Kames Capital Fixed income training September 2011 Scott Jamieson - - PowerPoint PPT Presentation

Kames Capital Fixed income training

September 2011 Scott Jamieson – Head of Multi-Asset Investing Scott Jamieson Head of Multi Asset Investing

What is a bond?

• Loans issued by governments and companies to raise cash
• Level of interest paid/demanded depends on financial strength or quality of issuer
• Once issued, bonds can be traded between investors
• Interest and redemption payments are fixed
• Hence, “fixed income”!
• But their prices rise and fall reflecting the value of the future payments

2

Bond terminology gy

• What does this mean?

– UK Treasury is the issuer

4 75% i th i t t “ ” t

90 100

Treasury 4.75% 2020

– 4.75% is the interest or “coupon” rate

paid so £4.75 is paid each year for each £100 nominal

– 2020 is the “maturity” or

50 60 70 80 90 shflow

y “redemption” date when the loan is repaid at “par” ie £100

• Index-linked gilts have inflation

10 20 30 40 Cas

linked coupon and redemption payments

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Year

3 For illustrative purposes only

Remember the capital structure p

Secured debt Bank debt

Bond holders above shareholders

Senior debt

Governments are recapitalising financial institutions by purchasing preference

Subordinated debt Preference shares

y p g p shares Rights issues

Preference shares Ordinary shares

g

4

y

Prices and yields

• The price is what you pay to receive the fixed cashflows
• Reflects the interest rate investors are willing to lend at

y

• Known as the gross redemption yield (GRY)

– Higher price

=> lower yield

– Lower price

=> higher yield

If h ld th ilt t t it t ill b th d ti i ld t h

• If you hold the gilt to maturity, your return will be the gross redemption yield at purchase
• GRYs are influenced by the economic picture
• But also, other asset classes and supply/demand

5

Why do bond managers talk about duration?

9% 10%

y g

• Duration is an approximate

measure of a 1% yield change on b d’ i Impact of 1% change in yields

ce

5% 6% 7% 8% 9%

a bond’s price

• Duration is a tool to profit from

yield changes L d t d b d h hi h

change in pri

1% 2% 3% 4% 5%

• Longer dated bonds have higher

duration and are more sensitive to yield changes Shorter dated bonds have less

Approximate c

0% 1% 1 2 3 4 5 6 7 8 9 10

• Shorter dated bonds have less

duration and are less sensitive to yield changes

F d Duration (years) A Yield Expectations Fund duration

6 For illustrative purposes only

What is a corporate bond?

• Bond issued by a company
• Ranks above shareholders in the event of insolvency

( )

p

Credit C

(but no voting rights)

• Rated by rating agencies on ability to make future

payments Yi ld hi h h il d di i k

Credit spread Corporat

• Yields higher than gilts due to extra credit risk –

known as “credit spread”

• Corporate bonds can have special features to

t f th dditi l i k

Gilt yield te bond

compensate for the additional risks

• Known as “credit”

Gilt yield yield

7

UK corporate bond exposure p p

5 52% 1.11% 10.61%

Telecommunications Travel & Leisure Utilities

0 97% 1.70% 1.60% 2.51% 5.52%

Media Oil & Gas Personal & Household Goods Retail Telecommunications

1.71% 1.42% 5.55% 0.63% 0.97%

Health Care Industrial Goods & Services Insurance Insurance-wrapped Media

0.48% 0.41% 4.96% 1.02%

Chemicals Construction & Materials Financial Services Food & Beverage ea t Ca e

0.27% 19.28% 0.37%

Automobiles & Parts Banks Basic Resources 0 00% 5 00% 10 00% 15 00% 20 00% 25 00%

8 Source: iBoxx as at 2 September 2011

0.00% 5.00% 10.00% 15.00% 20.00% 25.00%

Ratings g

• Ratings are an independent

assessment of the issuer’s credit thi

700 800

Sterling credit spreads

worthiness

• AAA the strongest down to D
• Issuers rated below BBB are non-

i t t d hi h i ld

400 500 600 d (bps)

investment grade or high yield and are more risky than investment grade bonds

200 300 400 Spread

Sample bonds

AAA Network Rail 4.625% 2020 AA Wal Mart 5 625% 2034

100 Jan 03 May 03 Sep 03 Jan 04 May 04 Sep 04 Jan 05 May 05 Sep 05 Jan 06 May 06 Sep 06 Jan 07 May 07 Sep 07 Jan 08 May 08 Sep 08 Jan 09 May 09 Sep 09 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11

AA Wal-Mart 5.625% 2034 A Verizon Wireless 8.875% 2018 BBB Imperial Tobacco 9% 2022

AAA AA A BBB 9 Source: iBoxx & Barclays as at September 2011

Why go global?

• Sterling market is relatively small!

y g g

3 40% 5.9% 3.40% 24.70% 12.80% 8.40% Gilts Sterling Corporate Bonds Euro Government Euro Corporate Bonds US Treasuries S$ C 18.00% 26.90% US$ Corporate Bonds US$ Sovereigns/ Sub Sov's

10 Source: Barclays, iBoxx, Bloomberg as at May 2011

Going global – bond selection opportunities g g pp

Vodafone

Total of 41 bonds

USD: 21 JPY: 1 GBP: 5 EUR: 12 CZK: 1 AUD: 1

EDF

T l f 8 b d

HSBC Wells Fargo & Co Total of 600 bonds

Total of 58 bonds

USD: 12 JPY: 7 GBP: 8 EUR: 22 FRF: 2 CHF: 7

HSBC Total of 2074 bonds

11 Source: Bloomberg as at May 2011

USD: 12 JPY: 7

Global bonds – 3 elements of risk/return

• Credit spread

– Does the credit spread offer value relative to the credit risks?

H d it i t th ’ th b d ?

– How does it compare against the company’s other bonds? – Does it offer value relative to other companies’ spreads? – [Kames Capital approach; only hold bonds where we see value in the credit spread]

• Duration
• Duration

– How does the bond’s duration affect overall portfolio duration and curve? – Does the bond provide duration in an economy where we want exposure? – [Kames Capital approach; find a bond that meets requirements or adjust with futures]

[ p pp ; q j ]

• Currency

– Will the bond’s currency appreciate relative to sterling? – Is the risk of depreciation greater than the potential reward? – [Kames Capital approach; usually to hedge, taking occasional small non-£ positions]

12

Factors affecting bond market returns – general

• Interest rate expectations
• Inflation/recession

g g

• Credit rating downgrades/upgrades
• Government budget deficits
• Extraneous (war/disaster/political uncertainty)

13

What is a high yield bond?

• Rated below investment grade at the time of issue
• They have a higher risk of default but typically pay higher yields than better quality bonds

g y

to make them attractive to investors

• Issuance is disproportionately centred in the US although issuers in Europe, Asia and

South Africa turning to high-yield debt in connection with refinancing and acquisitions Th ibili f d f l i h bi i k

• The possibility of default is the biggest risk
• In a recession interest rates may drop which tends to increase the value in investment

grade bonds; however a recession tends to increase the possibility of default of sub- i t t d b d investment grade bonds

• Other risks are downgrade risk, liquidity risk and economic risk

14

Emerging market debt (EMD)

• Bonds issued by less developed countries and primarily issued by sovereign issuers
• Corporate debt does exist in this category but they tend to borrow from banks and other

g g ( )

sources

• EMD tends to have a lower credit rating than other sovereign debt because of increased

economic and political risks. Most EMD is rated below investment grade Th k i i h h d b k i l di h T il C i i i

• The market is more prone to crises than other debt markets including the Tequila Crisis in

1994-95, East Asian financial crisis in 1997, 1998 Russian financial crisis and Argentine economic crisis in 2001-02 I di id l iti b illi id i d k t d bid/ ff d

• Individual securities become more illiquid in secondary markets and bid/offer spreads are

too wide to actively trade therefore investors tend to use mutual funds

15

Floating rate notes

• Bonds with a variable coupon linked to a reference rate of interest such as LIBOR, Euribor
• r federal funds rate plus a spread. The spread remains constant

f

g

• Almost all FRNs have quarterly coupons. The coupon is calculated by taking the reference

rate for that day and adding the spread

• In the US, government sponsored enterprises such as Federal Hone Loan Banks, Federal

N ti l M t A i ti (F i M ) d th F d l H L M t National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are important issuers. In Europe, the main issuers are banks

• FRNs carry little interest rate risk, have a duration close to zero and their price shows low

sensitivity to changes in market rates Therefore they are considered conservative sensitivity to changes in market rates. Therefore, they are considered conservative investment for investors who believe markets rates will increase

• They are not immune to credit risk

They are traded ‘over the counter’ rather than on a stock exchange In Europe they are

• They are traded ‘over-the-counter’ rather than on a stock exchange. In Europe, they are

liquid, however in the US, as most FRNs, are held to maturity the market is less liquid

16

Asset backed securities (ABS)

• A security whose value and income payments are derived from and backed by a specified

pool of underlying assets f f

( )

• The pool of assets is typically a group of small and illiquid assets that are unable to be

sold individually. Examples include common payments from credit cards, car loans, mortgage loans to esoteric cash flows from aircraft leases, royalty payments and movie revenues revenues

• Rating agencies rank ABS according to their default potential
• They can be very risky as there are two, not necessarily related sources of risk. Interest

rate risk (the value of the assets fluctuate according to interest rate levels) and the rate risk (the value of the assets fluctuate according to interest rate levels) and the unpredictability of defaults on loans that are the collateral for the debt. Thus the value of ABS can be very volatile

• Investors buy them to provide a unique risk reward pattern that might add further
• Investors buy them to provide a unique risk reward pattern that might add further

diversification to a portfolio

• A mortgage backed security (MBS) is an asset backed security that represents a claim on

the cash flow from mortgage loans the cash flow from mortgage loans

17

Not all bonds are the same

Index-linked Government Government

Credit Interest

Floating Rate Notes

Credit risk Interest rate risk

Investment Grade Corporate Bonds High Yield (EM) Government Bonds High Yield (EM) Government Bonds High Yield Corporate Bonds

18

Convertibles/ Preference Shares

What’s what?

IL Govt Bonds Govt Bonds £ Corporate Bonds £ High Yield Bonds Global Bonds

Good for Inflation protection/ diversification Diversification/ Income/ Lowest risk Diversification/ Income/ Low risk Diversification/ Income/ Rising interest rates/ Medium risk Diversification/ Higher risk/ Weakening £ diversification risk Medium risk Bad for Deflation protection Rising interest rates/ High inflation Rising interest rates/ High inflation Recession/ Rising defaults Low risk investment/ strengthening £ Best for Inflation protection Diversification Low risk income Income/ Medium risk investments Diversification

19

Appendices pp

20

What’s what?

Name Features Fixed rate bonds Have a coupon which is fixed throughout the life of the bond I d b th t d t d t d f lt i k Ch t i d th f t b d ith th l t Government bond Issued by the government and not exposed to default risk. Characterised as the safest bond with the lowest interest rate and often referred to as risk-free. Government bonds issued is the US are called Treasury Bonds. Floating rate notes (FRNs) Have a variable coupon linked to a reference rate of interest such as LIBOR or Euribor. Coupon rate is recalculated periodically, typically every one to three months Zero coupon bonds Pays no regular interest. Issued at a substantial discount to par value. The bondholder receives the full principal amount on the redemption date. I fl ti li k d Principal amount and interest payments are indexed to inflation. The interest rate is normally lower than for fi d t b d ith bl t it h th i i l t th t i Inflation linked bonds fixed rate bonds with a comparable maturity, however as the principal amount grows, the payments increase with inflation. Treasury Inflation-Protected Securities (TIPS) are inflation linked bonds issued by the US government. Asset backed Bonds whose interest and principal payments are backed by under lying cash flows from other assets. An securities example is a mortgage-backed security (MBS) which represent a claim on the cash flows from mortgage loans. Emerging market debt Bonds issued by less developed countries and primarily issued by sovereign issuers Convertible/ preference shares Lets the bondholder exchange a bond to a number of shares of the issuers stock

21

Market value of Sterling bonds (£ billion) g ( )

260 25 Gilts Corporate bonds Index-linked gilts Corporate index-linked 826 475

22 Source: iBoxx & Barclays as at May 2011

Important information – Asset Allocation Service (AAS)

This presentation relates to the AAS provided by Kames Capital plc. The AAS is subject to the terms of an investment management agreement between Kames Capital and a pension fund selecting the AAS and subject to such disclaimers, notices, warnings or separate agreements, including those set out below, as Kames Capital may communicate to you or agree with you. THE CONTENT OF THIS PRESENTATION IS DESIGNED FOR THE PROFESSIONAL PENSION FUND MARKET. IF YOU ARE NOT AN INVESTMENT PROFESSIONAL OR

p ( )

A PERSON PROFESSIONALLY INVOLVED IN OR HAVING RESPONSIBILITIES RELATING TO PENSION FUND MANAGEMENT YOU SHOULD NOT ACT UPON IT. This presentation is directed only at persons having professional experience in matters relating to investments falling within article 19 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 and high value entities or trusts falling within article 49 of that Order. Consequently, Kames Capital has not approved the content of this presentation for the purposes of section 21 of the Financial Services and Markets Act 2000. No other person should act upon this presentation or any information contained in it. Kames Capital has procedures in place to ensure that no instrument or investment activity referred to in this presentation is available to any other person. Th t t f thi t ti h b d l l f i f ti A t t t f t t f d t ti t j ti i l d d i th The content of this presentation has been prepared solely for information purposes. Any statements, forecasts, past performance data, estimates or projections included in the presentation are for illustrative purposes only and may be provided by Kames Capital or third parties. Any view, opinions or statements made in or in relation to this presentation should not be interpreted as recommendations or advice. Past performance is not a guide to future performance. The value of investments and the income from them may fall as well as rise and there is no guarantee that the AAS will achieve the objectives described in this presentation. No investment advice or tax advice is being given in this presentation. Nothing in this presentation should be regarded as an offer to provide investment services or products or as a comment on the merits of engaging in any investment transaction or activity or an inducement to do so. The content of this presentation is subject to change and correction g g g y y p j g without notice. Kames Capital does not represent that (i) the content of this presentation; (ii) any investments or investment services referred to in this presentation; or (iii) any oral or written statements provided by or made by Kames Capital or persons connected with it are suitable for or relevant to you. Kames Capital is an Kames Capital company and includes Kames Capital plc (no: SC113505) and Kames Capital Management Ltd (no: SC212159). Both are registered in Scotland and have their registered office at 3 Lochside Avenue, Edinburgh Park, Edinburgh, EH12 9SA. Kames Capital plc is authorised and regulated by the Financial Services Authority (FSA reference no: 144267). Kames Capital plc provides segregated and retail funds and is the Authorised Corporate Director of Kames Capital ICVC, an Open Ended Investment Company. Kames Capital Management Ltd provides investment management services to AEGON, which provides pooled funds, life and pension contracts. Kames Capital Management Ltd is an appointed representative of Scottish Equitable plc, an AEGON company, whose registered office is 1 Lochside Crescent, Edinburgh Park, Edinburgh, EH12 9SE (FSA reference no: 165548). Kames Capital UK rebranded to Kames Capital on 1 September 2011.

FP ID: 2011/12315 23