AMP Capital Understanding Fixed Income a glossary

Transcription

1 AMP Capital Understanding Fixed Income a glossary

2 Welcome to our educational series Understanding Fixed Income a glossary About fixed income at AMP Capital As one of the largest and most experienced fixed income managers in Australia and New Zealand, we offer clients a wide range of actively managed fixed income investments designed to take advantage of market opportunities. Our fixed income capabilities range from government bonds to high yield credit strategies, across domestic and global bond markets. We also offer customised portfolio solutions across all areas of the fixed income spectrum, tailored to individual client risk and return needs. Our size and reputation give us influence over pricing and terms and conditions, helping to protect the interests of investors in our funds. For further information Please visit Copyright, AMP Capital Investors Limited, 2013 Use, replication, quotation or reproduction of any part, or all, of this document, either in printed, audible or digital form, is subject to written approval from AMP Capital expressly authorising the usage and context of usage. Written permission must be obtained by contacting Marketing Department, AMP Capital, Level 12, 50 Bridge Street, Sydney NSW 2000, AUSTRALIA. Table of contents Types of fixed income investments 3 Glossary of fixed income investment terms 4 2

3 Different types of fixed income investments can play a role in almost any portfolio It is essential that investors understand the risk and reward characteristics of their chosen investment and allocate to their portfolios accordingly. Here we look at some categories and their differences such as between corporate bonds and hybrids and provide a helpful glossary of generally used fixed income terms. Hybrids: A cross between debt and equity securities. They offer the potential for capital appreciation and a steady income often in the form of a dividend for a fixed period and can then convert into underlying equity. As they are complex instruments, displaying equity and bond like characteristics, investors should fully understand these assets and complete a careful analysis of offer documents. Corporate bond: One issued by a corporation, rather than a government. They are lower down the risk spectrum than hybrids but still offer attractive income due to their higher perceived risk over government bonds. Before making a choice between these two types of investment, it pays to look at the main differences between them. The following table compares the characteristics of common direct securities with those of the AMP Capital Corporate Bond Fund in five key areas: Characteristics Income Diversification Downside protection Risk Liquidity Toll roads/ Greenfield Direct hybrid security Very good, typically strongest income No, unless individual holdings are kept to a low percentage Performs closer to equities than bonds Below equities but above corporate bonds Some, though subject to positive market conditions Direct corporate security Good, generally fixed margin over a floating base rate No, unless individual holdings are kept to a low percentage Low due to floating rate nature; low for fixed rate bonds Less than hybrids and equities depends on individual issue Some, though subject to market sentiment AMP Capital Corporate Bond Fund (the Fund) Good, pays monthly income Yes, holds 80+ bonds, no more than 3% to 4% of the portfolio is in one security Yes, as the Fund has duration (interest rate sensitivity) Less than hybrids and equities Daily, with sell spread 13% 15% 3% 5% Medium/High Income: While hybrids generally offer the strongest income of all fixed income investments, their terms may differ widely. Some hybrids pay dividends (including franking credits) while others pay interest and they may also be priced differently on conversion. For instance, they may convert to an ordinary share at a fixed rate such as one hybrid equals one share or at a variable rate, and some are not redeemable at all. The distribution terms of corporate bonds are generally more rigid, paying out income at regular intervals. Diversification: Investing in a small number of direct securities exposes a portfolio to concentrations of risk in issuers, industries or geographies so a systemic event can impact a large part of the portfolio. A corporate bond fund offers the benefits of diversification across these factors, spreading portfolio risk. An investment in hybrids generally means investing in just one issuer, or a much smaller number of issuers. Downside protection: Fixed rate bonds perform well when interest rates are falling, which leads to an increase in the price of a bond. This typically occurs when equity markets are underperforming making them an effective portfolio diversifier. On the other hand, floating rate corporate bonds do not have this protection and are most heavily affected by movements in the credit spread. Finally, because hybrids behave more like equities than debt investments, the risks associated with them are more equity like. Risk: If a company goes into bankruptcy, the first investors to be paid are bond holders, then hybrid owners and finally shareholders. The more subordinated the instrument, the greater the price drop. Differences in pricing between retail and wholesale markets occur from time to time, where a security s price can be too high or low for our understanding of the risk. In the absence of bond ratings in the retail market, it is especially difficult for investors to assess since a particular issue, or structure being marketed, may have risks very different to the senior debt of the same company. Liquidity: Finally, unlike corporate bonds which are traded daily, hybrids have an element of liquidity risk. Daily trading volumes are usually enough for the individual investor to exit the investment if their needs or views change but if all investors change their views, the low level of daily liquidity means the price impact to exit could be large. These differences show that not all fixed income investments are low risk or defensive investments. Investors who hold larger amounts of investments such as hybrids should consider their holdings as more equity like and do their homework on the structural elements and risks of each transaction. Although hybrids can play a role in a well diversified portfolio, investors seeking the defensive characteristics of traditional fixed income investments, such as stronger performance when equity markets are declining, portfolio diversification and regular income, investing in a corporate bond fund may be a more suitable option. 3

4 Glossary of fixed income investment terms Accrued interest Ask price Asset backed Bank capital Interest deemed to be earned on a security but not yet paid to the investor. Price being sought for the security by the seller. A bond or note backed by loan paper or accounts receivable other than mortgages. A collective term used for subordinated bonds issued by the banking sector. CMO (Collateralised Mortgage Obligation) Collar Collateralisation of derivatives A security backed by a pool of mortgage pass through securities or mortgage loans, which generally supports several classes of obligations. Upper and lower limits (cap and floor, respectively) on the interest rate of a floating rate note. Collateralisation is a process that substitutes the credit risk of the issuer of the collateral for that of the counterparty to the transaction. Basis point Bearer bond Bid One one hundredth of a percentage point. Yield differences among bond securities are stated in basis points (bps). A security that has no identification as to owner. It is presumed to be owned by the person who holds it. Bearer bonds are freely negotiable since ownership can be transferred quickly from seller to buyer by delivery of the instrument. The price at which a buyer offers to purchase a security. Convexity A volatility measure for bonds. Used together with duration, convexity provides a more accurate approximation of the gains and losses on a bond or bond portfolio from a change in interest rates rather than using duration alone. The higher the convexity, the greater the price gain or price loss for a given change in interest rates. Bonds with a longer maturity will generally have a higher convexity, and for instruments with the same duration, the more dispersed the cash flows, the greater the convexity. Bond Bond swap Call A debt instrument, similar to an IOU. It is a contract between the borrower (issuer) and the lender (bondholder). The issuer pledges to pay the loan principal to the bondholder on a fixed date (maturity date) as well as a specified rate of interest during the life of the bond. The sale of a bond and the purchase of another bond of similar market value. Swaps may be made to establish a tax loss, upgrade credit quality, extend or shorten maturity, etc. The repurchase of a bond by its issuer before its maturity date, without requiring the holder s consent. If a bond is callable, the date and price at which it can be called is specified on the certificate. Corporate bond Coupon Credit Credit rating Credit risk Also known as credit. A bond issued by a corporate entity. Also known as interest. Annual payout the borrower promises to pay the bondholder during the life of the bond. It is expressed as a percentage of the bond s par value. Most bonds are still offered with a traditional fixed rate, although floating rate notes and zero coupon bonds are also common. A collective term used for bonds issued by corporate entities. Designations used by credit rating agencies to give relative indications of credit quality. The risk of loss to an investor due to an issuer s non payment of interest or principal on a bond. Callable bonds Cap CDO (Collateralised Debt Obligation) Bonds which are redeemable by the issuer prior to the maturity date at a specified price at or above par. The top interest rate that can be paid on a floating rate note. A security backed by a pool of bonds, loans and other assets. CDOs are similar in structure to a collateralised mortgage obligation (CMO) but do not specialise in one type of debt. Credit spread Refers to the difference between the yield of a corporate bond and a government bond of the same The actual spread of a corporate bond versus a government bond is usually referred to in terms of basis points (bps). After purchasing a corporate bond the bondholder may benefit from a narrowing of the credit spread which contributes to a smaller yield to This drives up the price of the bond, delivering a capital gain. 4

5 Glossary of fixed income investment terms Credit spread duration Credit spread duration measures the sensitivity in the price of a bond to a 1% change in credit spread. This is a useful risk measure as it captures how much a portfolio might lose if credit spreads widen. Duration and yield The chart below shows that as yields have moved lower, duration has increased. CSA A Credit Support Annex (CSA) is a document capturing collateral arrangements that have been negotiated between two parties that trade OTC derivatives. The CSA is attached to a standard ISDA document. Current yield Debenture Default Discount Also known as running yield. It refers to the annual payout as a percentage of the current market price you actually pay. For example, a bond with a current market price of $1,000 that pays $80 per year in interest would have a current yield of 8%. Unsecured debt obligation, issued against the general credit of a corporation rather than against a specific asset. Failure to pay principal or interest when due. Defaults can also occur for failure to meet non payment obligations, such as reporting requirements, or when a material problem occurs for the issuer, such as a bankruptcy. The amount by which the purchase price of a security is less than the principal amount, or par value. Source: AMP Capital, UBS as at July 2012 Duration of spread (DxS) Embedded option Face value Floating rate note DxS is the credit spread duration times spread. This is one of our preferred measures of risk as it provides a more detailed sensitivity of the impact of changes in credit spreads on the portfolio. A provision within a bond giving either the issuer or the bondholder an option to take some action against the other party. The most common embedded option is a call option, giving the issuer the right to call, or retire, the debt before the scheduled maturity date. Also known as maturity value, par value, principal and redemption rate. The amount a bond or note will pay at A bond for which the interest rate is adjusted periodically according to a predetermined formula, usually linked to LIBOR. Discount note Discount rate Duration 1 Short term obligations issued at discount from face value, with maturities ranging from overnight to 360 days. They have no periodic interest payments the investor receives the note s face value at The rate the Federal Reserve charges on loans to member banks. Duration is an important measure of risk in bond investing. It measures the impact of a 1% change in yield on the price of a bond. Floor Government bond Gross redemption yield Hedge The lower limit for the interest rate on a floating rate bond. Also known as a sovereign bond. A bond issued by a government. Also known as yield to maturity. A yield based on the assumption that the security will remain outstanding till It represents the total of coupon payments until maturity, plus interest on interest, and whatever gain or loss is realised from the security at An investment made with the intention of minimising the impact of adverse movements in interest rates or security prices. High grade Also known as investment grade. Bonds considered suitable for preservation of invested capital by credit rating agencies and rated Baa or BBB or above. High yield bond Also known as sub investment grade bond or junk bond. Bonds issued by lower rated corporations, sovereign countries and other entities (Ba or BB or below) and offering a higher yield than more creditworthy securities. 5

6 Glossary of fixed income investment terms Foreign ownership of AUD bonds has never been higher Australian bonds have been bought in increasing numbers by offshore investors in recent years. This appetite has been fuelled by several factors including the resilience of the Australian economy relative to other developed markets, relatively higher yields and the AAA credit rating status of Australia s sovereign debt. AAA rating as per Moody s and S&P. 100% 80% 60% 40% 20% 0% Source: RBA, ABS, Commonwealth and State Treasuries, CBA Estimates Hybrid security Interest Interest rate swap ISDA CGS Kangaroos Semis Corporates Banks ABS A security that combines two or more different financial instruments. Hybrid securities generally combine both debt and equity characteristics. In the field of bank capital, hybrid is often used to refer to preferred securities. Also known as coupon. Annual payout the borrower promises to pay the bondholder during the life of the bond. It is expressed as a percentage of the bond s par value. Most bonds are still offered with a traditional fixed rate, although floating rate notes and zero coupon bonds are also common. Financial derivatives used by banks and other financial institutions for hedging market interest rate risk. A conventional swap comprises two legs, one fixed rate and the other floating rate which is referenced to an external reference such as LIBOR. They are an important asset liability management and risk management tool in financial markets. See also Swap spread. International Swaps and Derivatives Association (ISDA) is an association that represents participants in the private negotiated derivatives (OTC) market and is the largest global financial trade association, by number of member firms. Since its inception, ISDA has pioneered efforts to identify and reduce the sources of risk in the derivatives and risk management business. ISDA has developed a standard contract called the ISDA Master Agreement. Investment grade Issue date Issuer Junk bond Leveraged loan LIBOR (London Interbank Offered Rate) Liquidity Macaulay duration 1 Maturity date Maturity value Modified duration 1 Money market Municipal bond Also known as high grade. Bonds considered suitable for preservation of invested capital by credit rating agencies and rated Baa or BBB or above. The date of a bond issue from which the first owner of a bond is entitled to receive interest. An entity which issues and is obligated to pay principal and interest on a debt security. Also known as sub investment grade bond or high yield bond. Bonds issued by lower rated corporations, sovereign countries and other entities (Ba or BB or below) and offering a higher yield than more creditworthy securities. A loan provided to a company already holding a considerable amount of debt. Since the company being offered the loan is already highly leveraged, this type of loan carries more risk to investors who, in return, require higher rates of return. The rate banks charge each other for short term loans. LIBOR is frequently used as the base for resetting rates on floating rate notes. A measure of the relative ease and speed with which a security can be purchased or sold in the secondary market at a price that is reasonably related to its actual market value. This form of duration measures the number of years required to recover the true cost of a bond, considering the present value of all coupon and principal payments received in the future. Interest rates are assumed to be continuously compounded. It is the only type of duration quoted in years. See also Modified duration. The date when the principal amount of a security is payable. Also known as face value, par value, principal and redemption rate. The amount a bond or note will pay at This form of duration expands or modifies Macaulay duration to measure the responsiveness of a bond s price to interest rate changes. It is defined as the percentage change in price for a 1% change in interest rates. The formula assumes that the cash flows of the bond do not change as interest rates change. See also Macaulay duration. Market for short term debt securities with a maturity of one year or less, and often 30 days or less. Bond issued by a state, city or local government. 6

7 Glossary of fixed income investment terms NAV The Net Asset Value (NAV) reflects the value of all securities in the portfolio and will consequently tend to fluctuate daily. When a position is expressed as a per cent weight of NAV, this is a meaningful measure of the risk of loss to the portfolio in the event of a default. Running yield Also known as current yield. It refers to the annual payout as a percentage of the current market price you actually pay. For example, a bond with a current market price of $1,000 that pays $80 per year in interest would have a current yield of 8%. New issue A bond being offered for sale for the first time. Secondary market Market for issues previously offered or sold. Non callable bond Offer Over the counter Par value Preferred security Premium Primary market Principal Redemption rate Registered bond Reinvestment risk Revenue bond A bond that cannot be called for redemption by the issuer before its specified maturity date. The price at which a seller will sell a security. Over the counter (OTC) or off exchange trading is done directly between two parties without any supervision of an exchange. It also refers to debt securities and other financial instruments such as derivatives, which are traded through a dealer network. Also known as face value, maturity value, principal and redemption rate. The amount a bond or note will pay at A security possessing characteristics of both equity and debt. Preferred securities are generally longer term in maturity but have early redemption or call features. Preferred securities have been created by companies for their favourable accounting treatments and flexibility. See also hybrid security. The amount by which the price of a security exceeds its principal amount. The market for new issues. Also known as face value, maturity value, par value and redemption rate. The amount a bond or note will pay at Also known as face value, maturity value, par value and principal. The amount a bond or note will pay at A bond whose owner is registered with the issuer or its agent. Transfer of ownership can only be accomplished when the securities are properly endorsed by the registered owner. The risk that interest income or principal repayments will have to be reinvested at lower rates in a declining rate environment. A municipal bond payable from revenues derived from tolls, charges or rents paid by users of the facility constructed with the proceeds of the bond issue. Senior bond Sovereign bond Sub investment grade bond Subordinated bond Swap spread Transfer agent Treasury bond Trustee Senior bonds have greater seniority in the issuer s capital structure than subordinated bonds and preferred securities. That is to say, in the event the issuer goes bankrupt, senior debt must be repaid before other creditors receive any payment. Senior debt is often secured by collateral on which the lender has put in place a first lien. Also known as a government bond. A bond issued by a government. Also known as high yield bond or junk bond. Bonds issued by lower rated corporations, sovereign countries and other entities (Ba or BB or below) and offering a higher yield than more creditworthy securities. A bond whose claim on income and assets of the issuer in the event of default (or if the issuer files for bankruptcy) is ranked below the claims of senior bonds. A subordinated bond is paid after senior bonds but before ordinary shares in a liquidation. The difference between the swap rate on a contract and the yield on a government bond of the same The spread itself is the number of basis points the swap rate lies above the equivalent maturity government bond yield, quoted on the same interest basis. The higher rate payable on swaps represents the additional risk premium associated with bank credit risk compared to government credit risk. Swap spreads are based on LIBOR rates, the creditworthiness of the swap s counterparties and other economic factors that could influence the terms of the investment s interest rates. See also Interest rate swap. A party appointed by an issuer to maintain records of securities owners, to cancel and issue certificates, and to address issues arising from lost, destroyed or stolen certificates. A bond issued by the US government. A bank designated by the issuer as the custodian of funds and official representative of bondholders. 7

8 Yield Yield curve Yield to call Yield to maturity Zero coupon bond The annual percentage rate of return earned on a security. Yield is a function of a security s purchase price and coupon. A line tracing relative yields on a type of security over a spectrum of maturities ranging from three months to 30 years. A yield on a security calculated by assuming that interest payments will be paid until the call date, when the security will be redeemed at the call price. Also known as gross redemption yield. A yield based on the assumption that the security will remain outstanding till It represents the total of coupon payments until maturity, plus interest on interest, and whatever gain or loss is realised from the security at A bond on where no periodic interest payments are made. The investor receives one payment which includes principal and interest at redemption (call or maturity). See also Discount note. Source: ipac. The Securities Industry and Financial Markets Association (www. investinginbonds.com), OECD Glossary of Statistical Terms, Investopedia. 1 California Debt and Investment Advisory Commission, January Any ratings mentioned, i.e. High grade, High yield bond, Investment grade, Junk bond and Sub investment grade bond, are as per Moody s and S&P. Contact us If you would like to know more about how AMP Capital can help you, please visit ampcapital.com For your local contact, please visit ampcapital.com/contact or inquiry@ampcapital.com Important notice to all investors: This document has been prepared by AMP Capital Investors Limited (ABN , AFSL ) ( AMP Capital ) and AMP Capital Funds Management Limited (ABN , AFSL ) ( AMPCFM ) for providing general information about the product referred to in this document ( Fund ) and is qualified in its entirety by any product disclosure statement, information memorandum, private placement memorandum or other disclosure or offer document and legal documentation that may be subsequently available. This document is not intended to be and does not constitute a recommendation, offer, solicitation or invitation to subscribe regarding the Fund, and is not intended for distribution or use, in any jurisdiction where it would be contrary to applicable laws, regulations or directives. Prospective investors should make their own inquiries and consult their own professional advisers as to the applicable laws, regulations and directives (including any requisite governmental or other consents and any other prescribed formalities) in any particular jurisdiction (including, in which the person comes into possession of this document) and the consequences arising from a contravention of them at any relevant time. Any failure to comply with such restrictions may constitute a violation of applicable securities law. While every care has been taken in preparing this document, except as required by law, none of AMP Capital or AMPCFM or their associates makes any representation or warranty as to the accuracy or completeness of any statement, including, without limitation, any forecasts, or takes any responsibility for any loss or damage suffered as a result of any omission, inadequacy or inaccuracy. This document does not purport to be complete, does not necessarily contain all information which a prospective investor would consider material, and has been prepared without taking account of any particular person s objectives, financial situation or needs. Accordingly, the information in this document should not form the basis of any investment decision. A person should, before making any investment decision, consider the appropriateness of the information, and seek professional advice, having regard to the person s objectives, financial situation and needs. Past performance is not a reliable indicator of future performance and there can be no assurance that the Fund will achieve its objective or its target returns or that investors will receive a return from their capital. This document is provided to you strictly on a confidential basis and the information contained in it must be kept strictly confidential (with the exception of providing it to your professional advisors who are also contractually and/or professionally bound to keep it confidential) and may not be reproduced or redistributed (in whole or in part) or otherwise made available to any other person in any format without the express written consent of AMP Capital or AMPCFM. All information contained in this document, unless otherwise specified, is current at the date of publication and will not be updated or otherwise revised to reflect information that subsequently becomes available, or circumstances existing or changes occurring after that date. By accepting a copy of this document, you agree to be bound by the limitations, terms and conditions set out in this notice. AMPC_Fixed Income glossary_050613