JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS

March 1977

BOND PORTFOLIO STRATEGIES, RETURNS, AND SKEWNESS: A NOTE

H, Russell Fogler, William A, Groves, and James G. Richardson*

1, Introduction
The academic research has produced a series of contributions on optimal
portfolio strategies (Bradley and Crane (1], Crane (4], Cheng (3], Fisher and
Weil (5], Watson (9], Wolf (10]). Several of these studies—Bradley and Crane,
Watson, and Wolf—conclude that an optimal strategy for bank portfolios would be
a "dumbbell" strategy. Such a dumbbell strategy invests only in the shortest
and longest maturities, ignoring the intermediate maturities. The logic is
straightforward: liquidity risk is lowest in the shortest maturities and yield
is generally highest in the longest maturities. The risk/return superiority of
such a strategy was empirically verified by Watson, with subsequent confirmation
by the Bradley and Crane tests via a stochastic dynaunic prograunming formulation.
However, two important issues have not been fully addressed by these stud-
ies. First, what is an appropriate objective function—none of the previous
studies has used a holding-period return criterion, despite real-world emphasis
on performance evaluation. A second issue is whether bond portfolio holding-
period-returns, which include a guaranteed fixed portion, are more or less sym-
metrical than common stock returns; such a condition might present important
advantages for the stock/bond portfolio allocations of institutions such as
pension funds.
Accordingly, the purpose of this note is twofold: (1) to evaluate the
influence of a holding-period-return criterion on the risk/return efficiency of
the dumbbell strategy; and (2) to exaunine the moments of the return distribu-
tions for bond portfolios. To achieve these purposes, a bond portfolio simula-
tion is used for four alternative investment strategies under five patterns of
interest rate movements. The next section will describe the simulation prograun

University of Florida, University of Florida, and Cerny and Ivey Associ-

ates, respectively.

The next section contains the definitions of risk used in the previous
studies by Bradley and Crane, and also Watson. In the present study, risk is
equated with the standard deviation of a portfolio's holding-period return.
The holding-period return is calculated as the change in a portfolio's market
prices plus its cash yield divided by its initial value.

127
and the results. Section III then discusses the skewness of the returns, as
well as the effect of nonstationarity on the skewness measure,

II, Impact of Objective Function Specification

Watson's study was a major empirical simulation of the postwar yield curve
history and corresponding bank cash flow patterns. His results indicated that
the dumbbell strategy was superior on a risk/return criterion compared to other
strategies, and he noted that his measure of risk [9, p, 39] and return
...included all coupon instaOsility but only that portion of
the capital gains and loss instadaility caused by the forced
sale of bonds to meet liquidity needs. Realized capital
gains and losses caused by bond sales implemented solely to
restructure the maturities in the portfolio were excluded
from this measure of risk, [9, p. 38]
Bradley and Crane handled the bond problem much differently. Their formu-
lation had an objective function of terminal (horizon) value maximization sub-
ject to four types of constraints: nonnegativity, cash inflows and outflows,
interperiod balancing, and net capital loss. While they did include a constraint
on book (unrealized capital) losses at the horizon time period, constraints on
each period's capital loss were defined:
in order to reflect bank practice and to represent the
portfolio manager's attitude toward risk, constraints were
put on the allowaQ>le net realized capital loss during any
year, [1, p, 23]
Thus, Watson, Bradley and Crane, and Wolf did not penalize long-term
bonds for any risk from price fluctuation if the bonds were not sold. While
such a definition of risk might be considered a reasonable attitude because
bonds have little or no principal risk if held to maturity, a high rate of in-
flation does create purchasing power risk; it may be argued that loss in price
may be caused by inflation rather than merely a cyclical rise in interest rates.
Further, a price decline has an implicit opportunity cost of not obtaining the
highest rate possible. The two implicit problems of purchasing power risk and
opportunity costs make a strong case for a holding-period-return criterion.
To assess the results of using a holding-period-return (HPR) criterion, a
computer program was developed. Twenty maturities were availad^le for the
periods 1-20 years. Yield curves were generated for each year from 1946-1971,

Because previous studies had dealt only with government securities, inter-
est rates were collected for: (a) 3-month Treasury Bills; (b) Short-Term (3-5
year) Governments; (c) Intermediate (7-9 year) Governments; and (d) Long-Term
(over 15 year) Governments, These four data points were used to fit a third-
degree polynomial equation as the yield curve. The third-degree equation fit
the data nicely until about the seventh year. After the seventh year, espec-
ially for the humped yield curves, a linear fit between the yield estimate of
the seventh and twenty-third year produced an excellent approximation of the

128
 Depending upon which portfolio strategy was being evaluated, bonds were bought
at the beginning of the year and then sold at the end of year prior to calculat-
ing the HPR. Transactions costs on purchases and sales were 1/8 percent on one-
year maturities, 1/4 percent of maturities from two up to eight years, amd 3/8
percent on longer maturities.
Five interest rate patterns and four portfolio strategies were tested. The
selection of interest rate patterns was to provide a set of generating processes
which would replicate all reasonaQjle assumptions. The patterns selected were:
(1) cyclical with rising trend—1945-1970, (2) cyclical with declining trend—
1970-1945, (3) full trend cycle and cyclical—1945-1970-1945; (4) cyclical with-
out trend (1948-1950, repeated eight times for a simulated 24-year history);
and (5) rising with humped yield curves—1959-1970. Patterns #1 and #5 were
the actual data, while the other three patterns were artificially created from
the actual data.
The four portfolio strategies were: even-ladder, full-dumbbell, partial-
dumbbell, and buy-longest-and-hold (BLAH)-ladder. The even-ladder strategy was
to invest 1/20 of the portfolio's value in each maturity. The full-dumbbell
allocated 27 percent evenly spread between the shortest three maturities, and
the remaining 73 percent to the 20-year bond (the role of short maturities in
maximizing terminal wealth is summarized in Fogler (6, pp. 264-266] and Renshaw
(8, pp. 123-149]. The partial dumbbell was similar to the full dumbbell except

actual yield curve. This procedure was selected after extensive testing of other
curve fitting procedures.

The 27 percent was placed in short maturities because it has been shown
that, if you have a risky and riskless asset, you can obtain the highest return
over time (geometric rate of return—and correspondingly, the highest terminal
wealth which was Bradley and Crane's objective) by keeping a constant percentage
of your wealth in the riskless asset. The riskless asset acts as a sort of
diversifier. If your risky asset declines, you can invest more; this allows a
sort of dollar averaging effect, and amounts to a constant ratio plan assuming
a stationary return distribution.
The approximating formula for determining the percentage in riskless assets
was X = r-i where X_ is the percentage to be invested in the risky asset, £ is
2 the return on the risky asset, i^ is the return on a riskless asset
such as a one-period Treasury Bill, s£ is the variance of return
of the risky asset. The 1946-71 annual holding period returns (HPRs) for a 20-
year bond were calculated; these returns were divided by the market yield at the
beginning of each year (thus eliminating nonstationarity in the mean, as well as
putting the resulting returns on a percent of market yield basis). The variance
of these returns was approximately 0.52. Using r=8%, and i«5%, and s2»4.16%—
that is 8% multiplied by 0.52—yielded X = 73% and its complement for the risk-
less asset was 27%.
While this allocation procedure is only justifiable under the given assump-
tions, the resultant 27 percent allocation provided a reasonaUsle basis for compar-
ing the dumbbell to other strategies. Watson found the dumbbell to be superior
129
that the 20-year bond was not rolled-over until it had less than fifteen years
to maturity; this is, in each year available cash (interest payments, maturing
bonds, and sold bonds minus required reinvestment in the short-term 27 percent)
was reinvested in the 20-year bonds which would be held for the next six years.
The BLAH-ladder strategy was similar to the partial dumbbell except long bonds
were bought and held until they had less than four years to maturity.
For initial testing, one billion dollars was the starting portfolio, and
no further cash inflows or outflows were assumed (while no cash outflows seems
reasonaUDle for many types of institutional investors, the full impact of this
assumption will be discussed later on in this Section), Table 1 contains the
results for each strategy and interest rate pattern.
Clearly the full-dumbbell is always inferior to the other three strategies,
considering either return or risk/return. The partial-dumbbell strategy was
superior in its return when rates were either falling (1970-45) or fluctuating
cyclically (1948-50); however, the partial-dumbbell was always inferior to both
the even-ladder and the BLAH-ladder on a risk/return basis as measured by the
coefficient of variation.
By a risk/return criterion, either the even-ladder or the BLAH-ladder is
always best. The BLAH-ladder always dominates the even-ladder on both return
and risk/return, with the exception of the rising humped yield pattern (1950-70)
when the shorter average maturity of the level becomes a distinct advantage.
Over a full-trend-and-cycle interest rate pattern (1945-1970-1945), the return
advantage of the BLAH-ladder is a result of buying higher yields on average and
4
holding them. During the shorter period, the advantage is partly capital gains
during price declines and partially higher interest. The risk/return superior-
ity of the BLAH-ladder is due to its lower standard deviation; this lower stand-
ard deviation results from the property of higher coupon bonds to fluctuate less
than lower coupon bonds (remembering that BLAH is buying the highest coupons if
yield curves are upward sloping),

regardless of the percentage allocation between short versus long bonds,

4
This statement can best be documented by reference to Tad>le A-2 in the
Appendix, Table A-2 presents the holding-period returns after both capital
gains and transactions costs were removed. The resultant returns are interest
yields, and the BLAH-ladder can be seen to have a slight interest rate advantage
over the full period 1945-1970-1945,

Initially it was thought that the lower risk might be due to the gradual
maturing of the initial 73 percent long-term allocation into the intermediate
range. Accordingly, additional simulations were run of the full-ladder strategy,
but beginning with the 73 percent spread evenly between the maturities from 4
years to 20 years. The standard deviations were not significantly changed,

130
 TABLE I

HPRs and Risk of Portfolio Strategies

(Transactions Cost Included)

Interest Rate Patterns

Stragegy 1945-70 1970-45 1945-70-45 1948-50 1959-70

a. Geometric Rates of Return

Full-Dumbbell 1.63 4.48 3.08 2.11 2.98

Even-Ladder 2.37 4.68 3.57 2.35 3.90
Partial-Dumbbell 2.07 4.83 3.48 2.47 3.42
BLAH-Ladder 2.39 4.76 3.61 2.36 3.83

b. Standard Deviations

Full-Dumbbell 5.06 5.27 5.32 2.95 5.98

Even-Ladder 5.02 4.93 5.09 2.69 6.09
Partial-Dumbbell 5.06 5.27 5.29 2.98 6.02
BLAH-Ladder 4.61 4.50 4.56 2.66 6.03
2
c. Coefficients of Variation
Full-Dumbbell 2.89 1.14 1.65 1.37 1.90
Even-Ladder 2.02 1.03 1.38 1.13 1.50
Partial-Dumbbell 2.31 1.06 1.47 1.19 1.68
BLAH-Ladder 1.85 .93 1.23 1.11 1.51

Holding-Period-Returns (HPRs) are equal to (1.0 plus the geometric rate of

return). For ease of analysis, the 1.0 has been subtracted and only the
geometric rate of return is presented. 2.37 means 2.37%. This is the
same concept as bond traders' "total return."

The coefficient of variation is the standard deviation of the returns

divided by the arithmetic mean of the returns. As such, it gives a
measure of risk/return. This measure seemed most appropriate for a
bond portfolio, rather than the standard capital market measures
(e.g., Treynor, Sharpe, etc.) in which the return is measured as the
excess return above the risk-free rate of return.

131
 Because these results contradict those studies supporting dumbbell strate-
gies, it is only natural to question the impact of alternative treatments of:
(1) transactions costs; (2) unrealized losses; and (3) cash inflows and out-
flows. Accordingly, the above tests were repeated both with transactions costs
set to zero (Tadale A-1 in Appendix) and excluding all capital gains and losses
(Tadile A-2), When transactions costs are eliminated as in Watson's study, the
full-dumbbell's return is superior in those interest rate patterns where the
partial-dumbbell had previously been superior; also the full-dumbbell's return
outperformed the even-ladder over the period 1945-1970-1945, However, on a
risk/return basis, the coefficients of variation show that both the even-ladder
and BLAH-ladder are always superior, although the margin of superiority has nar-
rowed for several interest rate patterns. Similar, but worse, relative return
results were exhibited by the full-dumbbell strategy when capital gains and
losses were excluded. Thus, the full-dximbbell's risk/return inferiority caumot
be explained by the fact that our HPR included transaction costs and capital
gains and losses.
Yet the full-dumbbell would prove considerably superior if we had changed
one set of assumptions—no cash outflows. Both Watson and Bradley and Crane
assumed cash outflows and that these outflows occurred during tight money times,
when interest rates were high and capital losses would be realized. This
scenario was not run because it is definitionally obvious that the full-dumbbell
can be made superior; to do this only realized losses from liquidity requirements
are counted, and these losses are made great enough for all strategies except
the full-dumbbell (where such losses are insured against by enough funds in the
short maturities); then the full-dumbbell must be superior. Indeed, Watson
first determined his optimal short-term investment pattern [9, pp, 40-41] and
then added this to his long. Naturally, the Bradley and Crane model would opti-
mize the short-bond distribution automatically.

BLAH-laddering is really an extension of the dumbbell concept when the 27

percent is allocated to the shortest maturities, but without ever rebalancing
to the longest maturity. In fact, Bradley and Crane's results began to approach
this, but their time horizon was shorter and therefore full BLAH-laddering didn't
have time to occur.

Because our base case contained no cash outflow requirements, and because
Watson excluded all gains and losses except forced liquidation sales, for com-
our statistics in Tadjle A-2 reduced to the rate of interest returned.

Interestingly, Bradley and Crane often had a significantly different dis-

tribution for the shortest maturities compared to Watson's portfolio, Watson's
results indicated that the most efficient liquidity portfolio was an exponen-
tially declining distribution over 4-1/2 years of maturities. In contrast, Brad-
ley and Crane had several scenarios where their short distributions were heaviest
in the second maturity class (a two-year bond), To understand why they get this
132
 What do the above findings suggest? Basically, they confirm and extend
the Bradley and Crane observation that
the most important difference between Watson's simulation
results and those of the optimization model is that his
efficient portfolios contain no laddering at the long end.
This difference probably results from his assumption that
the long term bond can be sold at the end of each period
and a new one purchased at no cost.... If this unrealistic
assumption of no trading cost were removed, his analysis
would in all likelihood show that efficient portfolios
would be laddered on both the long and short end of the
maturity range. (1, p. 30]
However, Bradley amd Crane's analysis was limited to approximately three
time periods, versus an infinite horizon solution, because of the computational
magnitude of their stochastic dynaunic prograunming formulation. As they noted,
this prevented them from determining "when should the bonds be taken long again"
(1, p. 30]. The results of our analysis suggest that the answer may well be
that the bonds would never be taken long but rather that a BLAH-ladder might be
expected to evolve, especially for financial institutions with low liquidity
requirements. For institutions with higher liquidity needs, the short-term
allocation would be higher, but the remainder of the BLAH-ladder strategy would
be appropriate.

III. Skewness and Bond Portfolio HPRs

During the aibove tests, the computer prograun calculated both the geometric
and arithmetic average of the HPRs for each test. These averages were often
quite close, much closer than expected given the size of the standard deviations.
Accordingly, it seemed reasonadsle to posit that the returns must be positively
skewed, and Table II contains the results of calculating the skewness measures
for each portfolio strategy and each interest rate pattern. The results were
Q

positively skewed in all cases except the 1948-50 pattern.

Such skewness raises several questions. Although the impact of skewness
on stock prices is well known, the exact interpretation of its ex post time
result, it must be remembered that their model contained two types of constraints!
an upper limit on annual realized losses and an upper limit on unrealized losses
accumulated during the time horizon of the test case being run (generally three
periods). These limits (constraints) forced most strategies to be conservative
and thus the short-term end of their dumbbell had many funds that were not in-
vested for liquidity, i.e., these extra funds were invested because of the con-
servative constraints which emphasized safety from price fluctuations.

On examination of the 1948-50 pattern, the large negative returns occurred

during the year 1950 which was calculated based uoon January 1950 to January
1948; that is, 1948-1949-1950-1948-1949....for twentv-four years. This negative
return resulted from inadequate artificial splicing of the series; January 1948
had much higher rates than December 1950.

133
 TABLE II

Skewness of Bond Portfolio HPRs

(with Transactions Costs)

Interest Rate Pattern

Strategy 1945-70 1970-45 1945-70-45 1948-50 1959-70

Full-Dumbbell .94 .43 ,60 -.60 .89

Even-Ladder 1.42 .53 ,89 -.65 1.06
Partial-Dumbbell 1.02 .46 ,65 -.61 .84
BLAH-Ladder 1.58 .92 .93 -.61 1.08

Note: Relative skewness was measured as the third moment about the mean
divided by the cube root of the standard deviation. For a synmetrical
distribution, this measure is equal to zero. Larger coefficients indi-
cate greater skewness.

134
series measurement is less clear. For example, Fogler and Radcliffe (7] recently
showed that the Standard and Poor's Industrials from 1952-1969 exhibited posi-
tive skewness of HPRs when calculated on annual HPRs, but negative skewness
when calculated on quarterly and semi-annual HPRs. Further, skewness of annual
returns fluctuated widely depending upon the quarterly date used to begin the
tests.
To assess whether similar saunple sensitivity existed for bond portfolio
returns, it was decided to test the impact of alternative starting points and
differencing intervals. Table III (A) contains the annual HPR means, standard
deviations, and skewness measures for the even-ladder and full-dumbbell strate-
q
gies for two interest-rate patterns, but for four different starting dates.
As is evident, the skewness measures do fluctuate, fairly widely although they
are always positive and the fluctuation is nuch less than for stock HPRs. The
means and variances were relativelv stable as expected.
Since the above results do indicate some saunple sensitivity, it was ex-
pected that changing the differencing interval would also reflect sample sensi-
tivity. However, as Table III (B) illustrates, the skewness is relatively
sta±>le and positive. The even-ladder strategy could not be tested quarterly
because of the enormous storage requirements. Every bond by maturity and date
of purchase (with its aunount and coupon) is stored; for each maturity, therefore,
many bonds are subclassified by date of purchase. As the semi-amnual and quarterly
means suggest, more frequent rebalancing would have improved the annual returns
during periods such as 1945-1970-1945, but not during periods of continually
rising rates such as 1945-70. Also, since semi-annual and quarterly standard
deviations are proportionately larger than the annual, the risk/return is higher
for a shorter time horizon.
Given the positive skewness of returns regardless of starting point or
differencing interval, it is interesting to notice the postwar period's HPRs
for the even-ladder:
1945 5.0% 1954 2.5% 1963 .9%
1946 .9% 1955 - .5% 1964 4.2%
1947 -1.5% 1956 -1.4% 1965 .3%
1948 3.4% 1957 7.7% 1966 5.3%
1949 4.9% 1958 -5.0% 1967 -1.6%
1950 - .4% 1959 -1.3% 1968 1.7%
1951 -2.2% 1960 12.1% 1969 -4.3%
1952 2.6% 1961 1.5% 1970 19.2%
1953 3.6% 1962 7.0%

Only two patterjB were selected because of the large amount of computer
time required. It was felt that these two patterns would allow reasonaUale in-
ference from the results.

135
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136
As can be surmised, the positive skewness of 1.42 is a result of the large HPRs
in 1960 and 1970. This skewness is the result of large positive HPRs which
occurred at the end of a liquidity crisis. Negative HPRs were much less ex-
treme; price declines occurred more gradually as interest rates rose during
business recoveries. This underlying generating process also explains why
semi-annual and quarterly differencing did not produce negative skewness as in
the case of common stock returns. Finally, this positive skewness may make a
substantial contribution to reducing combined portfolio risk if bond and stock
returns are not highly correlated.

IV. Conclusions
The empirical results of this note suggest that dumbbell portfolio strate-
gies are not as efficient as indicated by previous analyses, although Bradley
and Crane's model would have likely reached the same conclusion if their time
horizon were longer. On a risk/return basis, the dumbbell strategies were con-
sistently outperformed by the buy-long-and-hold (BLAH) strategy.
In contrast to the earlier studies, the objective function tested in this
paper included unrealized capital gains and losses, and this inclusion plus the
lack of heavy liquidity requirements explains the different results. However,
such an objective function and lack of liquidity needs is typical of performance-
oriented bond portfolios for pension funds. Certainly, this class of institu-
tional investor should be aware of the impact of the assumptions in previous
studies.
Further, it was found that bond portfolio HPRs were skewed. The measure of
skewness was also found to be less sample sensitive to the differencing interval
and initialization point than the sample sensitivity of common stocks. It is
hoped that these findings will stimulate further research into both bond port-
folio and combined stock-and-bond portfolio return distributions, a topic of
high real-world importance.

APPENDIX
As mentioned in the foregoing note, portfolio simulations were duplicated
for two additional sets of assumptions: Transactions Costs Set Equal Zero
(Table A-1) and Holding-Period-Returns Excluding Capital Gains (Losses) and
Transactions Costs (Table A-2). These results are provided below.

137
 TABLE A-1

HPRs and Risk of Portfolio Strategies

(No Transactions Costs)

Interest Rate Patterns

Strategy 1945-70 1970-45 1945-70-45 1948-50 1959-70

a. Geometric Rates of Return

Even-Ladder 2.,41 4.73 3.61 2.,38 3.96

Full-Dumbbell 2.,18 5.05 3.65 2.,65 3.51
Partial-Dummbbell 2.,20 4.96 5.30 2..59 3.56
BLAH-Ladder 2.,45 4.83 3.67 2.,42 3.90

b. Standard Deviations

Even-Ladder 5.03 4.92 4.78 2.70 6.12

Full-Dumbbell 5.04 5.30 5.33 2.95 5.98
Partial-Dumbbell 5.12 5.22 5.32 2.95 6.12
BL.\H-Ladder 4.62 4.50 4.57 2.68 6.07

c. Coefficients of Variation

Even-Ladder 1.99 1 .02 1.37 1.11 1.48

Full-Dumbbell 2.19 1.02 1.41 1.10 1.63
Partial-Dumbbell 3.20 1.02 1.42 1.12 1.64
BLAH-Ladder 1.81 .91 1.21 1.09 1.49

13ft
 TABLE A-2

HPRs and Risk of Portfolio Strategies

(Unrealized Capital Gains and Losses Ignored, No Transactions Costs)

Interest Rate Patterns

Strategy 1946-70 1970-46 1946-70-46 1948-50 1959-70

a. Geometric Rates of Return

Even-Ladder 2.82 4.28 3.48 2.13 4.64

Full-Dumbbell 3.31 3.55 3.48 2.02 4.62
Partial-Dumbbell 3.20 3.63 3.48 2.00 4.58
BLAH-Ladder 3.00 4.10 3.52 2.04 4.55

b. Standard Deviations

Even-Ladder .90 1.11 1.10 .06 .45

Full-Dumbbell 1.32 1.38 1.40 .10 .92
Partial-Dumbbell 1.28 1.37 1.40 .07 .79
BLAH-Ladder 1.10 1.29 1.20 .04 .61

c. Coefficients of Variation

Even-Ladder .32 .26 .32 .03 .10

Full-Dumbbell .40 .39 .40 .05 .20
Partial-Dumbbell .40 .38 .40 .04 .17
BLAH-Ladder .37 .31 .34 .02 .13

*Note; These standard deviations are much lower than those in the previous
tables. This tendency is to be expected because unrealized price
fluctuations are not being considered.

130
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140