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IPPFA TRUSTEE CERTIFICATION PROGRAM 1
IPPFA/NIU
TRUSTEE CERTIFICATION PROGRAM
August 2011
Fundamentals of Fixed Income Investing
Presented By:
Thomas S. SawyerManaging Partner
Sawyer Falduto Asset Management, [email protected]
630-941-8560
SAWYER FALDUTO ASSET MANAGEMENT, LLC
IPPFA TRUSTEE CERTIFICATION PROGRAM 2
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.
IPPFA TRUSTEE CERTIFICATION PROGRAM 3
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.
IPPFA TRUSTEE CERTIFICATION PROGRAM 4
• A bond is a contractual obligation between a borrower and a lender.
What is a Bond?
IPPFA TRUSTEE CERTIFICATION PROGRAM 5
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)
IPPFA TRUSTEE CERTIFICATION PROGRAM 6
Features of Fixed Income Securities
Description:
$100 Face Amount (Par Value) U.S. Fourth Liberty Loan Bond 4.25% Due 10/15/1938.
Issuer: U.S. Treasury
Coupon: 4.25%
Maturity: 10/15/1938
Call: None
IPPFA TRUSTEE CERTIFICATION PROGRAM 7
Fixed Income Securities Permitted by Statute
• U.S. Treasury Bills, Notes and BondsU.S. Treasury Bills, Notes and Bonds
• Government AgenciesGovernment Agencies– Federal Home Loan Bank, Fannie Mae, Freddie Mac, Federal Farm CreditFederal Home Loan Bank, Fannie Mae, Freddie Mac, Federal Farm Credit
• Municipal Bonds issued in IllinoisMunicipal Bonds issued in Illinois
• Corporate Bonds (January 1, 2011)Corporate Bonds (January 1, 2011)
• OtherOther– Certificates of DepositCertificates of Deposit– State of Israel BondsState of Israel Bonds– GICsGICs– Money Market Mutual FundsMoney Market Mutual Funds
IPPFA TRUSTEE CERTIFICATION PROGRAM 8
A Word on Public Act 96-1495—Corporate BondsA Word on Public Act 96-1495—Corporate Bonds
• Allows investment in investment grade 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 Bonds must be rated as investment grade by either Moody’s or S&P at the time of purchase.time of purchase.
– Bonds must be liquidated within 90 days after the bonds are downgraded by Bonds must be liquidated within 90 days after the bonds are downgraded by both Moody’s and the S&P.both Moody’s and the S&P.
– Corporate bonds count as fixed income investments.Corporate bonds count as fixed income investments.
– Corporate bonds must be invested through an investment advisor, not Corporate bonds must be invested through an investment advisor, not through a consultant as defined in the Illinois Pension Code.through a consultant as defined in the Illinois Pension Code.
– Another way that pension funds may diversify their fixed income portfolio.Another way that pension funds may diversify their fixed income portfolio.
IPPFA TRUSTEE CERTIFICATION PROGRAM 9
Permitted Investments – Pension FundsPermitted Investments – Pension Funds
• Allocation to Fixed IncomeAllocation to Fixed Income
– Unlike the allocation to equities, the statute does not impose percentage Unlike the allocation to equities, the statute does not impose percentage allocation limitations.allocation limitations.
– Illinois Pension Code provides a complete list of acceptable investments.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 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 Pension Code also provides a list of prohibited transactions
• 40 ILCS 5/1-11040 ILCS 5/1-110
IPPFA TRUSTEE CERTIFICATION PROGRAM 10
Risk and Reward
Inverse Relationship – Bond Prices and Interest Rates
I = Interest RatesP = Bond PriceS
I P
IPPFA TRUSTEE CERTIFICATION PROGRAM 11
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.
IPPFA TRUSTEE CERTIFICATION PROGRAM 12
Risk and Reward
• Credit and Maturity Risk Spectrum:
Less Risk More Risk
Shorter Maturity Longer Maturity
Tsy Agy Muni Inv Grade Corp High Yield Corp
IPPFA TRUSTEE CERTIFICATION PROGRAM 13
Risk and Reward
10 Year Tsy Less 3 Mo T-Bill
-400
-300
-200
-100
0
100
200
300
400
500
1977-0
1
1978-0
3
1979-0
5
1980-0
7
1981-0
9
1982-1
1
1984-0
1
1985-0
3
1986-0
5
1987-0
7
1988-0
9
1989-1
1
1991-0
1
1992-0
3
1993-0
5
1994-0
7
1995-0
9
1996-1
1
1998-0
1
1999-0
3
2000-0
5
2001-0
7
2002-0
9
2003-1
1
2005-0
1
2006-0
3
2007-0
5
2008-8
2008-1
0
2009-1
2
2011-0
2
Monthly
Basis
Po
ints
BP Spread
AverageBonds Less Attractive
Bonds More Attractive
IPPFA TRUSTEE CERTIFICATION PROGRAM 14
Time Value of Money
• 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.
“The Eighth Wonder should be utilized by all of us to accomplish what we want. It is compound interest.”
- Baron Rothschild
IPPFA TRUSTEE CERTIFICATION PROGRAM 15
One Math Problem – Sorry!Time Value of Money
PV = FV
(1 + i)n
Or,
Present Value = Future Value
(1 + rate)periods
So,
$100 = $104.25
(1.0425)1
FV = PV(1 + i)n
Or,
Future Value = Present Value x (1 + rate)periods
So,
$104.25 = $100(1.0425)1
IPPFA TRUSTEE CERTIFICATION PROGRAM 16
Risk and RewardPremium 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.
IPPFA TRUSTEE CERTIFICATION PROGRAM 17
Risk and RewardPremium 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.
IPPFA TRUSTEE CERTIFICATION PROGRAM 18
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%.
IPPFA TRUSTEE CERTIFICATION PROGRAM 19
Risk and Reward
US TREASURY YIELD CURVE
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
1 MO 3 MO 6 MO 2 YR 5 YR 10 YR 30 YR
Maturity
% Y
ield
IPPFA TRUSTEE CERTIFICATION PROGRAM 20
Portfolio ConceptsDuration
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%.
IPPFA TRUSTEE CERTIFICATION PROGRAM 21
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.
Portfolio Concepts
IPPFA TRUSTEE CERTIFICATION PROGRAM 22
Portfolio Concepts
Diversification
Fixed Income Allocation Target Range Current
Cash Equivalents 0% 0 - 40% 0%
Bank Certificates of Deposit
0% 0 - 40% 0%
US Treasury Securities 30% 0 - 100% 30%
US Government Agency 35% 0 - 70% 40%
US Government Agency – Callable
20% 0 - 30% 15%
US Government Agency MBS
5% 0 - 10% 5%
Investment Grade Corporate Bonds
10% 0 - 30% 0%
Taxable Municipal Securities
10% 0 - 20% 10%
Maturity Distribution % of Fixed Income Securities
0 – 3 years 16.1%
3 – 5 years 34.2%
5 – 7 years 33.5%
7 – 10 years 13.2%
10 – 15 years 3.0%
Fixed Income Portfolio Characteristics
IPPFA TRUSTEE CERTIFICATION PROGRAM 23
A Few Comments on Corporate BondsA Few Comments on Corporate Bonds
IPPFA TRUSTEE CERTIFICATION PROGRAM 24
A Few Comments on Corporate BondsA Few Comments on Corporate Bonds
IPPFA TRUSTEE CERTIFICATION PROGRAM 25
A Few Comments on Corporate BondsA Few Comments on Corporate Bonds
IPPFA TRUSTEE CERTIFICATION PROGRAM 26
Fixed Income Portfolio Characteristics
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%
Quality, Yield and Duration
Quality Distribution AAA AA A BBB
Fixed Income Portfolio 97% 3% 0% 0%
Benchmark 99% 1% 0% 0%
Portfolio Concepts
IPPFA TRUSTEE CERTIFICATION PROGRAM 27
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 ReviewQTR
IQTR
IIQTR
IIIQTR
IVYTD
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%
Portfolio Concepts
IPPFA TRUSTEE CERTIFICATION PROGRAM 28
Current Market Environment
12/31/10 to 8/15/2011
0
1
2
3
4
5
1 MO 3 MO 6 MO 2 YR 5 YR 10 YR 30 YR
Maturity
% Y
ield
12/31/07 to 12/31/2008
0
1
2
3
4
5
1 MO 3 MO 6 MO 2 YR 5 YR 10 YR 30 YR
Maturity
% Y
ield
• Short-term interest rates likely to remain at near 0%.Short-term interest rates likely to remain at near 0%.
• Still, Still, Hints of inflation returning to economic data.Hints of inflation returning to economic data.
• What is the shape of the Yield Curve telling us today?What is the shape of the Yield Curve telling us today?
IPPFA TRUSTEE CERTIFICATION PROGRAM 29
Conclusion
Useful Resources:
• www.investopedia.com
• www.bloomberg.com
• www.yahoo.com (Finance)
• Illinois Compiled Statutes at www.ilga.gov (40 ILCS 5/)