific industries. These bonds are least affected by any interest rate volatility. The sweet spot issues currently have a higher credit spread as opposed to similar issues of shorter and longer maturity terms. The existence of such higher credit spread in an improving economic environment has been shown to act as a buffer to interest rate volatility (Refer to Appendix B: “Assessing the trade-off between credit risk and rate risk.” Goldman Sachs).

ii. Interest rates Movement

The US Federal Reserve rate has been at a low of 0.25 per cent since 2009. Although, it is forecasted that the central bank is unlikely to raise the short term interest rates in the near future. However, there is a likely chance that long term interest rates would be raised. In such an event, long term bond prices are expected to fall thereby making the bullet strategy more favourable as compared to the barbell and ladder strategies.

iii. Portfolio Duration

Investing in high coupon, high yield to maturity issues lowers our portfolio duration thereby protecting Excalibur in the event of rising interest rates.

iv. Portfolio Flexibility

Excalibur, with its low duration and relative immunity to interest rate movements bequeaths it the flexibility of changing its mix when better yields are expected in other sectors or maturities.

v. Investors Objective

Excalibur is targeted mainly at investors with medium term investment horizon (5 to 10 years).

d) Portfolio Allocation

i. Passive management – 20% in Pimco’s Top 10 Holdings

PIMCO TOP 10 HOLDINGS	Allocation
T-NOTE 2.500 30-Jun-2017	3.095%
T-NOTE 3.500 15-May-2020	2.984%
T-NOTE 3.125 30-Apr-2017	2.842%
T-NOTE 2.125 31-May-2015	2.148%
FNCL 4.500 2010	1.729%
T-NOTE 2.750 31-May-2017	1.709%
T-NOTE 3.625 15-Feb-2020	1.445%
BNTNF 10 01-01-2012	1.292%
T-NOTE 2.500 30-Apr-2015	1.146%
T-NOTE 0.625 30-Jun-2012	1.051%

Figure 4: Pimco Total Return Fund, Top 10 Holdings as at Nov 30, 2010

ii. Active management – 75% in Corporate Bonds

CORPORATES	Allocation	Coupon	Maturity	YTM	Rating	Sector	Industry
MERRILL LYNCH & CO INC	5%	5.700%	02-May-17	5.702%	A	Financial	Banks
CATERPILLAR FINL CORP PWRNTSBE	5%	6.500%	15-Mar-16	5.620%	A	Financial	Banks
REINSURANCE GROUP AMER INC	5%	5.625%	15-Mar-17	4.963%	A	Financial	Insurance
SHELL INTERNATIONAL FIN BV	5%	5.200%	22-Mar-17	2.992%	AA	Energy	Oil
CHEVRON CORPORATION	5%	4.950%	03-Mar-19	3.065%	AA	Energy	Oil
XTO ENERGY INC	5%	6.250%	01-Aug-17	3.118%	AAA	Energy	Oil
TOYOTA MTR CR CORP TMCC CORENO	5%	5.350%	21-Feb-17	4.709%	AA	Consumer Cyclical	Auto Mobiles
DAIMLER CHRYSLER NORTH AMER HL	5%	8.500%	18-Jan-31	5.376%	A	Consumer Cyclical	Auto Mobiles
DISNEY WALT CO MTNS BE	5%	5.625%	15-Sep-16	2.456%	A	Consumer Cyclical	Media Company
EMERSON ELEC CO	5%	5.375%	15-Oct-17	3.112%	A	Utility	Electricity
UNION ELEC CO	5%	5.100%	01-Aug-18	4.089%	A	Utility	Electricity
ATLANTIC CITY ELEC CO	5%	7.750%	15-Nov-18	3.630%	A	Utility	Electricity
DU PONT E I DE NEMOURS & CO	5%	6.000%	15-Jul-18	3.545%	A	Materials	Chemicals
RIO TINTO FIN USA LTD	5%	6.500%	15-Jul-18	3.785%	A	Materials	Metal Mining
BHP BILLITON FIN USA LTD	5%	5.400%	29-Mar-17	2.799%	A	Materials	Metal Mining

Figure 5: Selected Corporate Bonds

Since our fund was based on the PIMCO total return fund as its index, we used excel to match the duration of our holdings to that of PIMCO.

Attach is the full report, bond fact sheet and excel spread sheet