Fixed-Income Securities: A Foundation for Success

Transcription

1 Fixed-Income Securities: A Foundation for Success The loftier the building, the deeper the foundation must be laid. Thomas á Kempis, 14 th century by Stephen Kroah, CFA Wespath Investment Management continues to view today s investment marketplace through an optimistic lens. We seek investment opportunities using a cautious, well-reasoned approach while following the tenets of diversification and prudency. The fixed-income market has been, and will continue to be, a viable avenue for achieving our objectives. Therefore, in order to better navigate today s economic landscape, we feel it is important for all stakeholders to understand fixed-income securities, to be aware of their history, and to have a basic comprehension of their fundamental principles. In architecture, attention is drawn to the façade of a building. People focus on aesthetic flourishes the cornices, trefoils and friezes that give a building its character. Few think about the foundation the one element that most determines the strength and ultimately the longevity of a building. A sound investment strategy is much like a building. While flourishes attract attention in this case high-profile investments which offer lucrative returns (and correspondingly high risk) most likely it is the fixed-income investments which should comprise a suitable portion of your investment strategy foundation. The noted 14 th century biblical scholar, Thomas á Kempis, said it best: The loftier the building, the deeper the foundation must be laid. Fixed-Income Securities Primer According to the Investopedia definition, fixed-income securities are an investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. In its most basic form, a fixed-income security is a loan between a borrower and investors. The borrower otherwise known as the issuer of the security agrees to pay back the amount of money borrowed by a specific date. The issuer also agrees to pay interest or income to investors to make the investment worthwhile. There are three primary aspects of a fixed-income investment. Par value, otherwise known as face value, is the principal amount of the investment. This is the amount the issuer promises to pay back at the time the security comes due. The maturity of the investment is the term of the agreement; determining how long the payments will take place. Finally, the coupon rate is the rate Stephen Kroah Stephen Kroah joined the General Board of Pension and Health Benefits Wespath investment management division in January 2011 as director of fixed income. Previously, he spent much of his career as a principal and senior portfolio manager at Lotsoff Capital, a Chicago-based investment firm. Stephen also spent four years in the United States Marine Corps. He graduated magna cum laude from Northeastern University with a B.S. in International Business/ Finance and has an MBA from the Tepper School of Business at Carnegie Mellon University. He is also a CFA Charterholder.

2 used to determine the periodic interest to be paid on the principal amount. Much like equities, most fixed-income investments are traded in the marketplace, with a rise and fall in price as factors such as change in interest rates or change in credit spreads affect the investment. Therefore, investors may realize a capital gain or loss if they sell the security before maturity. Unlike stocks, they are generally traded by investment banks and not on a central exchange. Origins of the Fixed-Income Market The fixed-income securities market in America dates back to the very beginning of our nation. In 1790, the federal government combined state and federal Revolutionary War debt and issued $80 million in bonds. Alexander Hamilton, the nation s first Secretary of the Treasury, believed it was the responsibility of the new government to take on the individual states debts. He also wished to establish credit in the event the U.S. needed to borrow money from a foreign nation. The United States debt, foreign and domestic, was the price of liberty. The faith of America has been repeatedly pledged for it Among ourselves, the most enlightened friends of good government are those whose expectations of prompt payment are the highest... Alexander Hamilton 1790, First Report on the Public Credit Two years later, the Buttonwood Agreement formalized the securities market in our country. Meeting in New York City, twenty-four merchants and brokers signed the agreement, which authorized the sale of securities for a commission. Five securities, three government bonds and two bank stocks were initially traded. From these humble beginnings our system of selling and purchasing stocks and bonds began. $1000 Pacific Railroad Bond issued by the City and County of San Francisco, 1863 Manifest Destiny Spurs Market The expansion of our country westward fueled the growth of bond markets throughout the 19th century. During the 1820s, it became apparent that tax revenue alone was not sufficient to fund the building of the Erie Canal the state of New York issued a series of bonds to finance the venture. These bonds were well-received by professional speculators and the general public, and marked the beginning of a vigorous market in municipal and corporate bonds. Transportation bonds were at the forefront of an increasingly active corporate bond market. Not surprisingly, the railroads dominated this market. Hundreds of railroad companies were established seemingly overnight. With millions of dollars needed to build the lines and purchase the equipment, it became necessary for the railroads to hire intermediaries Wall Street financial firms to help raise the necessary funds. These intermediaries became rich acting on behalf of the railroads and in their own interests. Unfortunately, many individual speculators, lacking the necessary inside knowledge, lost their savings in proposed railroads that never came to fruition. Through War and Depression The bond market in the first half of the 20th century was dominated by two overriding factors: the need to fund two world wars through war bonds and the ramifications of the Great Depression. In an attempt to spur the economy, the federal government under President Franklin Roosevelt introduced a different form of fixed-income securities. The newly created Federal Deposit Insurance Corporation (FDIC) was established to guarantee depositor bank accounts. This led to insured, bank-issued 2

3 Certificates of Deposit. Soon afterward, in 1938, the Federal National Mortgage Association (Fannie Mae) was created to bring more capital and liquidity to the residential mortgage market by offering mortgage-backed securities. In subsequent years, other mortgage-backed securities were introduced through the creation of Ginnie Mae and Freddie Mac, agencies created to spur home ownership. Low-rated, high-yield bonds exploded onto the scene in the 1970s and 1980s and continue today. Moving away from traditional fixed-income securities, these high-yield bonds offer the promise of higher returns, with the inevitable increased risk. These high-yield bonds tend to be more equity-like, and their returns are highly correlated with the equity markets. They fill up the middle ground between equities and investment grade corporate bonds. Peaks and Valleys The fixed-income market hit its peak during the five-year period beginning in While fixed-income revenue of the top eight investment firms increased by 21 percent, other sources of corporate and institutional revenue grew by only one percent. However, to return to our building analogy, this was nothing more than a house of cards which collapsed with the subprime meltdown toward the end of the decade. During this time, the Federal Reserve was cutting interest rates to historically low levels to help offset a struggling economy. This aggressive action stimulated the housing market, with lenders becoming creative by developing a variety of mortgage options. Even people with bad credit joined the party and entered the market. Interest rates invariably rose, and many subprime borrowers defaulted when their monthly payments increased as adjustable rate mortgages were reset. The mortgage lenders and hedge funds were left holding the bag in this case finding themselves possessing property that was now worth less than the loan value, as the housing market inevitably weakened. Defaults increased and several lenders went bankrupt as the situation escalated. Like dominoes falling one by one, the meltdown precipitated a global financial crisis. Much has been written, and justifiably so, regarding the market volatility during this time. A lack of foresight, questionable financial dealings and rampant greed were three of the acknowledged contributing factors. The slide of all financial markets has been well-documented and has continued to be a drag on the economic recovery. The Role of the Fed At this point, it s important to understand the role the Federal Reserve System has adopted toward the economy. Since its creation in 1913, the Federal Reserve System the central bank of the United States has often initiated interest rate cuts to moderate recessions. During the past decade, the Fed (as it is commonly known), has taken on an exponentially larger role in boosting our flagging economy through interest rate manipulation as well as more aggressive stimulation efforts. According to a New York Times article dated September 14, 2012, Since Wall Street began to wobble in 2007, the Fed has been engaged in an enormous effort to stimulate growth. The article goes on to state that the Fed has been moving into unchartered waters, aggressively intervening in deals to prop up or sell off failing institutions, making loans available to banks in new ways and buying vast amounts of assets to help keep the global economy afloat. Amidst political debate and doubts from outside and within the agency, these attempts have been marked by mixed-results at best. Federal Reserve Bank, Washington, D.C. 3

4 Fixed-Income Securities: An Abundance of Choices Fixed-income investments come in a variety of forms from issuers in the public and private sectors. Generally, these investments fall under these main categories. Treasuries The U.S. government sells Treasury bills, notes and bonds to pay off debt and raise needed cash for expenses not covered by tax revenue. These Treasuries are traditionally considered one of the safest investments, as they are backed by the full faith and credit of the U.S. government. Treasuries are low-risk and low yield; interest earned from these investments is exempt from state and local income taxes (but subject to federal income taxes), increasing their appeal as an investment. Primarily, the difference between Treasury bills, notes and bonds is the length until maturity. Treasury bills (commonly referred to as T-Bills) are issued for terms of one year or less. Because they are of such short duration, they do not pay interest before maturity. Rather, they are typically sold at a discount of the par value to create a profitable yield at maturity. Treasury notes are issued for terms of 2, 3, 5 and 10 years with interest paid semi-annually. The 10-year Treasury is the most common note, and is often quoted when discussing the U.S. government bond market. Treasury bonds have the longest maturity, most commonly for a 30-year maturity. As with notes, Treasury bonds pay interest semi-annually. Treasury Inflation-Protected Securities (or TIPS) are inflation-indexed bonds issued by the U.S. Treasury. These securities are adjusted to the Consumer Price Index (CPI) and their principal rises and falls correspondingly to changes in the CPI. Municipal Bonds Municipal bonds are issued by states, their agencies and other municipalities, such as counties and cities. The two main categories of municipal bonds are general obligation bonds, backed by the issuer s power to tax, and revenue bonds, backed by revenue from a project built with the proceeds of the bond sale. Municipal bonds are generally exempt from federal taxes and state taxes for residents of the state issuing the bond. Companies issue bonds to grow their business. Corporate Bonds As their name implies, corporate bonds are issued by companies to help secure financing for a variety of business pursuits, such as building new plants, purchasing equipment or growing the business. The risk of investing in these bonds varies based on the credit rating of the issuing company. Corporate bonds usually earn higher interest than government-backed bonds with the same maturity, but can experience greater price volatility. There are a number of different types of corporate bonds. These include investment grade, which are unlikely to default and are highly rated by outside credit rating firms (which will be discussed later) and, high yield, which carry a greater risk of default, but also pay a higher interest rate to attract investors. Some are unsecured (generally investment grade), while others are secured by assets of a corporation. Convertible bonds are yet another type of corporate bond, and can be exchanged for equity at some point before the bond matures. Securitized Bonds Securitized bonds have received a great deal of notoriety during the past several years, being closely associated with the current financial crisis. Investment banks take pools of smaller loans such as mortgages, credit cards and auto loans and pool them in a bankruptcy remote trust. They structure the bonds into various tranches (specific classes) with different maturities and loss profiles. This allows the original lenders to move the liabilities off their balance sheet while still receiving income for servicing 4

5 these loans. These tranches are then sold to investors at various yields and maturities based upon their structure. Some of the most commonly known securitized bonds are Mortgage Backed Securities (MBS), Asset Backed Securities (ABS) and Commercial Mortgage Backed Securities (CMBS). As mentioned previously, subprime residential mortgages, a sector of the ABS market, are credited with the run-up in home prices, the subsequent downfall of the economy and with the demise of a number of investment firms, such as Lehman Brothers. Foreign Bonds There is a wide-range of securities available in foreign markets, such as sovereign and emerging market debt. These markets are similar to the domestic market, but have their own set of risks, such as currency and political issues. However, they can be a good source of diversification to the U.S. market, as other economies may be moving in a different direction than the U.S. market, and could potentially provide a better return. Ratings of AAA through BBB- are considered to be investment grade. Ratings can be upgraded or downgraded accordingly, and investors should be aware of the current rating before investing. While non-investment grade bonds have their place in today s market, investors need to be wary of such high-risk offerings. Liquidity Risk Since bonds are not generally traded on an exchange, it can be somewhat more difficult to trade or find a potential buyer. This also makes price discovery problematic. Some bonds are traded frequently, such as on the run Treasuries (the most recently issued U.S. Treasury bond or note of a particular maturity), and the spread between where investors are willing to buy or sell, known as the bid/ask, is very tight. Other bonds, such as higher risk, high yield bonds, trade in very illiquid markets. This can result in the inability to sell the bonds when desired. This adds a layer of risk to the already present credit risk. Risks of Fixed-Income Market As with any investment, there are some risks inherent to the fixed-income market. Three that potential investors need to be aware of follow. Interest Rate Risk Changes in interest rates constitute the biggest risk facing the fixed-income market. As the general level of interest rates increase, the value of fixed-rate bonds decrease. This is what ties the fixedincome market so closely to the Fed: its ability to change interest rates to battle inflation or stimulate the economy has a direct impact on the value of these bonds. The sensitivity of a bond to changes in interest rates is measured by duration. Convexity can also be used to help calculate risk. In mathematical terms, duration measures the change in price caused by a change in interest rates, while convexity measures a change in duration caused by a change in interest rates, making them the first and second derivatives of price change to interest rate change. Credit Risk When investing in municipal and corporate bonds, it is imperative to know the bond rating. Bonds are rated by firms such as Standard & Poor s and Moody s based on their risk of default. Wespath Approach Wespath s fixed-income market offerings exist in three funds the Fixed Income Fund (FIF), the Inflation Protection Fund (IPF) and the Multi Asset Fund (MAF), which holds the other two funds as well as the equity funds offered by Wespath. These funds are available to annual conferences, plan sponsors, institutional investors and other United Methodistaffiliated organizations. The objective of our Fixed Income Fund (FIF) is a traditional one to earn current income while preserving capital by investing in a broad mix of fixed income holdings. This is accomplished by investing in fixed income securities (U.S. government and agency bonds, corporate bonds and securitized products). The corporate bonds held are primarily from American companies and are investment grade, that is, securities which have received a rating of BBB- (or its equivalent) or above from a nationally-recognized securities rating agency. Wespath s FIF may also hold up to 20 percent of its value in bonds with a rating below investment grade, and up to 20 percent of its value in foreign bonds. FIF also holds loans secured by mortgages and other types of loans originated through the Wespath Positive Social Purpose Lending Program, which invests in affordable housing, charter schools, community facilities and microfinance. 5

6 Primarily, FIF is designed for investors who seek a greater portion of their investment return from current income, but exhibit a willingness to incur some risk for the potential of modest capital appreciation. The IPF objective is to provide investors with current income and to protect principal from loss of purchasing power due to inflation. This is accomplished by investing in a broadly diversified portfolio of inflation-protected investments, with 90 percent of its assets in fixedincome investments such as publicly traded U.S. Treasury Inflation Protected Securities (TIPS) and foreign inflation-linked securities. IPF is designed for risk-averse investors who wish to obtain long-term protection from the loss of purchasing power due to inflation, but are willing to incur some short-term losses of principal to do so. Wespath is committed to a long-term investment strategy and reviews its investment funds to align with market conditions and projections. Building a Strong Foundation A prudent strategy protects investors from unbridled enthusiasm and risk-taking. Fixed-income funds are a good diversifying investment and provide a smart choice even in today s low interest rate environment. Investors who understand the importance of a long-term approach and seek to build upon a strong foundation should include fixed-income funds in their investment strategy. Wespath provides UMC-affiliated institutional investors with access to well-managed investment programs that historically have delivered competitive performance while honoring United Methodist Social Principles. Wespath is a division of the General Board of Pension and Health Benefits of The United Methodist Church, a century-old institution with a well-regarded reputation for delivering returns aligned with values. Wespath is an established investment manager with approximately $18 billion in assets under management. Our name honors John Wesley, the founder of Methodism and a leader in establishing social principles that outline the tenets of socially responsible business practices. Wespath reflects this heritage, along with the idea of putting clients on the right path to financial growth with a commitment to values-driven investing. Copyright Wespath Wespath Investment Management 1901 Chestnut Avenue Glenview, IL wespath.com /112812