Risks and Rewards in Fixed Income

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1 C O C K B U R N L U C A S INDEPENDENT FINANCIAL CONSULTING An introduction to fixed income

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3 Content Introduction 4 What is fixed income? 5 Government bonds 6 Corporate bonds 7 What are the risks involved in fixed income investing? 10 What are yields? 12 How do I invest in fixed income? 13 What types of fixed income funds are available? 14 IMA sector descriptions 15 Bond ratings 16 Glossary 17

4 Introduction Investors, particularly those looking to generate an income from their portfolio, cannot afford to overlook fixed income as an asset class. The past decade has witnessed tremendous growth in the sector from a relatively niche market, used predominantly by large pension funds, to offer a wide variety of possible investment solutions. According to the Investment Management Association (IMA), close to 120 billion* is now invested in fixed income funds in the UK. With banks continuing to rein in their lending as they seek to rebuild their broken balance sheets, companies and governments are likely to look increasingly to the fixed income markets to fill the gap. While fixed income investments have been a natural choice for income seekers, the asset class is likely to have a part to play in any diversified portfolio. This guide will examine the different types of fixed income securities, weighing up the potential risks and rewards associated with each and assessing how investors can best gain access to them to suit their financial planning needs. Investors should be aware that the value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. * Investment Management Association, February

5 What is fixed income? Fixed income securities also known as fixed interest, credit or, more colloquially, bonds may be thought of in essence as IOUs. A company, government or supranational organisation, such as the International Monetary Fund, will issue a bond to raise money to fund, for example, a particular project or more general growth plans. Investors will purchase a bond in return for the income stream that stems from the regular fixed income payments or coupon the issuer agrees to pay at the outset as well as the repayment of the original capital or principal at the end of a set term. The level of the income will vary depending on the perceived risk of the issuer that is, how likely it is to default on its loan obligations. Bond ratings To help investors weigh up the likelihood of a default (the event that the issuer can not pay back the bond), organisations known as ratings agencies assess an issuer s creditworthiness and rate it, for example, from AAA, where the credit risk is seen as negligible, to as low as CCC for those seen as the most risky prospects. Ratings may be checked at the websites of the leading agencies Fitch ( Moody s Investor Services ( and Standard & Poor s ( To see the rating scale, please turn to page 16. Types of bonds Bonds tend to be classified with reference to their issuer, the great majority of which will be governments or companies, with the latter corporate bonds categorised either as investment grade or high yield depending on their bond rating. A bond may also be index-linked, where its coupon and/or principal are tied to the rate of inflation, or convertible, where the holder has the option to convert it into an equity for a preagreed price at some point in the future. In addition, there are floating-rate notes (FRNs ) that have variable interest rates. Buying bonds There are two ways of buying bonds, the first of which is direct from the issuer at the time of launch. For example, when BT issues a new tranche of bonds, fund managers and other buyers will go through the group s appointed investment bank to buy them. These bonds may come to the market at different rates to existing bonds and may also come with sweeteners particularly at times when the appetite for fixed income is low. Alternatively, once bonds have been issued, they can be bought and sold on the secondary market. Here, the price will be calculated according to the coupon available, the prevailing interest rate, the number of years to maturity and other factors at work in the market. 5

6 Government bonds Government bonds are debt instruments issued by governments to finance public spending. In the UK they are known as gilts (derived from Gilt-edged securities as the certificates originally had a gilt or gilded edge). Other well-known examples include treasuries in the US and bunds in Germany. A number of different factors will have an influence on the price of a government bond, but the most important will be the credit rating of the country issuing it. Historically, government borrowers have tended to be seen as less risky than companies. While that generally remains the case, the credit crunch has produced some anomalous situations where the perceived risk of default by governments has become so high that some are expected to pay a higher rate of interest than a number of corporate household names around the world. If a country s credit rating is downgraded, as happened to Spain due to concerns about the nation s debt burden, it pushes up the cost of borrowing for its government. People will naturally demand a higher income for lending because of the higher risks involved. 6

7 Corporate bonds Corporate bonds are debt instruments issued by companies and, as with government bonds, the creditworthiness of the issuer will determine the rate of interest paid to investors. Thus, if a company is perceived as presenting a higher risk of defaulting on its loan repayments, it will naturally have to pay investors a higher coupon to encourage them to take on that risk. As mentioned earlier, corporate bonds will usually be classified from AAA down to D by agencies and that rating will determine whether they are considered investment grade or high yield. However, not all bonds are rated as some companies prefer not to pay the rating agencies to do this. This is not necessarily a sign of a weak or high-risk company, though, and non-rated bonds include those issued, for example, by the well known department store John Lewis. Corporate bonds also encompass different levels or tiers of debt. If a company goes bankrupt, assets will be sold to pay off its debts and different types of debt-holders will be repaid in a certain order. The top tier, who will pay more at the outset for the security their type of debt provides, will receive their money back first and so may see a substantial amount of their money returned even if a company fails. For their part, the bottom tier will only receive any money back if all the debt-holders above them have been repaid and in practice may get little or nothing. 7

8 Corporate bonds Investment grade bonds A corporate bond is deemed to be investment grade if it is classified BBB- or higher by Fitch and Standard & Poor s or Baa3 or above by Moody s. In the UK, these would include blue-chip companies (nationally recognised, well established and financially sound companies) such as National Grid and Centrica. In general, investment grade bonds are issued by companies with solid balance sheets, a reliable long-term income stream and a stable business model. However, it should always be borne in mind that rating agencies are not infallible. Some highprofile companies have gone bust despite being highly rated including Enron in 2001 and Lehman Brothers in Investment grade bonds will usually pay a premium in comparison with government bonds. For example, if an investor receives 1.4% interest per year on a 30-year gilt, they may receive 2.9% on a bond from Centrica to reflect the fact that Centrica is more likely to default on its payments than the British Government. That 1.5% difference is known as the spread and, when the economy is buoyant, that spread will usually grow smaller while, as the economy weakens and increasingly nervous investors need more incentive to take on more risk, that spread will move wider. Company A For illustrative purposes only Yield=5.5%* (BBB-rated) Pure credit risk or spread =4.1% pa + Pure interest rate risk Risk free yield =1.4% pa 8

9 Corporate bonds Investment grade bonds tend to perform well at times of stable to rising growth for example, they did particularly well in the middle part of the last decade. As corporate earnings rise, the risk of default is perceived to shrink. That said, there usually comes a point in the economic cycle where spreads over government bonds become too narrow and companies take on too much debt. The risks of default become higher here and investors do not believe they are adequately compensated for that risk. Investment grade bonds also tend to do badly at times of high inflation, which erodes the value of the income stream payable on the bonds. In contrast, a low inflation and interest rate enviroment adds value to the income stream paid. High yield bonds Until relatively recently, high yield bonds were more commonly and less flatteringly known as junk bonds. The tag was misleading, however, as this area of the market has always contained a number of well-established companies such as Virgin Media and GKN. Ranked BB+ or lower by Standard & Poor s and Fitch and Ba1 or below by Moody s, these companies are considered to offer a higher risk of default compared to investment grade companies and this could be for a number of different reasons. They may be smaller, have more debt or their business may be cyclical. They may have a history of poor management or bad deals. They may just operate in a tough and highly competitive environment. Finally, they may have been downgraded from investment grade because of poor performance. Investing in high yield bonds may be seen as a way of making hay when the sun shines. If investment grade bonds are doing well, high yield bonds will tend to be doing better. For example, in 2009 the average fund in the Sterling High Yield sector rose 45.9%, compared to a rise of 14.3% in the Sterling Corporate Bond sector*. However, high yield bonds tend to behave more like equities, displaying similarly high growth potential while seeing significant falls in certain market conditions. Thus, in 2008 a difficult year for all asset classes Sterling Corporate Bond funds fell 10.3%, whereas the average Sterling High Yield fund fell 25.7%**. * Source: Lipper, net income reinvested 31/12/08 to 31/12/09. ** Source: Lipper, net income reinvested 31/12/07 to 31/12/08. Past performance is not a guide to future performance 9

10 What are the risks involved in fixed income investing? Before investing Fixed income investments are often described by the media as low-risk but, as ever, all things are relative not least because your individual circumstances should dictate how much risk you are prepared to take on. As with any other type of investment, you still need to ask yourself what you are trying to achieve and some fundamental questions to address would therefore include: What are your investment objectives? Are you looking to generate capital growth, income or both? How much risk do you feel comfortable taking on? Do you want to protect your money or can you stand to lose some of it in the hope of ultimately making a greater return? What sort of timeframe are you looking at? Are you in a position to leave your investment alone for the long term at the very least five and preferably 10 years or might you need access to it at short notice? Types of risk At the most general level government bonds will carry less risk than corporate bonds but, because there is always a possibility however small of default, neither investment may be regarded as risk-free or as safe as cash although they would usually carry less risk than equities. There are also a number of elements of risk that are specific to fixed income. Sovereign risk: this is the risk of a government defaulting on its debt obligations. The Eurozone crisis has focused investors attention on several countries that could possibly default, most obviously Greece. In 2010, the Greek government s finances were in such a parlous state it looked like it may not be able to pay back investors. Greece was bailed out by a coalition of its Eurozone partners and supranational organisations such as the International Monetary Fund. Despite the restructuring of Greece s loans, in 2012 it is still not certain that the country will repay all of its debts. Credit risk: this is the risk of a company defaulting on its loan obligations under the terms of a bond. Unlike dividends, which companies can choose to pay on their shares, debt repayments need to be met and a company that cannot pay its debts will be considered insolvent. At times of economic weakness, default rates will tend to be higher and vice versa. If a company goes into administration and can no longer pay its debts, bondholders could theoretically receive nothing. 10

11 What are the risks involved in fixed income investing? In practice, most companies have assets that can be sold off to raise cash and bondholders will receive a share of that. Although most bonds are rated by credit agencies, professional investors will carry out independent credit research of their own. Interest rate or duration risk: the price of every bond will contain an assessment of interest rate risk. The prevailing interest rate will have an impact on the price of bonds because it affects the value of the income stream. For example, if interest rates are 2% and the coupon is 4%, the bond will be more valuable than if interest rates were 3.5%. In general, there is more interest rate risk inherent in longerterm bonds because it is difficult to predict the ebb and flow of interest rates over a period of, say, 20 or 30 years. As such, investors will in normal conditions receive a higher income for taking on this risk. Investors who are worried about which way interest rates will move or those who believe they could rise sooner than the market is expecting are likely to move into shorter-dated bonds. Currency risk: if a sterling-based investor invests only in sterling-based bonds then no currency risk exists. However, if a sterling-based investor invests in foreign-currency denominated bonds, their investment returns, including the income generated, are likely to rise and fall in line with the relevant exchange rate. Some professional investors will look to hedge out this risk using financial derivatives while others believe it all evens itself out over time. The effects of interest rates Interest rates inversley impact bond values, so as interest rates go up, the value of bonds go down (and vice versa). Interest rates Interest rates Bond values Bond values 11

12 What are yields? The term yield is used to indicate the possible return on a bond investment. There are two types of yield: Running yield: (also known as the current, distribution or income yield): this represents, at any point in time, the effective annual yield payable by the fund. The yield calculation annualises the return and takes account of initial charges, spread and dealing costs. The income from most fixed income funds is distributed every six months but it can, in some cases be paid out monthly or every three months. The effects of bond values on yield As bond values are inversley impacted by interest rates, yields are inversley impacted by bond values. Redemption yield: this is used to indicate the total return, taking account of both income generated and any reduction or growth in capital that an investor can expect, given a number of assumptions. These could include: the period to encashment when calculating the effect of charges/expenses Bond values Yield that there will be no defaults how portfolios may vary the ongoing rate of income payments the effect of taxation As the value of the bond decreases, the yield increases. Bond values Yield As the value of the bond increases, the yield decreases. 12

13 How do I invest in fixed income? Over the last few years it has become somewhat easier for private investors, aided by independent sites such as the Securities Industry and Financial Markets Association s com, to assess and buy individual bonds. However, the associated technical considerations for example the outlook for interest rates and the research necessary to assess a company s creditworthiness mean all but the most experienced might prefer to consider a collective fund run by a professional fund manager. Aside from expertise and research capabilities, collective fixed income funds, which are almost exclusively openended vehicles, offer a number of other potential advantages for investors. For example, their managers will aim to blend a portfolio of bonds together to minimise risk particularly credit and duration risk and they also look to take advantage of any mispricing anomalies in the market. In doing this they may aim to add value through credit selection or through having an alternative view on the economic outlook from the rest of the market. In credit selection, fund managers will try to find a balance between the risk and reward of any given bond. For example, it may be that a manager believes the market is pricing in too high a risk of default for a chain of high street shops. The market may believe the chain is likely to suffer as economic conditions weaken and consumers tighten their belts whereas the manager s own research may have led them to believe the company s outlook is much better than is generally expected. Usually, bond fund managers will undertake their own credit research rather than relying on that provided by the rating agencies indeed, this is how many managers believe they add most value. Coping with the various risks inherent in the fixed income sector requires extensive research. Investors and their financial advisers should look to ensure their chosen bond fund manager is properly supported by the investment house for which they work. Are they reliant on external rating agencies or do they include external research as part of a much more comprehensive process? Do they work in an open environment where research generated by fixed income and equity fund managers is shared? How many years experience does the manager have in fixed income fund investing? Advantages of collective fixed income funds: Expertise and research capability Blend portfolio of bonds to minimise risk Balance risk and reward Own research, different view from ratings agencies 13

14 What types of fixed income funds are available? As the fixed income market has grown, so have the different types of product on offer to investors. Some will specialise in developed market sovereign debt, others emerging market sovereign debt and some may offer access to a combination of the two. Similarly, on the corporate bond side, some funds will use a blend of investment grade and high yield debt while others will specialise in a single area. Some funds will only invest in sterling-denominated bonds, others will mix in bonds issued in euros, dollars or other currencies and there is even a small group of funds that invest in sterling index-linked debt. A more recent development has been the emergence and growing popularity of what are known as strategic bond funds. Rather than specialising in one part of the bond market, these are unconstrained portfolios that have the mandate to invest in different areas depending on what the manager sees as the best opportunities to enhance returns. For example, a manager may have a substantial proportion of their portfolio in high yield bonds at times of economic buoyancy or move into gilts when the economy looks set for a recession. The last few years have also seen European legislation, known as UCITS III (short for undertaking for collective investments in transferable securities ), give retail fund groups the power to make use of a broader range of investment strategies, products and techniques including financial derivatives than had previously been allowed. The great majority of bond funds will aim to pay investors an income in addition to generating some element of capital return. That said, some portfolios are run specifically to generate a target level of income while others take a total return approach that includes coupon interest, interest on interest and any realised and unrealised gains or losses. As such, these funds would be unsuitable for investors who are looking for a consistent income stream. As recently as 10 years ago, the fixed income sector was a relatively straightforward place where financial advisers could operate a simple rule of thumb that the percentage of an investor s portfolio invested in bonds should broadly be in line with their age thereby ensuring the investor took on less risk the closer they moved to retirement. Now, faced with the choice between hundreds of vehicles investing in different types or combinations of fixed income and with different aims or targets, investors and their financial advisers need to ensure the objectives of their chosen fund or funds are compatible with their needs. 14

15 IMA sector definitions The Investment Management Association (IMA) is the trade body for the UK investment industry. To help identify funds with similar characteristics, the IMA assigns funds to different sectors. Each sector is made up of funds investing in similar assets, the same stock market sectors or in the same geographical region. Fixed income funds appear in one of the following sectors: UK Gilts: Funds which invest at least 95% of their assets in sterling denominated (or hedged back to sterling) AAA rated, government backed securities, with at least 80% invested in UK government securities (gilts). UK Index Linked Gilts: Funds which invest at least 95% of their assets in sterling denominated (or hedged back to sterling) AAA rated government backed index linked securities, with at least 80% invested in UK index linked gilts. Corporate Bond: Funds which invest at least 80% of their assets in sterling denominated (or hedged back to sterling), BBB - or above corporate bond securities (as measured by Standard & Poor s or an equivalent external rating agency). This excludes convertibles, preference shares and permanent interest bearing shares (PIBs). Strategic Bond: Funds which invest at least 80% of their assets in sterling denominated (or hedged back to sterling) fixed income securities. This includes convertibles, preference shares and permanent interest bearing shares (PIBs). At any point in time the asset allocation of these funds could theoretically place the fund in one of the other fixed income sectors. The funds will remain in this sector on these occasions since it is the manager s stated intention to retain the right to invest across the sterling fixed income credit risk spectrum. High Yield: Funds which invest at least 80% of their assets in sterling denominated (or hedged back to sterling) fixed income securities and at least 50% of their assets in below BBB - fixed income securities (as measured by Standard and Poor s or an equivalent external rating agency), including convertibles, preference shares and permanent interest bearing shares (PIBs). Global Bonds: Funds which invest at least 80% of their assets in fixed income securities. All funds which contain more than 80% fixed income investments are to be classified under this heading regardless of the fact that they may have more than 80% in a particular geographic sector, unless that geographic area is the UK, when the fund should be classified under the relevant UK (sterling) heading. 15

16 Bond ratings Glossary Moody s S&P Fitch Aaa AAA AAA Aa1 AA+ AA+ Least risky Aa2 AA AA Aa3 AA- AA- A1 A+ A+ A2 A A A3 A- A- Baa1 BBB+ BBB+ Investment Grade Baa2 BBB BBB Baa3 BBB- BBB- Ba1 BB+ BB+ Ba2 BB BB Ba3 BB- BB- Most risky B1 B+ B+ B2 B B B3 B- B- Caa1 CCC+ CCC High Yield Caa2 Caa3 CCC CCC- Ca C D Any D Default 16

17 Glossary of terms Corporate bond: Coupon: Cyclical: Default: Diversified: Duration: Equity: Government bond or gilt: High yield bond: Investment grade bond: Portfolio: Principal: Redemption yield: Running yield: Sovereign bond: Spread or credit spread: Corporate bonds are debt instruments issued by companies. The creditworthiness of the company will help determine the rate of interest paid to investors. The interest rate stated on a bond when it s issued. The coupon is typically paid annually. A business that is sensitive to the business cycle where profits are likely to be higher in periods of economic prosperity and lower in economic downturns. The failure by an issuer to pay a coupon or the principal when due, or meet any other obligations under the terms of the bond. Owning a range of different investments rather than, as it were, having all your eggs in one basket. A measure of a bond s sensitivity to changes in interest rates. Another name for an ordinary share of a company listed on a stock exchange. Government bonds are debt instruments issued by governments to finance public spending. In the UK they are known as gilts, derived from gilt-edged securities as the certificates originally had a gilt or gilded edge. A high yield bond is a corporate bond rated BB+ or lower by Standard & Poor s and Fitch or Ba1 by Moody s. An investment grade bond is a corporate bond rated BBB- or higher by Standard & Poor s and Fitch or Baa3 or above by Moody s. Collective term for an investor s holding of shares, bonds, funds and other financial instruments. The original amount invested in a bond, separate from earnings/interest. This is used to indicate the total return of a bond, taking account of income generated and reduction/growth in capital. This is also known as the current yield, distribution yield or income yield. This is the effective annual yield payable by a fund. The yield calculation takes the annual income on an investment and divides it by its current market value. It takes account of initial charges, spread and dealing costs. This is a debt security issued by a national government. This is the difference in yield between different securities, due to different credit quality. 17

18 Important information This document is issued by Cazenove Capital Management, the name under which Cazenove Capital Management Limited (registered no ) and Cazenove Investment Fund Management Limited (registered no ), both of 12 Moorgate London EC2R 6DA and authorised and regulated by the Financial Services Authority, provide investment products and services. This document is prepared for the information of both professional advisers and individual investors. The contents of this document are based upon sources of information believed to be reliable. However, save to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to its accuracy or completeness and Cazenove Capital Management, its directors, officers and employees do not accept any liability or responsibility in respect of the information or any recommendations expressed herein, which, moreover, are subject to change without notice. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Investors should remember that past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. Funds investing partly or wholly in bonds will tend to be less volatile than pure equity funds, as bonds are generally considered to be more secure, usually including a condition to repay the original sum at a specified date in the future and normally provide a fixed level of income. However, the capital value of a bond fund and the level of its income will still fluctuate. The levels and bases of, and reliefs from, taxation may change. Investors should obtain professional advice on taxation where appropriate before proceeding with any investment. The preceding descriptions are intended to provide a summary only of the main risks associated with investments in fixed income funds. Investment in fixed income funds may not be suitable for all investors. Any investment should be considered against an investor s investment needs and attitude to risk. Investors should refer to the Full Prospectus and Key Features document before making any investment and this booklet is for information purposes only. K12035_An intro_to_fixed_income_cl 18

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