Chapter 2 Capital market- fixed income instruments Government issues - T-bonds and notes - TIPS o Principal adjusted for changes in consumer price index o Marked with trailing “I” in quote sheets - Municipal bonds - Federal agency debt Probably better to be termed debt instruments or bonds because yield isn’t always fixed Corporate bonds Mortgage securities US government borrows funds by selling treasury notes and treasury bonds t-notes issued with maturities from 10-30 years pay coupons semiannually prices are quotes as a % of year Agency issues (federal government) most are home-mortgaged related: FNMA (Fannie Mae), FHLMC (Freddie Mac), GNMA (Ginnie Mae), FHLB (Federal Home Loan Banks) Risk of these securities? - Implied backing by government - In September 2008, federal government took over FNMA and FHLMC Municipal bonds - Issued by state and local governments - Similar to treasury and corporate bonds except income free from federal tax (usually state and local too). Do pay capitalgains tax when sold - G.O. vs. revenue - Industrial development (revenue bond) - Taxation (compare after tax rate of bonds) rtaxexempt=rtaxable * (1-tax rate) R= tax rate Compare Bonds - Investor needs to compute the after-tax rate of return on each bond in order to compare o Determine interest rate on taxable bonds that would be necessary to prvide an after-tax return equal to that of municipals o Let t= investors tax bracket (total) and Rtaxable o Rtaxable=Rmuni / (1-t) o Cutoff tax bracket = 1 – (Rmuni/Rtaxable) Muni bond can be checked through ETFs Corporate Bonds - Way in which private firms borrow public money - Pay coupons semi-annually and return face value at maturity - Vary according to risk (default) - Secured bonds have specific collateral backing them - Unsecured (debentures and subordinated debentures) have none - Some issued with options attached (callable bonds and convertible bonds) Mortgaged Back Securities - Backed by pool of mortgages with pass through of monthly payments, most have been comprised of conforming mortgages (loans satisfy certain underwriting guidelines) o Traditionally all mortgages conform since 2006 Alt-A and subprime mortgages included in pools - Private banks purchased and sold pools of subprime mortgages - Issuers assumed housing prices would continue to rise 2008 crisis- no doc mortgages led to the many defaults which caused the crisis Securitization has not ceased in the credit markets - Car loans - Student loans - Credit card loans - Home equity loans US Fixed Income market - Treasury debt - Federal agency - Corporate bonds - Tax-exempt - Mortgage-related - Other asset-backed Fixed Income Indexes (Extra stuff from class) Examples of sectors Global- Global emerging markets, USD emerging markets sovereigns, EUR sovereigns local currency, USD emerging markets corporate US- USD benchmark (treasuries, sovereigns, sub-sovereigns, corporate), USD High yield- most indexes that investors go to because higher yield though there’s more risk, USD leveraged loan Europe- EUR benchmark ( sovereigns, sub-sovereigns, corporate) Asia Most Popular Aggregate Bond Index - US aggregate index o Most common proxy for US investment grade bond market o Primary tracking benchmark for core bond index funds o Represents US dollar denominated investment grade, fixed-rate, taxable bonds - Barclays US aggregate index represents the attributes sought by core bodn investors: intermediate duration, high-quality US fixed income - [9100 issues, $17.6 trillion market cap, US Stock market Cap, $20 trillion]= 49% of total US bond market Barclays Capital US aggregate bond index Instruments include: - nominal treasuries - Agency mortgage backed securities - Investment grade corporates Barclays Indices cover bond types: - Investment grade - High yield - Inflation linked - Hard and local currency - Emerging markets - Municipal - Convertible Barclays Global Sector Classification scheme covers 4 major classes - Treasury - Government-related - Corporate - Securitized Bond total return calculations - Total return included capital appreciation and security price movements, interest payments and accruals, and principal payments in case of amortizing or sinkable bonds o Monthly price return, monthly coupon return, monthly paydown return, monthly currency return - Required date to calculate o Daily bond prices o Accrued interest calculations o Record of timing and amount of coupon and principal payments o Daily spot and forward FX rates, where applicable - Bond excess return is metric quantifying duration-neutral return of a security Blackrock one of top ETF companies Equity Common stock- ownership shares in corporation - Residual claim- last in line as claimants of assets and income - Limited liability- most you could lose is original investment - Can be bought or sold freely on exchange Preferred Stock (equity and debt) - Priority over common - Fixed dividends: limited gains - Nonvoting - Tax treatment: corporate tax exclusions on 70% of dividends earned (causing them to sell at lower yields even though they are lower on claims ranking) Depository Receipts - American depositary receipts (ADRs) also called American Depositary shares (ADSs) - Certificates traded in US representing ownership in foreign security - Nowadays you could use ETFs - Each share represents ownership of a fraction or a foreign share, one share, or several shares of the foreign corporation - Provides US investors a way to invest in and trade the shares of foreign corporations Index - Statistical methodology used to measure changes in value of something over time - Measure changes in value of group of securities - Market risk and return Benchmark - Represent market for asset class or sub-asset class - Broad equity market index is perfectly diversified portfolio of stocks - Broad fixed income market index is a diversified portfolio of investment grade bonds Role of Indexing - When you think of US equity market, what do you use? o Both DOW and S&P 500 because high correlation DJIA- price weighted index, DJIA started because Wall Street Journal needed date for finance section in 1896 Constructing Market Indexes - Weighting schemes o Price weighted average Add prices and divide by divisor o Market value weighted Return = weighted average of returns of each security proportional to market value o Equally weighted index: Computed from simple average of returns S&P not top 500. Most pension funds will use Wilshire 500 because of risk. During implementation they’ll use Russell 3000 because of unexplained risk Index Users and Uses Users: - Consultants, fund managers/trustees, exchanges, banks, RIAs, Academia, Media, research houses, retail- individual investors Uses: - Gauge of public or market sentiment indicators - Performance measurement - Asset class benchmarks and asset allocation - To underlie investment vehicles - Universe for stock selection Measuring market performance - Important phenomenon that has shaped global investment management industry since 1970s is the rise of index investing and separation of alpha and beta - Beta- markets returns represented by index - Alpha- greater than market returns Total market = # of shares outstand * price per share Passive investing (Beta) - Seeks to track performance of index - Tracking error is how much they differ - Typically involved low fees Active investing (Alpha) - Aims to outperform market Indexes = way to access to market returns - Buy underlying stocks, buy ETF, buy call and sell put, buy SWAP and earn interest, buy futures earn interest Derivative Markets Derivative- security with payoff that depends on price of other securities Option- contract that allows but doesn’t require investor to buy or sell underlying instrument like a security, ETF or index at predetermined price at future date
