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DIVERSIFICATION BENEFITS FOR BOND PORFOLIOS - Evidence from the eurodenominated investment grade bond market

OBJECTIVES The study examines diversification benefits for euro-denominated investment grade bond portfolios. The objective of the study is to investigate the minimum portfolio size at which the marginal benefits measured in terms of risk reduction or reward-to-risk improvement from additional diversification become very small. It is examined how such diversification benefits and minimum portfolio sizes vary when differentiating the investment opportunity sets by the sector of the issuer. Furthermore, the study investigates whether diversification benefits seem to have varied in different time periods in 2002 – 2010. The study also gives an overview of European bond markets and the characteristics of bonds as financial instruments and presents measures that can be used to evaluate portfolio performance and diversification benefits.

DATA AND METHODOLOGY The bond sample is extracted from the Bank of America Merrill Lynch Global Index System database. The data consists of monthly returns of bonds belonging to the Merrill Lynch Euro Broad Market Index. The data is collected from 01/2002 – 12/2010. Also bond-specific descriptive data on the bond sector and domicile of the issuer of the bond was collected. Three metrics are used in the study to examine diversification benefits. The measures used are excess standard deviation or mean derived deviation, Sharpe ratio and cross sectional kurtosis.

The study was conducted by first completing the return data of the bonds, majority of which exiting the index during the period under review due to their time to maturity rolling below 1 year, into a table format with no empty observations. The same was repeated for the set of all bonds as well as for each sector and each time sub-period separately so as to allow sector- and time-specific examination. The study is implemented by selecting bonds randomly in order to create 1000 portfolios for each investment opportunity set and each portfolio size. A portfolio size ranging from 2 to 100 is examined for each set and the optimal portfolio size is thought to have been achieved when the marginal improvement in the measure decreases below 1%.

RESULTS The minimum portfolio size is found to vary by issuer type, time period under review and the metric used to measure the marginal benefits of further diversification. While the marginal benefits of further diversification are generally achieved with PSs of 25-55 bonds when using the mean derived deviation or Sharpe ratio as the criteria, the untapped benefits of full diversification are still sizeable. When examining the Sharpe ratio, with the optimal portfolio size the unrealized diversification benefits are still over 50%. When using the MDD metric the overall diversification benefits range between 63 and 95 percent. When examining kurtosis the required portfolio size seems to be higher, mostly in the range of 55 to 80 bonds, at which overall diversification benefits are roughly 68 to 92 percent.