by WWM | Aug 30, 2017 | Fixed Income
Today we will review longer term fixed income securities.
There is some differentiation in the way that people define these assets. Many define a bond as a debt instrument that is secured against specific assets of the issuer. Bonds may also be seen as any debt exceeding 1 year in term to maturity.
No one way is the “right way”. But we will go with my terminology to stay consistent in my posts.
Bonds, Notes, and Debentures
I tend to aggregate bonds, notes, and debentures as just “bonds” for discussion purposes. That is because most of their characteristics are very similar. Plus, when you look at fixed income in the investment world, the short form for these three defaults to bonds. Where there are differences between the three, I shall definitely point them out.
Like short term money market instruments, all bonds are fixed-obligation debt securities.
Investors invest in the debt issue. In return, the issuer agrees to pay a certain amount of interest at pre-determined dates over the term of the debt. At maturity, the issuer agrees to repay the principal amount of the debt to the investors.
Bonds may be issued from many sources. Corporate, as well as issues from the various levels of government.
Term to Maturity
Unlike money market instruments, bonds are longer term obligations. I divide debt maturities into three time horizons:
Money market instruments are short term debt issues that mature in 1 year or less.
Notes are intermediate term debt issues with maturities between 1 and 10 years.
Bonds are long term debt issues with maturities greater than 10 years.
Not hard and fast rules on terms and maturities. But those terms are the most commonly used.
When I refer to short, intermediate, and long term debt issues, the characteristics of the bond change as it moves toward maturity. The name of the bond does not change from bond to note to money market. But, as we will see in our pricing discussion later, the major determinant of price volatility is the remaining term of the bond.
For example, General Motors issues a 30 year bond on January 1, 1991. It will mature and its face value repaid to investors on December 31, 2020. At issue, this would be considered a long term bond of 30 years. However, if it traded in the secondary markets and you purchased it on June 1, 2014, you would actually be acquiring a bond with intermediate term characteristics as the time to maturity was less than 10 years but more than 1. And if you sell the bond on June 1, 2020, it will be considered a short term debt security when pricing the bond, although not a money market instrument.
Types of Issues
Secured Bonds
Bonds that are backed by legal claims on specific assets of the issuer. That is, if the issuer defaults on the bond, investors have a claim against the specified collateral on the issue.
You may see secured bonds referred to as “senior” or “mortgage” bonds.
Senior bonds are often secured, but do not have to be. In the event of a default, a senior bond will have priority over other subordinate debt issues when the company pays out any money. A very useful feature should an issuer in financial distress have more debt outstanding than cash available. As a senior debt holder, you move to the front of the line for repayment. In essence, that is an investor’s security.
Mortgage bonds have mortgages secured (attached) to specific assets. Usually real estate or real property such as operating equipment. In the event of non-payment, these assets may be seized by the bond holders and sold to pay off the issue. Again, this provides security that the face value of the bond can be repaid.
A good example of secured debt is the mortgage on your house or the loan on your car. Until you have fully repaid the debt, the lender has a lien on the home or vehicle. Should you miss your payments, the lender may seize those specific assets detailed in the loan agreement.
The same holds true for secured bonds.
Unsecured Bonds
Also known as debentures, unsecured bonds are not backed by specific assets. Instead, the issue is supported only by the general promise from the issuer to pay interest and principal on the agreed dates.
Debt of this nature is part of the issuer’s general credit obligations. Should the issuer fail, debt holders would be one of many creditors fighting for a piece of the entity’s remaining assets.
Subordinated Bonds
Subordinated bonds, or junior debentures, only hold a claim on assets that is lower in position or seniority to other debt obligations.
Subordinated bonds may or may not be secured against specific assets. If they are secure, then there is already senior debt in place that takes precedence in the event of default.
A common example would be a second or third mortgage on a piece of real estate, such as your home.
If you hold the secondary claim and there is a default, you will wait in line until after the senior debt holders are repaid.
When investing in secured, subordinate bonds, be careful as to the assets you are linked with. An indenture will tell you the key details of a bond issue. The indenture is the legal contract between the issuer and the debt holder which specifies the issuer’s legal requirements.
If there is already enough senior debt to consume the asset’s entire value, then you really have no security at all. This needs to be factored into the pricing of the bond. With no practical security, the bond becomes riskier and investors require additional compensation for that increased risk.
The same logic applies to junior debentures. But here, there is no security. The debt holder is simply one of many creditors trying to get their money back if a default occurs. Standing in the back of the line waiting for more senior debt holders to be repaid is a risky proposition.
Unless the potential returns are high enough to justify the risk (in your eyes) or the issuer is one with an impeccable credit rating (e.g., US Government), I would suggest that you avoid debentures as a direct investment option.
Relevance for Investing
Ceteris paribus, it should be obvious that investors prefer secured bonds over unsecured and senior over junior issues.
Security
Whether you are investing in public debt issues or loaning money to your brother-in-law, always attempt to get as much security as possible in return. The more security you can get, the safer your investment.
That said, you need to also consider the liquidity and potential for decrease in market value of the collateral. If it is not liquid, or if the collateral can only be sold at distressed levels (a.k.a. fire sale prices), the security you possess might not cover all the debt owed.
For example, you are considering investing in a new debt issue by Sadco. They plan to expand operations in Dictatorland; a country with rumours the government may nationalize foreign company assets. This concerns you, so you only wish to invest in a secured bond issue. As the pledged assets are worth three times the bond value, you decide to invest.
Good strategy.
Unfortunately you did not read the indenture or prospectus and notice that the pledged assets were the company’s operating facilities in Dictatorland. In short order, the facilities are seized and Sadco files for bankruptcy. Good thing you had a secured bond. Now if only you can get the President-for-Life to agree to release the assets to you.
The same securitization issue applies to (say) operating equipment in a factory. New, the equipment may be worth $100 million and amply cover as security for a 20 year, $50 million bond offering. But, like your car, computer, motorboat, etc., over time general wear and tear erodes market value. If the issuing company experiences financial difficulty 10 years out, do you think the equipment will be worth its value brand new?
Any security or pledged assets attached to a debt offering should be worth more than the offering through its term to maturity. If not, is it really protection for your investment? Nope.
Just because a bond is “secured”, does not mean it practically is. Worth remembering.
Risk-Return Principle
If you cannot get proper security, then you need to receive a higher return for the additional risk you face on the debt.
This is a basic risk-return principle. The higher the risk, the greater the return required.
In this post, the greater return will likely come from higher interest payments or deeper discounts on pricing. You can see the level of security offered by a bond issuer plays an important role in the pricing and yield to maturity of any debt issue.
But more attractive returns may also involve sweeteners, such as equity conversion privileges or warrants. Anything that may make the offering more enticing to potential investors as compared to other issuers’ debt.
Before investing, ensure you know which of the above categories your investment resides within. Then compare that issue with other similar offerings to ensure that you receive the appropriate expected return for the assessed level of risk.
Debt with relatively less security will provide higher returns than debt with good security.
For most investors, it may not be prudent to directly invest in individual debentures or junior debt issues. However, you can use diversification techniques to reduce the portfolio risk and still enjoy the higher returns. This may mean investing in multiple offerings to spread out the investment risk. Or to invest in higher risk bonds through mutual or exchange traded funds, so as to spread the risk even more than you could do on your own with limited resources.
When we review portfolio construction we shall look at diversification tactics in some detail.
As for assessing the investment risk, we have reviewed some issuer specific, non-systematic risk factors here and here. We will also look at a few additional bond considerations shortly.
Next up though, a look at some common bond issues you will see in the marketplace.
by WWM | Aug 23, 2017 | Cash Equivalents, Fixed Income
We began our review of the fixed income asset class with some key terms.
As for the asset class, it is common to group fixed income debt into three categories: money market, bonds, and debentures. Today we will look at money market instruments.
Money Market Instruments
I consider almost all money market instruments to be Cash Equivalents within one’s investment portfolio. But as they are technically debt, and are influenced by many of the same variables as other debt issues, I will cover them here.
Money market instruments are part of the short term debt market used primarily by governments and large capitalized corporations with very strong credit ratings. By short term, less than one year until maturity.
Most money market instruments are issued at a discount and mature at face value. No actual interest is paid by the issuer. Rather the difference between the purchase price and the value at maturity is considered the interest.
In every jurisdiction I can think of, the amount earned between the purchase price and face value is treated as interest income, not a capital gain, for tax purposes.
However, if the money market instrument is traded in the secondary market prior to maturity, a portion of the return may possibly be treated as a capital gain or even capital loss.
Government Treasury Bills
For short term borrowings up to 1 year in duration, governments issue treasury bills (T-bills).
No interest is paid on T-bills. They are issued at a discount to face value equal to the required interest rate. Upon maturity, the face value is paid to the investor and the difference between the discount and par value is treated as interest income.
Longer term bonds that do not pay interest, but are issued at deep discounts, are known as zero coupon bonds.
T-bills are guaranteed by the issuing government of a country. Because of the ongoing solvency of most countries, the shorter term T-bills are considered the safest of all investments. As such, the interest rate on T-bills is normally viewed as the risk-free rate of return.
Note that the fortunes of countries rise and fall. At any given time, a specific country’s T-bills may not be risk-free. For example, US T-bills are considered totally safe as I write this post. However, countries like Belarus, Greece, and Venezuela may not be seen as 100% secure right now.
Like any debt instrument, the interest rate offered by the issuer will depend on its credit rating. The worse the credit rating, the greater the interest rate that needs to be paid.
Corporate Money Market Instruments
Often corporations require short term funding to pay for current liabilities or finance short term assets such as trade receivables or inventory.
On average, corporations are riskier than governments. That should be intuitive. Though this can obviously differ on a case by case basis. For example, Apple may have a market capitalization that would equate it in the top tier of most national governments. Or the current credit rating of Venezuela is lower than many companies.
But being generally riskier than governments, you should expect to see corporate money market instruments paying higher interest rates than similar short term government debt.
When corporations issue debt for periods up to one year, they have a variety of options. Three typical ones, include:
Commercial Paper
Unsecured debt issued by a company. Because the debt is not secured against any corporate assets, only companies with very strong credit ratings issue commercial paper.
Depending on the credit-worthiness of the issuer, these notes may be more or less risky. Interest rates offered on commercial paper will fluctuate between corporations based on their relative risk.
Acceptance Paper
Also know as Finance Paper or Asset-Backed Commercial Paper.
Secured debt that is issued by a finance or acceptance company. The issue is secured by specified assets such as receivables or inventory.
Assuming that the security is adequate to cover the issue, secured debt is normally less risky than unsecured debt.
For example, Debtcorp issues two classes of paper. One secured against its trade receivables and inventory. The other unsecured. The non-secured debt will require a higher interest rate to be offered to reflect the higher risk of the paper.
Banker’s Acceptances (BAs)
Debt issued by a non-financial corporation but where a bank guarantees its repayment.
Of the three corporate options, the least risky for investors. This is because there are two layers of protection with the involvement of the bank guarantee.
Because it is the least risky, all other things equal, BAs will offer the lowest returns.
Investing in Money Market Instruments
Most individual investors never directly invest in money market instruments. That is because the required minimum purchases are too high for many investors.
However, individual investors do purchase these instruments indirectly through money market funds (MMF). As you develop your investment portfolio, I would expect you to have a portion of your assets in MMF. Likely for your emergency funds, cash set aside awaiting investment opportunities, cash available for near term financial obligations, and so on.
While each investor is unique, normally investing in MMF is preferable to holding your cash in savings or chequing accounts. That is because MMF offer higher returns than bank accounts, tend to be low risk, and are highly liquid.
Depending on the financial institution, they usually offer better returns and greater liquidity than term deposits and Guaranteed Investment Certificates.
I think the key takeaway with money market instruments, and any other fixed income offering, is the risk-return relationship. The more risky the debt instrument, the more incentive must be offered to entice investors. For short term money market instruments, this will be in higher interest rates offered for riskier debt.
But for longer term debt, it may be in securitization of the debt or priority of repayment. Or it may be in other sweeteners like conversion privileges into common shares. We will review various sweeteners in the near future.
The higher the risk of a debt offering, the less desirable it is for investors, and the greater interest and/or sweeteners required to attract investors.
You can also look at this from basic demand driven economics that applies to any asset (eg., your vehicle, house, art, gold). You decide to sell your home. If there is substantial demand for your house in the local market (hot market, great house, attractive area, little else for sale, etc.), you can ask more money. If you are selling your home in a down market with few potential buyers, you may need to list for less.
The same logic applies for all types of debt and equity issues. The more attractive an asset is to the investor, the less a company must do to raise capital. The less attractive the asset, the more a company must pay to attract capital. We will see this over and over and over again as we explore different investments.
Next we will review bonds and debentures.
by WWM | Aug 16, 2017 | Fixed Income
We will start our review of fixed income securities today.
As there are some good things to know, we shall break it down into a few posts.
First, I want to quickly review a few key terms that relate to fixed income. If you can understand a little of the terminology, it will make the whole area easier to follow.
We will refer to the following example as we go through the terms.
On January 1, 2017, you purchase a new issue of $10,000 par value 5 year Canada Government bonds for $10,250. The bond has a coupon of 8% and a current yield of 7.8%.
Fixed Income Securities
In general, assets in this class provide a known stream of fixed income over the life of the investment. Hence the term.
At the end of the asset’s life, the original capital is repaid in full to the investor by the issuer borrowing the funds.
If you hold the security until maturity, there is relative certainty as to your income stream, both the amount and the timing, and in the repayment of your invested capital.
We will consider the “relative” aspect in due course.
In our example, the fixed stream of income is $400 of semi-annual interest payments for the 5 year life of the bond. At the end of 5 years, you also receive the face value of $10,000. Unless the government defaults on its debt, there is a high certainty as to the timing of the payments and the amounts you will receive.
I would include all debt instruments and most preferred shares in the fixed income asset class.
That said, for every rule there are exceptions.
Some debt issues and many preferred shares may not have expiration dates. Other issues may have variable rate coupons, or interest rates that change based on specific events.
Some debt may have the interest coupons stripped from the instrument. You may purchase the debt paying no periodic interest (zero coupon bonds) or you may invest in the coupon stream with no principal repayment (interest only strips).
Also, one can engage in swaps or asset re-engineering to completely alter the characteristics of certain investments. For example, investors may use futures contracts to increase or decrease the maturities of Treasury bills. Or one can utilize an equity swap to take an underlying fixed income portfolio and create a synthetic equity portfolio without selling the bonds or purchasing shares. But these areas are outside the scope of our discussion.
So while the above definition works in most instances, be aware that there are exceptions.
Principal
The “face value” of the security that must be repaid to the investor at maturity. Principal may also be referred to as the “stated value” or “par value”.
All four terms are interchangeable.
In pricing analysis, the principal is typically viewed in multiples of $100.
In our example, the $10,000 is the principal amount. The par is $100 for pricing.
This differs from what you actually paid for the security. The amount you paid, $10,250, is your “purchase price” or “adjusted cost base”. In pricing terms, you paid $102.50 for the bonds.
In this case, you paid $250 more than the face value of the bond. If you pay more than the par value, the extra amount is known as the “premium”. Had you paid less than the face value for the bonds, the difference would be the “discount”.
Note that with debt instruments, you often purchase accrued interest. For the moment we shall ignore this consideration.
Term to Maturity
This is simply the time remaining before the debt instrument matures and it is retired.
At maturity, interest payments end and the face value of the debt is repaid to the investor. There is no longer any obligation by the issuer to the debt holder.
Investors are not concerned with the original maturity date, only the term that remains.
For example, on January 1, 2017, you plan to invest in a 30 year US government bond that matures on December 31, 2018. The fact that the bond had an original maturity of 30 years is irrelevant. You should only be concerned with the cash flow over the remaining 2 years.
Also, the 30 year bond will exhibit the investment characteristics of a 2 year bond. That is very important.
Coupon Rate
A security’s periodic fixed income payment is called its “coupon” or “interest” component.
It is what is actually paid out in interest income each year and is compared relative to the face value of the debt. Not to what you actually paid for the asset.
In our example, the coupon rate is 8%. For every $100 of face value debt, a semi-annual interest payment of $4 will be made by the government. As you purchased a face value of $10,000, your annual interest income is $800.
As a formula, simply divide the interest payment received by the face value of the debt. If you own debt with a par value of $300,000 and receive an annual interest receipt of $18,000, your coupon rate is 6%.
For most debt instruments, interest payments are made semi-annually on the anniversary date of the issue. In some cases though, interest payments may be made more or less frequently. And in some instances, such as with zero coupon bonds or most money market instruments, actual interest is never paid.
Yield
Yield on a fixed income asset is a different creature from the coupon rate. It may be the same, but often it is different.
The yield represents the annual return to the investor based on his investment cost.
Current Yield (CY)
Whereas the coupon rate compares the interest paid out to the face value of the debt, the CY compares the interest payments to your actual purchase price (adjusted cost base).
In our example, you paid $10,250 for the bonds. But regardless of what you paid for the bonds, you will still receive interest at the coupon rate of 8% based on the face value. So each year you receive $800 in interest.
To calculate the CY, you only need to know the current price of the security and the coupon rate.
Simply divide your annual interest income into the purchase price and you have the CY. And if you know the CY, you can easily calculate either the proper purchase price or coupon rate, assuming you have one or the other.
If you buy a fixed income security at par value, the coupon rate and the CY will be the same.
However, because you paid a premium for your bonds in our example, your CY will be less than your coupon rate. In this case, your CY is only 7.8%.
Note that had you received a discount on your bond purchase, your CY would be higher than the coupon rate. Knowing this rule on the impact of premiums or discounts on your yield versus coupon is very useful for personal calculations.
Also, as interest rates change, that will impact the current price of the fixed income asset. If market interest rates fall, then the current price of your bond should increase, ceteris paribus. Over time, your CY may fluctuate, so you always need to update your calculations based on current prices.
A major weakness in the CY is that it does not factor in potential capital gains or losses into the annual return.
Yield to Maturity
The yield to maturity (YTM) does account for capital gains or losses in its calculation.
To determine the YTM, you need to know the security price, the coupon rate, and the term to maturity. And, if you have any three numbers, you can easily calculate the missing fourth.
While you can calculate YTM by formula, I suggest you use a financial calculator. In our example above, the YTM is 7.7%.
This should make some intuitive sense if you think about it.
In our example the CY is 7.8% and the YTM is slightly less at 7.7%.
The CY only considers the interest stream against the purchase price. The YTM needs to also factor in any capital gains or losses between the purchase price and the face value at maturity.
You paid $10,250 but will only receive back $10,000. Because you paid a premium, you have a capital loss that must be reflected in the YTM. This loss will lower the yield (your overall return) as compared to the CY.
Had you received a discount on the purchase, you would receive a capital gain at maturity. Factoring this gain into your calculations will result in a higher YTM than the CY.
For example, instead of paying $10,250 for the bonds, you only pay $9750. Your CY will increase to 8.2%. However your YTM will rise even higher to 9.0%, reflecting the capital gain at maturity.
Okay, I think that gives you some understanding of the key fixed income terms.
Next we will review the common investments within the fixed income asset class.
by WWM | Mar 5, 2017 | Fixed Income
I tweeted today about a Bond 101 Primer courtesy of PIMCO. Well worth a read.
When we reach asset classes in this blog’s investment series, we will go into bonds in detail. A good article, but the PIMCO primer illustrates why I am trying to build up some core investment knowledge before tackling the assets, strategies, and tactics. It is a much better read if you understand diversification, correlations, hedging, and such.
Bonds Get a Lot of Questions
I mention it now as bonds are usually a big question from clients.
Namely, “Why should we invest in an asset class (bonds) that tends to offer weaker expected returns than other classes (e.g. equities)? Shouldn’t we want to put our money in assets with the best expected returns?”
I would not disagree with either question. So why should you invest anything in bonds?
Non-Return Bond Benefits
I like bonds in portfolios for a variety of reasons.
Yes, you can get real returns from bonds, so they are not a waste of capital (though they can be in certain economic conditions). You can also generate substantial capital gains (or losses) from bonds (again, depending on economic conditions). So there are possible returns from capital as well as interest.
But I like bonds in client portfolios for non-return benefits.
Bonds often provide higher stability and certainty of returns than equities. Over time, bonds may earn less than equities, but your risk level should be lower. Preservation of capital may outweigh potential returns for many investors. And, as you approach retirement and plan to live off your savings, having a known income stream is important.
Bonds often are less than perfectly correlated with equities. This enhances portfolio diversification, a desired result.
Bonds may provide hedging opportunities which can be beneficial.
Bonds come in multiple sub-classes in a variety of currencies. Depending on your risk appetite, some bonds may offer potentially lucrative returns versus equities. Tactical bond strategies within the asset class alone can increase returns, reduce portfolio risk, and enhance hedging. You can purchase plain vanilla buy and hold until maturity bonds. Or you can engage in many varied tactics. Bonds offer all things to all investors and can achieve a wide variety of objectives.
I think most investors, even those with extremely long investment time horizons, can benefit with a percentage of bonds in their portfolios. Obviously, the exact proportion fluctuates between individuals, as well as over time for a specific investor, based on unique and ever-changing personal circumstances.
One Other Note
I do suggest taking a look at the PIMCO piece. If you understand all the terminology and concepts, great.
If not, do not worry. The article illustrates what I am attempting to do with my blog posts. Over the next little while, we will lay a solid foundation of investment concepts. Asset correlations, diversification, hedging, etc.
By the time we get into the properties, advantages, and disadvantages of various asset classes, you will easily follow the points. But without the groundwork, probably not as much value diving right into asset class pros and cons.
For example, I tweeted that I tend to favour using bond ladders for the average investor. PIMCO touches on ladders. But when we finish the core concepts and get into fixed income, you will better understand WHY bond ladders may be useful in your portfolio strategies.
To me, it is the understanding why something should be utilized that makes investors successful.
Hopefully, over time, we achieve that together.