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Fixed Income 101

The following information is intended to give a high level introduction to debt or fixed-income investing.

What are fixed income investments?

A fixed income investment pays a fixed rate of return. Fixed income, typically, refers to government, corporate, or municipal bonds which pay a fixed rate of interest until the bonds mature.
What is risk and what are types of risk in government fund investing?
By its very nature, investing involves risk. Risk and return are related, and, generally, there is a trade-off between risk and return. Even though public sector investing is limited to investments on the low end of the risk spectrum, those with high credit quality and low market risk, risks still remain. The key to prudent investing is identifying and recognizing the risks, and managing them in a way that yields appropriate risk-adjusted returns, given the government’s risk tolerance. Understanding a government’s appetite or tolerance for risk is fundamental in determining the risk/return make-up of the government’s portfolio.

There are several risks that investors of public funds must understand.

Credit (default) risk

This may be one of the easiest risks to understand. Credit or default risk is the risk that a part or all of a government’s investment – both principal and the interest due – will be lost. This risk involves an issuer’s credit-worthiness. It is the risk that the issuer will not be able to pay the interest or repay the principal when they are due. This risk also involves the perception by the market of weakness of an issuer or of a security. This may also negatively affect a security's price, resulting in a loss for an investor.

While the instruments public funds are allowed to invest in are considered amongst the safest, there are differences in the credit risk they carry and, typically, in the yields they provide to compensate for that spectrum of risk. Investors should always be aware of the risks that they are taking and make sure they are adequately compensated for those risks.

Credit risk can be managed by conducting due diligence on credit quality including issuer financial strength, the structure of an investment, the collateral securing the investment and by placing limits on the credit quality of investments. Risk involving the broker or financial institution selling an investment can be managed by having third-party safekeeping and requiring delivery-versus-payment on all securities purchased.

Making use of third-party evaluation can be helpful in the credit due diligence process. Nationally recognized statistical ratings organizations (NRSROs), such as Standard & Poors, Moody’s, and Fitch, provide ratings for some of issuers and securities public funds typically invest in, including agencies, GSEs, municipal bonds, commercial paper, corporate bonds and other securities. Private sector research firms such as IDC Financial Publishing, Inc., and VERIBANC, and Bauer Financial provide analyses of financial institutions such as banks and savings and loans (S&Ls). These can be useful to government investors in evaluating the issuers and securities they invest in, but also for evaluating the financial institutions they do business with (such as banks for depository products or broker-dealers). While public funds investors can use such ratings, they should be mindful that they are not necessarily foolproof. Assessments can change dramatically fast, and investors, including government investors of public funds, have lost money on securities/issuers that had previously been highly rated.

Another source of research comes from the financial institution, such as the broker-dealer, that sells an investment.

Government investors should be conscious of the risks involved in investing in securities carrying credit risk and perhaps, limit their investment in these if they are not comfortable with the expertise, either internal or external, that they have to analyze these. Investors of public funds who have the expertise to evaluate credit risk should make sure the return they are getting compensates for the risk.

Market risk

Market risk is the risk of a decline in value of an investment declines due to a change in the market.

Interest rate risk

A basic tenet of fixed income securities is that an inverse relationship exists between interest rates and the price or value of a security. All other factors being equal,
- fixed-income security prices fall when interest rates increase
- fixed-income security prices or market value rise when rates decrease
- longer-term securities are more heavily impacted than shorter term securities
- securities with lower credit are more affected than highly-rated securities
Put simply, interest risk is the risk of a decrease in the value of a security as a result of interest rates increasing. Modest ways to mitigate this risk include:
- developing and updating cash flow forecasts to have a sense of short and on-going liquidity requirements
- structuring investment portfolio to meet obligations
- understanding maturity structure of securities in the government’s portfolio (especially important for callable securities)
- adopting average short and on-going liquidity needs maturity or average duration limitations (Duration measures the sensitivity of a fixed-income security’s price change as a result of changes in interest rates).
- not investing in securities with maturities beyond those allowable in the government’s investment policy.
Liquidity risk

Liquidity risk is the risk of being unable to liquidate an investment prior to its maturity date. If no secondary market exists for an investment, the investor may experience a loss. Typically, non-negotiable certificates of deposit (CDs), and certain commercial paper issues are examples of investments that may not have an active market in which an investor can turn to sell a security if a need for this arises. What tends to happen in these situations is the price of the security would fall to where a willing buyer is interested in buying or there might be a penalty for an early sale, as is often the case for non-negotiable CDs.

Reinvestment risk

Reinvestment risk is the risk that cash flows from an investment, including interest payments and returned principal, will be invested at an interest rate less than that initially contemplated. Downward trending interest rates create reinvestment risk. Reinvestment risk is realized when interest rates fall, and interest payments are reinvested at the reduced interest rate. This risk is an important consideration for investors in callable securities. Some bonds are issued with call features that allow the issuer to call or repay the bonds prior to their maturity date. Generally, this happens if interest rates fall low enough that the issuer saves money by calling the bonds, paying off the existing higher coupon bonds, and issuing new bonds at lower rates. The issuer stops paying the higher coupon and the investor stops receiving the higher interest rate. For a callable bond, when it is in the issuer’s benefit to call a bond, it is to the investor’s detriment because in these situations, the investor must then reinvest the returned principal also at a reduced interest rate.

Reputational risk

Reputational risk is the risk that an investment activity – loss, mismanagement, fraud, mistakes – negatively affects the reputation of the treasurer, finance director, the investment officer, or the government. Such happenings are hard to overcome. As the old adage goes, a lost reputation is hard to find. While harm can come to one’s reputation or that of a government, despite the best laid out plans, having a well-thought out investment policy and remaining in compliance with it are safeguards against this risk.

Opportunity risk

Opportunity risk is the risk of missing an opportunity, or the rate of return an alternative would provide.
What is a bond?

A bond is an interest bearing or discounted government, corporate or municipal security that obligates the issuer to pay the bondholder a specified sum of money, at specific intervals and to repay the principal at maturity.
What are the components of a bond?

Principal

Principal means the “face” amount, the “par” value, or the “maturity” price. This is important because interest accrues on the outstanding principal or face amount. Importantly, the principal or the “face” may and often does, differ from its purchase price.

Market value

Market value or market price is the price of a security. It is the price which market participants – sellers and buyers – agree on. This value is contrasted with the “par” or “face” value is the nominal value of a security. It is the amount on which interest is calculated and the principal paid to the investor at maturity.

Discount

The discount is the difference between the price of a security and the face when the market price is below the par.

Example

A government investor may purchase a U.S. Treasury note with a par value of $1 million for the price of $945,000. The principal amount of this security is $1 million and the $55,000 represents the discount for the security. At maturity, the government investor will receive the face value of $1 million and the discount will accrue over the life of the investment.

Premium

Premium refers to the difference between the par or face value of a security and its market price when the market price is above the face. Investors, typically, pay premiums when the coupon of the security is higher than the interest rates.

Example

A government investor may purchase a U.S. Treasury note with a par of $1 million for the price of $1,100,000. The principal amount of this security is $1 million and the $100,000 represents the premium for the security. At maturity, the government investor will receive the face value of $1 million and the premium will be amortized over the life of the investment.

Book value/amortized cost/adjusted cost

Book value is the cost of a security adjusted to reflect the accretion of a discount or amortization of a premium. This value changes as a function of the passage of time.

Interest

A defining characteristic of debt securities is that they bear interest on the principal amount. This part of the security is the compensation by the issuer (as debtor/borrower) to the investor (as lender) for the money for a specific period of time. There is a time value to money. Interest includes coupon payments and interest accruing at an interest rate. Interest is calculated as a percentage of the principal amount borrowed over the specific period.

The time period can be calculated various ways – on a 360 day year with 30 days per month or a 365-day year with actual days per month. The particular calculation depends on the instrument.

Discount interest

For instruments that pay interest on a discount basis like treasury bills, the investor pays the discounted amount and receives face or par value at maturity. The difference is the interest earned and it is calculated as follows:

The actual number of days until maturity / 360 days

Example

The discount amount invested and yield-to-maturity of a $1 million face value Treasury bill, purchased at a discount rate of 1.5 percent with a term to maturity of 312 days is calculated as follows:

Discount interest =

$1,000,000 X 312/360 X 1.5% = $13,000

Amount invested =

$1,000,000 – $13,000 = $987,000

And the yield-to-maturity is calculated as follows

$13,000/((312/360) x $987,000)) = 1.52%

Investors in discounted securities invest less than the face amount, so the yield-to-maturity is higher than the discount rate. The yield-to-maturity is based on the amount invested while the discount rate is based on the face or par value.

Interest-bearing

30/360

Some securities that have semi-annual interest use the 30/360 day convention. This is used regardless of the actual number of days in each month and the number of days in the year.

Example

To calculate the interest on a semi-annual agency with a 3 percent coupon from an August 1, 2016 issue date through the first coupon date of January 1, 2017, we use the 30/360 convention. So the five months between these dates result in 150 days for the period. Accordingly, interest for the period will be $12,500.

$1,000,000 X 150/360 X 3% = $12,500

Actual /Actual

The convention used for Treasury notes and bonds is the actual days in a period over the actual number of days in the year.

Example

An investor purchases a $1,000,000 face value Treasury bond with a 3.5% coupon. The investor buys the bond on May 1 and holds it to August 1. Interest payments are made April 1 and October 1. The investor holds the bond (31+30+31) for a total of 92 days.The investor is entitled to receive interest as calculated below:

$1,000,000 X (92/(2 X 183)) X 3.5% = $8,797.81
Bond characteristics
Maturity

Principal is payable at a specified date. In fixed-income investing, “maturity” means the date the face or par value of a debt security become due and payable.

Weighted average maturity (WAM)

Also called average weighted life, weighted average maturity measures the average maturity of an investment portfolio as weighted by the market value of each investment in the portfolio. It is a more accurate measure than average life because it accounts for the portion of the portfolio that each investment represents.

Example

An investment portfolio has three investments:
1. A $300,000 market value security with 275 days to maturity
2. A $10,0000 market value security with 365 days to maturity
3. A $1,100,000 market value security with 10 days to maturity
The average maturity of this portfolio is (275+365+10)/3 = 217 days

The weighted average maturity is (($300,000 x 275) + ($10,000 x 365) + ($1,100,000 X 10))/$1,410,000 = 69 days.

Taking market value weightings into account produces a meaningfully different maturity calculation.

Effective maturity

The calculation of effective maturity is used for estimating average maturity when there are call features. This calculation depends on the behavior of interest rates over time and makes various assumptions to calculate a maturity that is not known but depends on what interest rates do.

Duration

Duration is a useful concept in fixed income investing and measures price sensitivity of fixed-income investments. Recall that movement in the value or price of a fixed income security is negatively related to the direction of interest rates. As rates increase, prices fall, and conversely, as rates fall, prices increase. Duration measures the weighted average of the present value of the cash flows of a security. So in this/ respect, it is improvement over maturity that only considers future values. The greater the duration of a bond, the greater its volatility. In general, duration rises with maturity, and falls with frequency and size/ of coupon payments.

Modified duration is a multiplier that measures the approximate percentage change in the value or price of a security or portfolio given a 1% (100 basis points) movement in interest rates.

Example

For example, if a security has a modified duration of 2.5 and interest rates rise by 75 basis points, the security would experience approximately a -1.88% change in value.

(-1%) X modified duration X (basis point change in yield/100)

(-1%) X 2.5 X (75/100) = -1.88%

Convexity

While duration is a useful measure of sensitivity for small changes in interest rates, for larger yield changes, convexity is a useful measure of volatility. The term derives from the price yield curve of a bond, which is convex. A rule of thumb is the more convexity a bond has, the better. What this means is as interest rates increase, the price of a fixed income security falls more slowly and as rates decrease, the price of a fixed income security rises more quickly. As with duration, convexity of simple (noncallable) securities increases with lower coupons, lower yields and longer maturities.

Convexity’s effect on price movement is measured by the equation:

Convexity X basis point change squared X 100

Example

If a security has a convexity of 86 and interest rates increase by 75 basis points, the security would experience approximately a 0.48% change in value

86 X (0.0075*0.0075) X 100 = 0.48%

To calculate the effects of duration and convexity together, simply add the results. So assuming, the same bond has the modified duration (2.5) and convexity (86) illustrated above, the results would be as follows:

Example

Total Price change = Change from duration + change from convexity

[(-1%) X modified duration x (basis point change in yield /100)] +

[Convexity X basis point change squared x 100] =

-1.88% +0.48% or - 1.39%
What are different yield measures?

Yield measures the income from a security or portfolio as a percentage of the value of the security or of the portfolio. Assume the security is a bond. There are different ways to calculate yield. Some of the more common calculations are:

Yield to maturity

The yield to maturity is the rate of return or income an investor will receive if a bond is held to its maturity date. It considers purchase price, redemption value, time to maturity, coupons and the time between payments. Another way to consider yield to maturity is the rate at which present value of all payments equals the present price of the bond.

Yield to call

The yield to call of a bond assumes the bond will be called by the issuer of the bond at the first all date. The same calculations used for yield to maturity would be used in calculating yield to call but using the call date.

Yield to worst

This yield measure is the lesser of yield to maturity and yield to call.
What is optionality?
Optionality are features that provide options in investing.

Calls

A call features is the most common form of optionality in investing public funds. A callable bond combines a bond with a call option. From the investor’s perspective, buying a callable bond is like buying a regular bond and selling a call option to the issuer. The investor gets a premium in the form of an interest rate higher than the rate on a non-callable bond equivalent.

There are different types of calls:
- European calls – have a one-time call option at a specified date, after a specified lockout period
- Bermuda calls – bonds may be called per a specified schedule after initial lockout.
- American calls – bonds are continuously callable after initial lock out.
- Canary calls - A step-up bond that cannot be called after completing its first-step period. The issuer of the bond reserves the option to call back the bond until the first step is reached. A canary call may only be exercised on predetermined dates.
- Make whole – a call option that allows the borrower to pay off remaining debt early by making the investor “whole.” The payment is derived on discounting future coupon payments that will not be paid because of the call.
- Sinking fund call – is the option to call bonds for a set rate, using money from a sinking fund created by the issuer specifically for such calls.
What is the yield curve?

The yield curve is a line graph displaying the yield on bonds at different maturities within a market sector, such as Treasuries, agencies or corporates. The yield curve generally slopes upwards, and this is called a normal yield curve. Sometimes, the yield curve is inverted with short term rates higher than long term rates

Glossary

Key Takeaways

What rules of thumb help when investing public funds?

Know who you are doing business with

The relationships you have with financial service providers are paramount. You cannot function without them. Implement appropriate due diligence processes to follow for entering into and continuing relationships with various external vendors, including banks, broker-dealers, investment advisers, custodians and others.

Undertake competitive procurement

Competitive procurement helps ensure you are aware of and understand all the alternatives available to your government and can make educated decisions. It ensures you are getting a value proposition. Cast a wide net and take inventory of what the market has to offer.

Have competitive bidding

Whether through collecting at least three bids for each trade, or through the use of robust electronic trading platforms, competitive bidding gives a firsthand look and understanding of the market. When tools such as Bloomberg may not make sense from a cost/benefit perspective, make sure you still know the market.

Insist on third party custody

The broker-dealers selling securities to a government should never have custody of the government’s assets. Nor should investment advisers provide custody. They provide advice or management - not custody. Governments should always insist on a third-party custodian, ideally selected competitively, evidenced by a custody agreement with trades settled delivery-versus-payment.

Require collateral for deposits

Follow state statute in collateralizing your government’s funds. Pay close attention to what security types and maturities are appropriate for collateral. Make sure your collateralization agreements specify appropriate collateral, restrict unauthorized substitution of the collateral, mandate third-party safekeeping of the collateral and require notification if value fluctuates below “floor” or any changes made. Consider accepting letters of credit from a Federal Home Loan Bank.

Diversify

A concept as simple as not putting all your eggs in one basket can help ensure the safety of your government's investment portfolio. Nonsystematic risk, the risk of individual securities or different categories can be reduced by appropriate diversification. Different asset classes, sub-assets, securities, different issuers, different maturities, different structures may react differently to changes in the market. Reducing this diversifiable risk is the goal of diversification.

Do not concentrate in one LGIP or one MMMF

Related to the take-away on diversification, do not assume if you invest all your assets in a diversified LGIP or MMMF that you are diversified. You are not. You are concentrated. Make sure that your portfolio is diversified.

Understand the return/risk nature of investing

Investing entails risk. Determine the level of risk or volatility your government is comfortable with – or can tolerate – before you invest. Higher returns are accompanied by greater volatility. If an investment is “beating” its benchmark, ask, what is different? Why is this the case? Are there more risks involved?

The basic tenet of fixed income is an inverse relationship of values or prices and interest rates

When interest rates increase, the value of fixed-income securities falls. This price decline can be painful to portfolios for which safety is the most important objective. Total return metrics can help stay on top of portfolio price movement.

Keep the government’s investment policy fresh

Create and have your governing body approve a comprehensive investment policy that stands the test of time. It should serve to guide the entire investment program. Review it annually, but do not think it needs to be altered every time it is reviewed. Update the date it has been most recently reviewed.

Communicate

Take a proactive approach to communicating about your investment program – whether with your oversight committee, governing board, your citizens or other involved stakeholders. Embracing transparency goes a long way to building trust and goodwill that may prove useful in turbulent times.

Be a good steward

Understand the funds entrusted to you are not your own. Be aware of your fiduciary duty. Follow the parameters of your investment policy. Avoid conflicts. Good stewardship will make your job easier.

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