Bond portfolio optimization

1 The tools of modern portfolio theory are in general use in the equity markets, either in the form of portfolio optimization software or as an accepted frame- 2 work in which the asset managers think about stock selection. In the ? xed income market on the other hand, these tools seem irrelevant or inapplicable. Bond portfolios are nowadays mainly managed by a comparison of portfolio 3 4 risk measures vis ¶a vis a benchmark. The portfolio manager’s views about the future evolution of the term structure of interest rates translate th- selves directly into a positioning relative to his benchmark, taking the risks of these deviations from the benchmark into account only in a very crude 5 fashion, i. e. without really quantifying them probabilistically. This is quite surprising since sophisticated models for the evolution of interest rates are commonly used for interest rate derivatives pricing and the derivation of ? xed 6 income risk measures. Wilhelm (1992) explains the absence of modern portfolio tools in the ? xed 7 income markets with two factors: historically relatively stable interest rates and systematic di? erences between stocks and bonds that make an application of modern portfolio theory di–cult. These systematic di? erences relate mainly to the ? xed maturity of bonds. Whereas possible future stock prices become more dispersed as the time horizon widens, the bond price at maturity is 8 ? xed. This implies that the probabilistic models for stocks and bonds have 1 Starting with the seminal work of Markowitz (1952).