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Bond Portfolio Optimization: A Risk-Return Approach

The portfolio approach pioneered by Markowitz is one of the cornerstones of modern portfolio management. A broad knowledge has been accumulated about the performance, the strengths, and the weaknesses of this approach when applied to equity portfolios. However, much less is known about portfolio optimization in bond markets.

There are at least two reasons for this observation: First, at the time when Markowitz's approach became more widely recognized as a useful tool for portfolio management, interest rates were not particularly volatile and a portfolio approach seemed somehow unnecessary. However, this observation has changed over the last decades.

Even if one concentrates on government bonds of highly rated countries and leaves default risk aside, there are very substantial risks in bond investments due to possible changes in interest rates. Given that many diĀ®erent bonds with different maturities are available, it is a natural issue to think about the potential for risk diversifcation.

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Bond Portfolio Optimization: A Risk-Return Approach