SAWYER FALDUTO
ASSET MANAGEMENT, LLC
IPPFA/NIU
TRUSTEE CERTIFICATION PROGRAM
August 2011
Fundamentals of Fixed Income Investing
Presented By:
Thomas S. Sawyer
Managing Partner
Sawyer Falduto Asset Management, LLC
tsawyer@sawyerfalduto.com
630-941-8560
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Introduction
• Features of fixed income securities.
– More specifically those allowed by statute.
• Risk and return concepts.
• Portfolio structure and investment policy guidelines.
• Benchmarking fixed income portfolios.
• Current market environment.
• Additional Terminology.
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Introduction
• Although stocks seem to get most of the attention, fixed income
markets are large, varied and dynamic.
• Fixed income securities (bonds) represent the lion’s share of police
and firefighter pension fund assets.
• Understand the risks associated with bonds.
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What is a Bond?
• A bond is a contractual
obligation between a borrower
and a lender.
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Features of Fixed Income Securities
•
Issuers:
–
–
–
–
•
U.S. Treasury
U.S. Government Agencies
States, Municipalities and Local Units of Government
Corporations
Coupon:
–
•
Stated Rate of Interest
Maturity:
–
•
Term of the Loan
Redemption Options:
–
Call Provisions (the issuer’s option to pay off the loan early)
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Features of Fixed Income Securities
Description:
$100 Face Amount (Par Value)
U.S. Fourth Liberty Loan Bond
4.25% Due 10/15/1938.
Issuer:
Coupon:
Maturity:
Call:
U.S. Treasury
4.25%
10/15/1938
None
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Fixed Income Securities Permitted by Statute
•
U.S. Treasury Bills, Notes and Bonds
•
Government Agencies
–
Federal Home Loan Bank, Fannie Mae, Freddie Mac, Federal Farm Credit
•
Municipal Bonds issued in Illinois
•
Corporate Bonds (January 1, 2011)
•
Other
–
–
–
–
Certificates of Deposit
State of Israel Bonds
GICs
Money Market Mutual Funds
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A Word on Public Act 96-1495—Corporate Bonds
• Allows investment in investment grade corporate bonds.
–
Bonds must be rated as investment grade by either Moody’s or S&P
at the time of purchase.
–
Bonds must be liquidated within 90 days after the bonds are
downgraded by both Moody’s and the S&P.
–
Corporate bonds count as fixed income investments.
–
Corporate bonds must be invested through an investment advisor,
not through a consultant as defined in the Illinois Pension Code.
–
Another way that pension funds may diversify their fixed income
portfolio.
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Permitted Investments – Pension Funds
•
Allocation to Fixed Income
–
Unlike the allocation to equities, the statute does not impose
percentage allocation limitations.
–
Illinois Pension Code provides a complete list of acceptable
investments.
•
40 ILCS 5/1-113, 113.1, 113.2, 113.3, 113.4 and 113.4a
–
Pension Code also provides a list of prohibited transactions
•
40 ILCS 5/1-110
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Risk and Reward
Inverse Relationship – Bond Prices and Interest Rates
I = Interest Rates
P = Bond PriceS
I P
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Risk and Reward
• Types of Risk Usually Associated with Bonds:
– Credit Risk
– Maturity Risk
– Price/Interest Rate Risk
• Duration and Convexity:
– Measures of the sensitivity to changes in interest rates.
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Risk and Reward
• Credit and Maturity Risk Spectrum:
Tsy
Agy
Muni
Less Risk
Shorter Maturity
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Inv Grade Corp
High Yield Corp
More Risk
Longer Maturity
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Risk and Reward
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Time Value of Money
“The Eighth Wonder should be utilized by all of us to accomplish
what we want. It is compound interest.”
- Baron Rothschild
• Present Value: The amount of money that must be set aside today
in order to achieve a specified future value.
• Future Value: The value of an amount of money set aside today at
a specified date in the future.
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One Math Problem – Sorry!
Time Value of Money
PV = FV
(1 + i)n
FV = PV(1 + i)n
Or,
Or,
Present Value = Future Value
(1 + rate)periods
Future Value = Present Value x
(1 + rate)periods
So,
$100 = $104.25
(1.0425)1
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So,
$104.25 = $100(1.0425)1
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Risk and Reward
Premium or Discount to Par
Scenario: A tough winter has caused coal prices to rise dramatically.
Due to increased concern over inflation, interest
rates on
U.S. Treasury securities have moved higher. The
yield on bonds maturing in 1938 now yield 5%.
We paid $100 for our bond, with a coupon of 4.25%,
maturing in 1938. Because investors now require a higher
yield, the present value of the bond is now $99.27. The
bond is trading at a DISCOUNT to par.
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Risk and Reward
Premium or Discount to Par
Scenario: The coal mines of Central Illinois stepped up production.
Coal prices abated from recent high levels. Yields on U.S.
Treasury securities maturing in 1938 declined dramatically to
3.75% as investors turned their attention to an anticipated
slow down in the economy.
We paid $100 for our bond, with a coupon of 4.25%,
maturing in 1938. Because investors now are willing to
accept a lower yield, the present value (price) of the bond is
now $100.49 The bond is trading at a Premium to par.
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Features of Fixed Income Securities
(Yield isn’t necessarily Yield)
• Coupon: the stated rate of interest. In the case of our bond, the
coupon is 4.25%.
• Current Yield: the ratio of the coupon (4.25% x $100 = $4.25) to
price. When our bond was trading at a discount to par, the current
yield was 4.28%. $4.25/$99.27 = 4.28%.
Later on, our bond was trading at a premium to par. The current
yield was 4.23%. $4.25/$100.49 = 4.23%.
• Yield-to-Maturity: YTM is a better measure as it accounts for cash
flows to maturity. Using our bond maturing in 1938, under the
discount scenario, the YTM is 5.0%. Under the premium scenario,
the YTM is 3.75%.
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Risk and Reward
US TREASURY YIELD CURVE
4.5
4
3.5
% Yield
3
2.5
2
1.5
1
0.5
0
1 MO
3 MO
6 MO
2 YR
5 YR
10 YR 30 YR
Maturity
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Portfolio Concepts
Duration
Remember the inverse
relationship between interest
rates and bond prices…..
Assume the average duration of
a portfolio of bonds = 5.
Rates rise by 1% - portfolio value
declines by 5%.
Rates decline by 1% - portfolio
value increases by 5%.
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Portfolio Concepts
Portfolio Structure and Investment Policy
•
Should be a risk management tool.
•
Provide for diversification across issuing sectors.
•
Establish duration and maturity ranges.
•
Be flexible enough to adapt to changing conditions.
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Portfolio Concepts
Fixed Income Portfolio Characteristics
Diversification
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A Few Comments on Corporate Bonds
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A Few Comments on Corporate Bonds
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A Few Comments on Corporate Bonds
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Portfolio Concepts
Fixed Income Portfolio Characteristics
Quality, Yield and Duration
Quality Distribution
AAA
AA
A
BBB
Fixed Income Portfolio
97%
3%
0%
0%
Benchmark
99%
1%
0%
0%
Portfolio Statistics
Duration: 3 to 7
Yield-to-Maturity
Current Yield
Average Coupon
Fixed Income Portfolio
4.62 yrs
3.16%
3.78%
3.80%
Benchmark
4.64 yrs
2.40%
3.19%
3.32%
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Portfolio Concepts
Benchmarking Fixed Income Portfolios
•
Benchmark should be a “best fit” with investment policy and objectives.
•
Selected fixed income benchmarks:
–
–
–
–
–
Government Bond Index
Intermediate Government Bond Index
Government/Credit Bond Index
Treasury Index
Short term Treasury Indices
Performance Review
QTR
I
QTR
II
QTR
III
QTR
IV
YTD
Total Account Return
1.5%
1.5%
1.5%
1.5%
6.3%
Account Benchmark
1.2%
1.2%
1.2%
1.2%
5.1%
Fixed Income Return
1.0%
1.0%
1.0%
1.0%
4.5%
US Treasury / Agency
0.8%
0.8%
0.8%
0.8%
3.7%
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Current Market Environment
• Short-term interest rates likely to remain at near 0%.
• Still, Hints of inflation returning to economic data.
• What is the shape of the Yield Curve telling us today?
12/31/10 to 8/15/2011
5
5
4
4
% Yield
% Yield
12/31/07 to 12/31/2008
3
2
3
2
1
1
0
0
1 MO
3 MO
6 MO
2 YR
5 YR
Maturity
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10 YR 30 YR
1 MO
3 MO
6 MO
2 YR
5 YR
10 YR 30 YR
Maturity
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Conclusion
Useful Resources:
• www.investopedia.com
• www.bloomberg.com
• www.yahoo.com (Finance)
• Illinois Compiled Statutes at www.ilga.gov (40 ILCS 5/)
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