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Analyses that deal with the integration of high-yielding instruments in bond portfolios must take into account the market inefficiencies mentioned above. Otherwise, false conclusions cannot be ruled out. Because of the biased correlations between individual bonds, historical estimates of the volatility of high-yield indices are too low. Generally, this causes suboptimal portfolio weights that are too high for the risk incurred. Occasionally this effect is also observed for small cap stock indices and real estate indices.

Subsequently, we will transfer a technique Blundell and Ward (1987) proposed for the desmoothing of appraisal based real-estate indices to the highyield sector. The method presumes that the serial correlation in high-yield index returns is exclusively caused by nonsynchronous trading and that the “true” time series follows a random walk. Firstenberg et al. (1988) and Geltner (1993) propose alternative approaches to desmooth empirical time series.

All of the examined asset classes exhibit significant positive autocorrelation. There are two main reasons that should be noted. As mentioned earlier, one reason is the illiquidity of certain segments of the international bond markets. The high-yield sector is a typical example for a rather illiquid market segment. Broad high-yield indices represent the investment universe of institutional investors with regard to speculative grade corporate bonds. There are several qualitative criteria that benchmark indices generally have to satisfy. Among the most important are transparency, stability and representativeness. With respect to the adequate mapping of short- and medium-term fluctuations of high-yield bond prices, the last point is critical. The low liquidity of many high-yield bonds causes irregular and nonsynchronous trading. Rajan (2000) points out that about threequarters of the index constituents are traded less than once per month.

Information that is relevant for the valuation is comprised in the prices of those bonds with a significant time lag. Thus, price changes of individual bonds may seem uncorrelated even if they were caused by a common factor. This nonsynchronicity induces positive serial correlation in index returns and biases the traditional estimates of index volatility such as the annualized standard deviation of returns.

Levy (1992) points out that lower partial moments of first order are consistent with second-order stochastic dominance. The concept of stochastic dominance has several important advantages. It requires no distributional assumptions, takes all the moments of the return distributions into account and requires only very mild assumptions about investor behavior. With respect to the comparison of the performance of several investment choices, it allows to create two different groups. The efficient set contains the desirable alternatives, the inefficient set those investments that are found to be stochastically dominated by at least one other investment. The preference criteria are that the investor prefers more to less, is risk averse and prefers positive skewness. For all utility functions, investment G dominates F stochastically

Our study displays the composition of the optimized portfolios. As a comparison the market capitalization weights should be kept in mind. Roughly speaking, the market weights of government bonds, agencies and mortgage-backed securities with respect to the US bond market are 26, 12, and 32 percent. Investment grade and high-yield corporate bonds are responsible for 23 and 7 percent of the market value of outstanding US bonds. In this context, municipal bonds are excluded because they do not play a significant role in the portfolios of international investors.

Across all of our optimization approaches, the MRPs and TPs are mainly made up of agencies and mortgage-backed securities, whereas government bonds are not represented in any of the portfolios. Despite its high volatility the high-yield sector seems to provide significant diversification benefits.

However, it should be noted that the high-yield weight decreases when skewness and kurtosis are considered during the process of portfolio construction. In the sample period investors willing to accept the risk of a pure government portfolio would have been best off to invest a large part of their assets in a broadly diversified portfolio of investment grade and high-yield  corporate bonds. Thus, they would have earned an excess return of 6–8 bp per month over government bonds.

Develop as accurate as possible a projection of the future operations in which the money is going to be used or the operation of the project, taking into account sales, costs and other relevant financial issues. Typically, the projection should be broken down for each year of the period of the investment.

Quantify positive and negative cash flows for each year of the projection, and the annual net totals of cash inflow or outflow.

Estimate the value of the cash flow for the final year of the projection. A conservative and prudent approach that is widely adopted is to assume that the final year’s cash flow will continue in perpetuity.

Discounted cash flow is based on one key principle: that the value of money changes, effectively reducing with time. In other words, cash today is worth more than cash promised in the future. For example, it is not worth investing $100,000 today for the promise of the same amount returned next year; more usefully, discounted cash flow can show that it may not even be worth investing $100,000 today for the promise of $110,000 in three years’ time and explain why. There are three reasons for this:

The organisation investing the $100,000 is bearing a market risk, and risk demands return. The greater the risk, the greater is the return required.

Investors are bearing an opportunity cost – they cannot invest the same money in another venture – and this cost also requires return.

Perhaps most significantly, the value of investors’ money is being reduced by inflation, and this also demands a return. If annual inflation is running at 2.5%, then someone investing $100,000 will need a yield after tax of $2,500 a year, just to compensate for inflation. This is central to the concept of the time value of money.

Ensure that customer decisions improve profitability. Stepping back from routine decisions and considering how to derive greater value from existing customers and products may enhance profitability. Questions to consider include:
How can customer loyalty (and repeat purchasing) be enhanced?

How can the sales proposition be made more competitive? (Simply improving it may not be enough; this improvement needs to be made relative to the opposition.)

How can existing markets, sales channels, products, brand reputation and other resources be adapted to exploit new
markets and new opportunities?

How can sales expenses be reduced?

How can the overall effectiveness of marketing activities be increased?

Consider how to increase profitability by managing people. Active, successful leadership is a prerequisite to profitability. People need to be motivated and supported. This implies rewarding them fairly for their work, training and developing them, providing a clear sense of direction and focusing on the needs of the team, task and individual.

Some of the most useful practical techniques to improve profitability are as follows:

Focus decision-making on the most profitable areas. Concentrating on products and services with the best margin will
protect or enhance profitability. This may involve redirecting sales and advertising activities.

Decide how to deal with the least profitable products. These often drift, with dwindling profitability. Decisive action is needed to turn around a poor performer. You can reduce costs, raise prices, alter discounts or change the product; or you can abandon it altogether to prevent a drain on resources and reputation.

Ensure that new products enhance overall profitability. New product development often focuses on market need or the production process, with insufficient regard to the financial issues of cost, price, sales volume and overall profitability, which are inextricably linked. Interestingly, for certain products in certain markets, lower prices may reduce demand.

Manage development and production decisions. The amount spent on research and the priorities and methods used affect profitability. Too little expenditure may result in larger costs in the long term. The shelf-life and appeal of a product should be considered when deciding whether to continue production or not.

The number and quality of suppliers are also important. Decide what the buying policy should be (for example, will you have a small number of preferred suppliers or a bidding system among a larger number of potential suppliers). Consider techniques for controlling delivery charges, monitoring exchange rates, improving quality control, reducing stockholding and improving production lead times.

Harley-Davidson, a motorcycle manufacturer, hit hard times during the late 1970s that resulted in a management buy-out in 1981. At this point, senior managers visited Honda’s Marysville, Ohio, motorcycle facility. The contrast with their own facility was dramatic in terms of layout, production flow, efficiency and inventory management. Harley’s managers concluded that if they were to compete with Japanese motorcycle manufacturers, they would have to effect a business-wide, just-in-time manufacturing initiative. They called it MAN: materials as needed.

Production operations were moved together, reducing the resources required for materials handling. Managers were also able to reduce the quantity of inventories received (and produced) too early and the amount of space required for manufacturing. As it later turned out, they were creating space for additional production.

Caterpillar had a similar experience. During the 1980s, Caterpillar’s managers concluded that the company’s cost structure was significantly higher than that of its principal competitor Komatsu, a Japanese firm. Caterpillar was moving parts and partially finished products from one production area to another, whereas Komatsu was using more of a “flow” process. Caterpillar’s managers undertook a significant plant rearrangement initiative called PWAF (Plant With a Future). This led to their own flow process, with a marked reduction in distances between operations, material handling expenses, inventory levels and cycle time to produce products. In some cases, cycle time was reduced as much as 80%.

For decades, leading Japanese companies have directed much of their cost-management efforts towards muda or waste elimination. This involves techniques such as process analysis, mapping and re-engineering, which are important parts of operational decision-making. The value of process analysis is that it enables waste to be identified and eliminated and costs to be reduced by thinking of activities as a chain of events from the beginning of the process to the end, with each part of the chain comprising discrete, identifiable tasks.

The idea of thinking about everything that goes on in a business in terms of processes and waste elimination is fundamental. In a Japanese factory, you can see how processes have been laid out and almost feel the continuing search for better ways of doing things in the least wasteful way.