Active Bond Management Overview

We recommend active management over buying and holding individual bonds for the following reasons:

• Interest Rate Risk Management: The active management of interest rate exposure often allows for the taking of gains in falling rate environments and the preservation of principal in rising rate environments. During periods of rising rates, active management can also minimize the opportunity cost of locking into lower rates for extended periods.

• Maturity Structure Management: Yield curve analysis can allow for advantageous portfolio construction resulting in an improved risk versus reward balance. For instance, a barbell structure tends to perform well when the yield curve flattens. Short-term bonds can be reinvested at higher rates as they mature and longer-term bonds can appreciate as long-term
rates fall.

• Sector Exposure Management: The relative attractiveness of Government, Agency and Corporate sectors can also be managed to achieve gains or preserve principal in various business and economic cycles. If a flight to safety is expected to drive the yield of Treasuries lower, Treasury prices will rise offering the opportunity to realize gains. When the economy is
moving from contraction to expansion, the spreads on corporate bonds often narrow, allowing them to outperform other sectors.

• Credit Spread Management: The risk to reward ratio within investment grade corporate bonds can provide opportunities similar to those offered across sectors. Active managers will increase or decrease a portfolio’s exposure to AAA, AA, A or BBB corporate bonds based on anticipated changes in their relative spread levels.

• Credit Risk Management: At the security level, the bond market can be very inefficient. A combination of quantitative and qualitative analyses can often identify significant opportunities (or avoid significant risks) for those who monitor the market on a routine basis.

• Reinvestment Risk Management: A buy and hold strategy may result in bonds maturing at a poor time in the interest rate cycle. Often the surplus proceeds are reinvested into another bond or set of bonds independent of market conditions.

Building a bond portfolio with a desired risk-to-reward profile is more complex than simply picking bonds. Empirical evidence supports the argument that active management can produce a better risk versus reward tradeoff than passive investment strategies like laddering. To avoid pitfalls and optimize opportunities, thought must be given to how you determine the maturities, structure, sectors and credit qualities appropriate for the objectives of a given portfolio.

© Madison Investment Advisors, Inc., April 12, 2006.