Managing a Fixed-Income Portfolio vs. a Benchmark

Transcription

1 Managing a Fixed-Income Portfolio vs. a Benchmark 林 瑩 慧 (Susan Y. Lin) Managing Director Head of International Development The Yield Book/Index Citigroup Global Markets Taiwan Limited April 2009

2 Outline Introduction to Fixed Income Securities Debt Market Basic Bond Math The Time Value of Money Bond Price Sensitivity Fixed Income Indices Cycle of Portfolio Management vs. Benchmark 2

3 April 2009 Introduction to Fixed Income Securities

4 Bond vs. Equity Bonds are debt, stocks are equity Stock investor is an owner in a corporation which comes with voting rights and the right to share in any future profits. A bond investor is a creditor to the issuer (corporation or government). A bond holder has a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder. However, the bondholder does not share in the profits if a company does well - he or she is entitled only to the principal plus interest. 4

5 Why Issue Bonds? A company needs funds to finance its operations To raise capital to pay for expansion or modernization To cover operating expenses To finance corporate takeovers or other changes in management structure Governments need money for everything from infrastructure to social programs Cities, counties, town governments issue bonds To pay for a wide variety of public projects: schools, highways, stadiums, sewage systems, bridges To supplement their operating budgets Whatever the needs are, a large sum of money needs to be raised! 5

6 Why Bonds, not Bank Loans Although companies can borrow from banks, direct borrowing from a bank is more restrictive and expensive than selling debt on the open market through a bond issue. Many CFOs consider banks as lenders of last resort because of the restrictive debt covenants that banks place on direct corporate loans A few examples of the restrictive covenants Can not issue any more debt until the bank loan is completely paid off Can not participate in any share offerings until the bank loan is paid off Can not acquire any companies until the bank loan is paid off CASE: Asian financial crisis in

7 Bond Market Requirements A healthy bond market requires the following Sound legal structure Effective credit ratings agencies Strong institutional investor base Timely, honest, and credible reporting of firms financial circumstance Enough supply: government and corporate bonds 7

8 Bond Basics A bond is a loan that pays interest over a fixed term, or period of time. When the bond matures at the end of the term, the principal, or investment amount, is repaid to the lender, or owner of the bond. Characteristics of a bond Face Value/Par Value: is the amount of money a holder will get back once a bond matures. Coupon (The Interest Rate): is the amount the bondholder will receive as interest payments. It's called a "coupon. Most bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. Maturity: is the date in the future on which the investor's principal will be repaid. Maturities can range from as little as one day to as long as 30 years (though terms of 100 years have been issued). Issuer : The issuer of a bond is a crucial factor to consider, as the issuer's stability is your main assurance of getting paid back. 8

9 Issuer Rating The bond rating system helps investors determine a company's credit risk. The chart below illustrates the different bond rating scales from the major rating agencies in the U.S.: Moody's, Standard and Poor's and Fitch Ratings 9

10 Issuer Rating Example Citi The same company can have many ratings depending on the type of debt it issues. Below is an example for Citi rating. 10

11 Who should be investing in Bonds? Stocks are exciting, bonds seem boring Institutions should invest in assets that suit their risk profile. All it takes is a bear market like today to remind investors of the virtues of a bond's safety and stability. Are bonds really safe? 11

12 Types of Bonds Different types of bonds based on the issuer Government bonds Municipal bonds Corporate bonds Different types of bonds based on bond characteristics Zero coupon bond Callable/Putable bond Convertible bonds Mortgage backed securities Asset backed securities Collateralized Mortgage Obligation Structured notes. 12

13 Callable Bonds vs. Bullet Bonds Why issue callable bonds? A callable bond gives the issuer of the bond the right to redeem it at predetermined prices at specified times prior to maturity. For example, a 10NC3 is a 10 year bond that can be redeemed after 3 year. The 3- year non callable period is called lockout period. The main cause to issue callable is anticipation of a decline in interest rates or upgrade in credit rating. Why buy callable bonds Yields on callable bonds tend to be higher than yields on non callable, bullet maturity bonds because the investor must be rewarded for taking the risk the issuer will call the bond if interest rates decline, forcing the investor to reinvest the proceeds at lower yields 13

14 Bond Issuance Process Bonds are issued in the primary markets. Government Bonds are typically done through auctions. For corporations, issuing a bond is a lot like making an initial public offering, through underwriting. One or more securities firms (dealers) form a syndicate, help set the terms, buy the entire issue of bonds from the issuer, and re-sell them to investors. After issuance, bonds trade in the secondary market, which means they are bought and sold through brokers, similar to the way stocks are traded. The issuer gets no money from these secondary trades. Like stock, bonds can trade in exchanges or Over-the-Counter (OTC). 14

15 Bond Trading Liquidity Measures of bond liquidity Bid-ask spread Issued amount Age Price volatility Liquidity for different bond markets Treasury bonds vs. Corporate bonds Developed vs. Emerging markets 15

16 Bond Price and Yield Bond's price changes on a daily basis, just like any other publicly-traded security. If investor holds bonds to maturity, you're guaranteed to get your principal back assuming no default. A bond does not have to be held to maturity. At any time, a bond can be sold in the open market, where the price can fluctuate - sometimes dramatically. 16

17 April 2009 Basic Bond Math

18 Fixed Income Securities Bonds A series of (identical) payments in the future (known as coupons) along with a single principal payment on the same date as the final coupon payment (most Treasury bonds are bullets) Valuation: How do you determine the price of a bond? Need to know the cash flows and timing Concept: The Time Value of Money 18

19 The Time Value of Money Present Value / Future Value A dollar today is worth more than a dollar tomorrow (assuming no deflation) How much more depends on how far in the future we re talking about, and the interest rate available to us The math is pretty standardized, and easy PV FV = ( 1+ r) n FV=PV(1+r) n Where FV = Future Value PV = Present Value r = Periodic Interest Rate (as a decimal) n = Number of Compounding Periods 19

20 Theoretical Building Block: Zero Coupon Bond Zero Coupon Bond A Zero Coupon Bond repays its Face Value at maturity but pays no interim coupon a single cash flow received at a known date in the future Basic building block of fixed income securities. Most securities can be reconstructed as a portfolio of zero coupon bonds. Valuation: What are you willing to pay today for $100 in the future (i.e., on a specific date in the future)? 20

21 Theoretical Building Block: Annuity Annuity A series of (identical) cash flows received at a known regular intervals in the future (i.e., a string of equally spaced, equally sized zeros) Valuation: What are you willing to pay today for $100 on each of many dates in the future? 21

22 Discounting: Full Term for Each Flow Bond (Bullet Bond) A Bond (without special indenture provisions) can be viewed as an annuity (the coupon payments) plus a zero coupon bond (the final principal payment). Question: What is the rate being used to discount the cash flows in order to obtain the present value? 22

23 Yield to Maturity The yield to maturity (YTM) is the discount rate which makes the present value of a bond s cash flow equal to its market value. It is a standardized measure that is commonly used to estimate the rate of return and is also known as the Internal Rate of Return. What is the relationship between Yield to Maturity and Price of a bond? 23

24 Yield to Price Means you are given a yield, and must calculate a price This is the easy calculation Simply determine the present value of each cash flow, and sum them up c c PV = + + (1+r) (1+r) 2 c (1+r) c (1+r) n-1 + c+p (1+r) n 24

25 Price to Yield This calculation is the hard one, requiring a solution to an n th order polynomial (solve for r ) This is an iterative calculation to find a value for r that satisfies the equation above This single r is known as the Internal Rate of Return, or IRR c c c c PV = (1+r) (1+r) 2 (1+r) 3 (1+r) n-1 c+p (1+r) n 25

26 How did traders in early days (70s, early 80s) convert Price/Yield? Keep in Mind, No Computers, No Excel Spreadsheet. 26

27 Then Monroe / HP Calculators (Bond Trader) 27

28 What about Today? Excel In-house software Commercial software Bloomberg Reuters The Yield Book 28

29 Bond Example Time Value of Money A $100 Nominal amount of a 3 year 12% annual pay coupon bond Cash Flows Time Payment Made Coupon Principal End of Year End of Year End of Year How much would you be prepared to pay today for a bond that promises to pay you the set of future cash-flows laid out above? What is the interest rate / discount rate? 29

30 Present 10% Annual Present Values are additive, hence the present value of a bond is the sum of the present values of each of the individual coupon and principal payments Example: 3 Year 12% Coupon Bond, 10% annually compounded discount rate PV(Bond)= = (1.10) 2 = (1.10) 3 = Premium Bond 30

31 Present 12% Annual Example: 3 Year 12% Coupon annual pay bond at 12% discount rate PV(Bond)= = (1.12) 2 = (1.12) 3 = Par Bond 31

32 Present 14% Annual Example: 3 Year 12% Coupon annual pay bond PV(Bond)= = (1.14) 2 = (1.14) 3 = Discount Bond 32

33 The Price - Yield Relationship As can be seen from the previous three slides, the price and yield of a bond are inversely related. Yield > Coupon Discount Bond, i.e. price < 100 Yield = Coupon Par Bond, i.e. price = 100 Yield < Coupon Premium Bond, i.e. price >

34 The Price - Yield Diagram Relationship between Yield and Price Price Yield 10yr, 10% 34

35 Shortcomings of Yield to Maturity YTM is not a good proxy for Expected Total Return if: Bond is not held to maturity. (Investment horizons are typically shorter, and changes in rates and therefore prices have a major effect on return.) Coupons are not reinvested at YTM. (Reinvestment rates change over time) 35

36 What Is Duration? Duration is the relative sensitivity of a bond s price to a change in its yield. The duration of a bond is the approximate increase in its market value due to a 1% drop in its yield. What can Duration be used for? Measuring and managing a portfolio s aggregate interest rate exposure. Matching the exposure of Assets and Liabilities ( Immunisation ). Structuring trades. Providing an accurate estimate of a portfolio s aggregate sensitivity. 36

37 Yield Curve The yield curve is the relation between the interest rate (yield) and the time to maturity of bonds. Yield curves are usually upward sloping; the longer the maturity, the higher the yield, with diminishing marginal growth Normal upward sloping yield curve 37

38 Example of More Complicated Bond: Structured Note 38

39 Why More Complicated Structures? 39

40 Yet, Try This: CMO Cash flow sliced up into various pieces to meet investor s risk profile Cash flow projected using a fixed prepayment speed assumption 150 PSA Cash flow projected using a prepayment model, at a higher prepayment speed Note the Saw tooth shaped cashflow Note the cash flow comes in faster than the 150 PSA case 40

41 Total Rate of Return Calculation Total Rate of Return is composed of capital gain of the security, along with the payments from coupon, principal, and reinvestment income Eg. If a security is priced at $99 on 3/1/2009 and $100 on 4/1/2009, and the coupon income during this month is $2 (assuming no reinvestment and principal payments), the total rate of return during the month of March will be: ($100 $99 + $2) / $99 = 3.03% 41

42 April 2009 Citigroup Indices

43 Benchmarking: Why? Absolute performance is what people care about But You cannot control the market, you can only influence your performance relative to the market You would like to get paid even if the market as a whole goes down And Investors want to understand your broad investment goal Fund s likely risks and returns Like-for-like performance comparisons 43

44 Benchmarking: Why? The benchmark provides information to the investor: Indication of historical returns and volatility Default investment universe and mix Default approach to hedging currency risk For the fund manager: In the absence of a view, it s the place to stay With a view in mind, it s the thing to beat 44

45 Benchmarking: Relevance Index represents the market Benchmark is fund-specific, reflecting the fund s objectives and guidelines: Maturity limits Credit exposures Single / Multi-currency 45

46 Why Do Investors Use Citigroup Indices? More than 30-years of experience producing international indices Citi has market presence in more than 100 countries Recognized leader in indices and analytical tools Data available to all institutional investors through various data and analytics vendors 46

47 What Makes A Good Benchmark? Relevance Comprehensiveness Replicability Stability Barriers to Entry Expenses Simple and Objective Selection Criteria 47

48 Construction Rules for Bond Indices Index Composition: Monthly frequency of re-balancing Market capitalization weighting Index Returns: Sectors returns are weighted averages of individual bond returns Bid prices are used for bonds, mid for exchange rates Cash flows are reinvested at a short term interest rate until month-end Daily and Monthly returns are published Returns can be expressed in local and base currency Currency-hedged returns assume rolling one-month forward contracts 48

49 Citigroup Index Family Source: The Yield Book 49

50 World Government Bond Index profile WGBI Market Weight Japan, US, UK, 6.41 Canada, 1.67 Denmark, 0.62 Switzerland, 0.52 Poland, 0.51 Other, 1.68 Singapore, 0.30 Australia, 0.32 Norway, 0.21 Malaysia, 0.37 Sweden, 0.47 EURO, Data as of 3/31/

51 WGBI Market Sector Profile as of April

52 Average Maturity for WGBI Markets vs Taiwan 16 Jan-01 Jan-05 Jan US Japan EMU UK Denmark Poland Norway Sweden Switzerland Canada Australia Singapore Malaysia Taiwan Taiwan and Malaysia government bond index was launched Jan

53 Average Issue Size for WGBI Markets vs Taiwan (in Billions USD) 25.0 Jan-01 Jan-05 Jan US Japan EMU UK Denmark Poland Norway Sweden Switzerland Canada Australia Singapore Malaysia Taiwan Taiwan and Malaysia government bond index was launched Jan

54 Asian Government Bond Index profile AGBI Market Weight (%) Malaysia, Thailand, Taiwan, Singapore, Indonesian, 3.32 Philippines, 2.31 Korea, Data as of 3/31/09 54

55 Taiwan Government Bond Index Market value in Millions TWD Data as of 3/31/

56 April 2009 The Yield Book

57 What Is The Yield Book? The Yield Book Introduced July 1989, originated from Salomon Brothers Fixed Income Analytical System Calculation engine to analyze bonds, trades, portfolios, and benchmarks Employs financial models to assess risk and relative value of portfolios and benchmarks Allows access to databases maintained by Citi Covers a broad range of securities consistently 57

58 Who Uses The Yield Book? In the US, 82 of the top 100 fixed income money managers use The Yield Book, including 50 of the top 50 Nearly 400 institutions worldwide use The Yield Book products in 36 countries Customers include: Central Banks, Investment Managers, Banks, Insurance Companies, Pension Funds, Hedge Funds, Broker Dealers 30 Primary and Regional Dealers 58

59 Why Do People Use The Yield Book? Analysis of complicated securities Mortgage pass-thru, CMO, ABS, CMBS Derivatives: swaps, swaptions, caps, floors, structured notes Advanced Portfolio Functions Portfolio Scenario Analysis Tracking Error and Value at Risk Return Attribution Portfolio Optimization The Yield Book provides constituent level data for Citigroup Indices. All advanced portfolio functions can also be used to analyze indices for benchmark comparison 59

60 April 2009 Analysis using The Yield Book & Citigroup Indices

61 Portfolio Management Tool The Yield Book s main functionalities: Individual Security Analysis Portfolio Risk Reporting Scenario Analysis Optimization Return Attribution Tracking Error Value at Risk Source: The Yield Book 61

62 Individual Security Analytics The Yield Book offers both indicative data and analytics for our customers. User can enter any pricing level (such as price, yield, or spread) to calculate a full set of analytics on the security. Example: US 10 Year On-the-run Treasury Source: The Yield Book 62

63 Portfolio Risk Report Portfolio risk from each year points movement on the yield curve Source: The Yield Book 63

64 Benchmark Comparison Report Average Life Source: The Yield Book 64

65 Scenario Analysis Comparison against Benchmark Comparison of total rate of return between the portfolio and the benchmark, under 7 parallel shift yield curve scenarios Source: The Yield Book 65

66 Optimization Yield Book optimizer calculates the solution and creates a portfolio that satisfies all the tracking constraints and objective Source: The Yield Book 66

67 Tracking Error / VaR Projection The Tracking Error and Value at Risk model calculates portfolio and benchmark return distributions based on the 10,000 simulations Expected return and volatility of return over a 1 month horizon Value at Risk calculated for 95% and 99% confidence interval Source: The Yield Book 67

68 Return Attribution Concept Dissects historical total returns into return attribution factors, which explains why the bond achieved the return that it did Total Return Local Currency Return Inter-Currency Return (Multi-Currency Portfolio) Curve Return (Govt Return) Spread Return A benchmark is needed Sector Selection Issue Selection 68

69 Single Bond Return Attribution Matrix How do we interpret the numbers from the return attribution analysis? More intuitive to interpret the attribution results by rows Focus on one security and look at 3 x 3 Matrix: GE 5.625, Rows Curve return + Spread return Total return 3 Columns Rolling Yield return + Market return = Total return 69

70 Return Attribution: Portfolio vs. Benchmark Example: Portfolio Curve Return: bps Under-perform by 3.7 bps Portfolio Spread Return: 44.6 bps Out-perform by 23.9 bps Portfolio Total Return: bps Out-perform by 20.0 bps Source: The Yield Book 70

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