Bond portfolio optimization

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Modern portfolio theory is widely applied in equity markets through optimization software and frameworks for asset managers. In contrast, these tools appear irrelevant in fixed income markets, where bond portfolios are primarily managed by comparing risk measures against benchmarks. Portfolio managers base their strategies on predictions of interest rate term structures, positioning themselves relative to benchmarks while only crudely accounting for the risks associated with these deviations. This is surprising given that sophisticated models for interest rates are regularly employed in pricing derivatives and assessing fixed income risks. Wilhelm (1992) attributes the lack of modern portfolio tools in fixed income to two main factors: historically stable interest rates and fundamental differences between stocks and bonds that complicate the application of modern portfolio theory. These differences stem from the fixed maturity of bonds; while stock price variability increases over time, bond prices are predetermined at maturity. Consequently, the probabilistic models used for stocks and bonds diverge significantly, leading to challenges in applying the same portfolio management strategies across these asset classes.