IPPFA/NIU TRUSTEE CERTIFICATION PROGRAM August 2011

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


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.


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.


• A bond is a contractual obligation between a borrower and a lender.

What is a Bond?


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)


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


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


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.


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


Risk and Reward

Inverse Relationship – Bond Prices and Interest Rates

I = Interest RatesP = Bond PriceS

I P


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.


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


Risk and Reward


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


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


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.


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.


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%.


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


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%.


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


Portfolio Concepts

Diversification

Fixed Income Portfolio Characteristics


A Few Comments on Corporate BondsA Few Comments on Corporate Bonds






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


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


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?


Conclusion

Useful Resources:

• www.investopedia.com

• www.bloomberg.com

• www.yahoo.com (Finance)

• Illinois Compiled Statutes at www.ilga.gov (40 ILCS 5/)

http://www.investopedia.com/

http://www.bloomberg.com/

http://www.yahoo.com/

http://www.ilga.gov/

Documents

IPPFA/NIU TRUSTEE CERTIFICATION PROGRAM August 2011