Kames Capital Fixed income training September 2011 Scott Jamieson – Head of Multi-Asset Investing Scott Jamieson Head of Multi Asset Investing
What is a bond? • Loans issued by governments and companies to raise cash • Level of interest paid/demanded depends on financial strength or quality of issuer • Once issued, bonds can be traded between investors • Interest and redemption payments are fixed • Hence, “fixed income”! • But their prices rise and fall reflecting the value of the future payments 2
Bond terminology gy • What does this mean? Treasury 4.75% 2020 – UK Treasury is the issuer 100 90 90 – 4.75% is the interest or “coupon” rate 4 75% i th i t t “ ” t 80 paid so £4.75 is paid each year for 70 each £100 nominal shflow 60 50 – 2020 is the “maturity” or y Cas 40 “redemption” date when the loan is 30 repaid at “par” ie £100 20 • Index-linked gilts have inflation 10 0 0 linked coupon and redemption 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 payments Year For illustrative purposes only 3
Remember the capital structure p Secured debt Bank debt Senior debt Bond holders above shareholders Subordinated debt Governments are recapitalising financial institutions by purchasing preference y p g p Preference shares Preference shares shares Ordinary shares y Rights issues g 4
Prices and yields y • The price is what you pay to receive the fixed cashflows • Reflects the interest rate investors are willing to lend at • Known as the gross redemption yield (GRY) – Higher price => lower yield – Lower price => higher yield • If you hold the gilt to maturity, your return will be the gross redemption yield at purchase If h ld th ilt t t it t ill b th d ti i ld t h • GRYs are influenced by the economic picture • But also, other asset classes and supply/demand 5
Why do bond managers talk about duration? y g Impact of 1% change in yields • Duration is an approximate 10% measure of a 1% yield change on ce 9% 9% a bond’s price b d’ i change in pri 8% • Duration is a tool to profit from 7% yield changes 6% 5% 5% Approximate c • Longer dated bonds have higher L d t d b d h hi h 4% duration and are more sensitive 3% to yield changes 2% 1% 1% • Shorter dated bonds have less Shorter dated bonds have less A 0% duration and are less sensitive to 1 2 3 4 5 6 7 8 9 10 yield changes Duration (years) F Fund d duration Yield Expectations For illustrative purposes only 6
What is a corporate bond? p • Bond issued by a company • Ranks above shareholders in the event of insolvency Credit Credit Corporat C ( (but no voting rights) ) spread • Rated by rating agencies on ability to make future payments • Yields higher than gilts due to extra credit risk – Yi ld hi h h il d di i k te bond known as “credit spread” • Corporate bonds can have special features to Gilt yield Gilt yield compensate for the additional risks t f th dditi l i k yield • Known as “credit” 7
UK corporate bond exposure p p Utilities 10.61% Travel & Leisure 1.11% Telecommunications Telecommunications 5 52% 5.52% Retail 2.51% Personal & Household Goods 1.60% Oil & Gas 1.70% Media Media 0 97% 0.97% Insurance-wrapped 0.63% Insurance 5.55% Industrial Goods & Services 1.42% Health Care ea t Ca e 1.71% Food & Beverage 1.02% Financial Services 4.96% Construction & Materials 0.41% Chemicals 0.48% Basic Resources 0.37% Banks 19.28% Automobiles & Parts 0.27% 0 00% 0.00% 5.00% 5 00% 10 00% 10.00% 15 00% 15.00% 20.00% 20 00% 25 00% 25.00% Source: iBoxx as at 2 September 2011 8
Ratings g Sterling credit spreads • Ratings are an independent 800 assessment of the issuer’s credit 700 worthiness thi 600 • AAA the strongest down to D 500 • Issuers rated below BBB are non- d (bps) i investment grade or high yield t t d hi h i ld 400 400 Spread and are more risky than 300 investment grade bonds 200 100 Sample bonds 0 Jan 03 May 03 Sep 03 Jan 04 May 04 Sep 04 Jan 05 May 05 Sep 05 Jan 06 May 06 Sep 06 Jan 07 May 07 Sep 07 Jan 08 May 08 Sep 08 Jan 09 May 09 Sep 09 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 AAA Network Rail 4.625% 2020 AA AA Wal Mart 5 625% 2034 Wal-Mart 5.625% 2034 AAA AA A BBB A Verizon Wireless 8.875% 2018 BBB Imperial Tobacco 9% 2022 Source: iBoxx & Barclays as at September 2011 9
Why go global? y g g • Sterling market is relatively small! 3 40% 3.40% 8.40% 5.9% 24.70% Gilts 12.80% Sterling Corporate Bonds Euro Government Euro Corporate Bonds US Treasuries US$ Corporate Bonds S$ C 26.90% US$ Sovereigns/ Sub Sov's 18.00% Source: Barclays, iBoxx, Bloomberg as at May 2011 10
Going global – bond selection opportunities g g pp Vodafone Total of 41 bonds AUD: 1 CZK: 1 EUR: 12 GBP: 5 JPY: 1 USD: 21 Wells Fargo & Co Total of 600 bonds EDF HSBC HSBC T Total of 58 bonds l f 8 b d Total of 2074 bonds CHF: 7 FRF: 2 EUR: 22 GBP: 8 JPY: 7 JPY: 7 USD: 12 USD: 12 Source: Bloomberg as at May 2011 11
Global bonds – 3 elements of risk/return • Credit spread – Does the credit spread offer value relative to the credit risks? – How does it compare against the company’s other bonds? H d it i t th ’ th b d ? – Does it offer value relative to other companies’ spreads? – [Kames Capital approach; only hold bonds where we see value in the credit spread] • Duration • Duration – How does the bond’s duration affect overall portfolio duration and curve? – Does the bond provide duration in an economy where we want exposure? – [Kames Capital approach; find a bond that meets requirements or adjust with futures] [ p pp ; q j ] • Currency – Will the bond’s currency appreciate relative to sterling? – Is the risk of depreciation greater than the potential reward? – [Kames Capital approach; usually to hedge, taking occasional small non-£ positions] 12
Factors affecting bond market returns – general g g • Interest rate expectations • Inflation/recession • Credit rating downgrades/upgrades • Government budget deficits • Extraneous (war/disaster/political uncertainty) 13
What is a high yield bond? g y • Rated below investment grade at the time of issue • They have a higher risk of default but typically pay higher yields than better quality bonds to make them attractive to investors • Issuance is disproportionately centred in the US although issuers in Europe, Asia and South Africa turning to high-yield debt in connection with refinancing and acquisitions • The possibility of default is the biggest risk Th ibili f d f l i h bi i k • In a recession interest rates may drop which tends to increase the value in investment grade bonds; however a recession tends to increase the possibility of default of sub- i investment grade bonds t t d b d • Other risks are downgrade risk, liquidity risk and economic risk 14
Emerging market debt (EMD) g g ( ) • Bonds issued by less developed countries and primarily issued by sovereign issuers • Corporate debt does exist in this category but they tend to borrow from banks and other sources • EMD tends to have a lower credit rating than other sovereign debt because of increased economic and political risks. Most EMD is rated below investment grade • The market is more prone to crises than other debt markets including the Tequila Crisis in Th k i i h h d b k i l di h T il C i i i 1994-95, East Asian financial crisis in 1997, 1998 Russian financial crisis and Argentine economic crisis in 2001-02 • Individual securities become more illiquid in secondary markets and bid/offer spreads are I di id l iti b illi id i d k t d bid/ ff d too wide to actively trade therefore investors tend to use mutual funds 15
Floating rate notes g • Bonds with a variable coupon linked to a reference rate of interest such as LIBOR, Euribor or federal funds rate plus a spread. The spread remains constant • Almost all FRNs have quarterly coupons. The coupon is calculated by taking the reference f rate for that day and adding the spread • In the US, government sponsored enterprises such as Federal Hone Loan Banks, Federal N ti National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage l M t A i ti (F i M ) d th F d l H L M t Corporation (Freddie Mac) are important issuers. In Europe, the main issuers are banks • FRNs carry little interest rate risk, have a duration close to zero and their price shows low sensitivity to changes in market rates Therefore they are considered conservative sensitivity to changes in market rates. Therefore, they are considered conservative investment for investors who believe markets rates will increase • They are not immune to credit risk • They are traded ‘over-the-counter’ rather than on a stock exchange. In Europe, they are They are traded ‘over the counter’ rather than on a stock exchange In Europe they are liquid, however in the US, as most FRNs, are held to maturity the market is less liquid 16
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