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Fixed Income Investment Management
Based on Process and Discipline Behind the Process 

A Few Facts About Bonds And Fixed Income

       •   There are only 2 things to do with money:
     -- Spend it
     -- Invest it

      •   There are traditionally three core areas for investments:

     -- Stocks
     -- Bonds
     -- Real estate
  •  Stocks are all about capital gains.
  •  Real estate is all about location … and rent.
  •  Bonds are all about the income.
  •  And the Bond Market is one big organized and regulated I.O.U. 

  •  Some people always need to borrow money.
  •  Some people like to borrow money so they can buy things today, even though they don’t have the cash today.
  •  Some people seem to always have money that could be invested … if the terms were right.
  •  Borrowers and lenders … those who “want” or “need” versus those who “have.”
  •  When a borrower and a lender come together, they develop a mutual understanding . They create a “bond” between themselves … each one can benefit with the help of the other.
  •  What does the borrower have to offer ? ( interest income )
  •  How good is the borrower’s promise to repay the loan ?
  •  What does the lender want ? ( return of principal and interest income )
  •  What is this I.O.U worth ?
– a 1-day promise ? 
– a 30-year promise ?

The Bond Market
  •  There are two markets:
– New issue market
– Secondary market
  •  There are two types of quality:
– Investment grade
– Junk … High Yield … Speculative
  •  There are two types of bonds:
– Fully taxable at the Federal and State level
– Tax advantaged at Federal and/or State level
  •  There are four ways to invest in bonds:
– Individual bonds
– Mutual funds
– Exchange Traded Products ( ETPs )
– Closed-End Bond Funds
  •  There are six main sectors:
– U.S. Treasuries
 U.S. Government Sponsored Enterprises ( Agencies )
– Corporate Bonds
– Structured Products ( Mortgages and Asset-Backed )
– Municipal Bonds
– Cash and Cash Equivalents

Price Action Of A Bond
  •  Rates change either because the credit quality changes or because the “economy” changes.
  •  The coupon payment does not get interrupted just because the price changes
  •  If interest rates go up because the economy is doing better and the economy is generating some inflation, a bond investor has to be able to live with the fact that the price of a bond or a bond portfolio may go down. But the coupon payment does not get interrupted.
  •  If interest rates go up because the perceived credit quality of the borrower has deteriorated, then the bond investor may have a problem with his loan to this borrower. But perceived deterioration of credit quality does not cause the coupon payment to be interrupted.
  •  Prices change daily. Coupon payments do not.
  •  And the typical bond investor only cares about the coupon payments ( the interest income ), not the daily price change of a bond based on variables outside of his/her control.

Municipal Bond Market
  •  There are two markets:
– New issue market
– Secondary market
  •  New issue market:
– Negotiated
– Competitive
  •  Secondary market:
– Sorted by State
– Sorted by Maturity
– Sorted by Credit quality
  •  There are three classifications of quality:
– Investment grade
– High yield
– Insured
  •  There are three primary measures of relative value:
– Tax-free yield as a percent of Treasuries
– Tax-free yield spread to the MMD scale
– Taxable equivalent yield spread to Treasury curve
  •  There are 4 ways to buy municipal bonds:
– Individual bonds
– Mutual funds
– Exchange Traded Products ( ETPS )
– Closed-end funds 

Corporate Bond Market
  •  The spread may be the most important characteristic of a corporate bond. It theoretically quantifies the credit risk compared to a bond with an assumed zero credit risk ( a U.S. Treasury )
  •  Corporates are priced at a “spread” relative to Treasuries.
  • When Treasury yields go up, spreads narrow (go down); when Treasury yields go down, spreads widen (go up). If Treasury yields are going up then the assumption is the economy is strong and inflation is moving higher. Then the ability of a corporation to make its debt payments are high because business is good, the company is making money so it has the cash to pay its bills ( interest income is a bill that a company has to pay ). If Treasury yields are going down, then the assumption is the economy is doing bad and inflation is not a problem. If the economy is doing bad, then the company is not making money and the company may have a hard time paying their bills. The risk is higher that the company won’t be able to make its debt payments so spreads move wider/higher to compensate for the higher risk. 

Total Return
  •  Coupon + price = total return
  •  Buy a 5.00% coupon at par ($100.00)
  •  Rates are unchanged after 1-year
– Total return = 5.00% ( coupon return of 5% with zero price return )
  •  Rates go up 100 basis points in 1 year
  •  Total return = 5.00% coupon return + price drop of bond ( since interest rates went up prices went down ) resulting in total return less than 5.00%
  •  Rates go down 100 basis points in 1 year
 Total return = 5.00% coupon return + price increase of bond ( since interest rates went down prices went up ) resulting in total return greater than 5.00% 

Income vs. Total Return
  •  Coupon return versus price return.
  •  An account has to make a decision on the preference for income or total return.
  •  What is the importance of an index or a benchmark to the investor ?
  •  How do you select an index or a benchmark ?
  •  Are you willing to see total return numbers below an index ?
  •  Are you willing to see negative total return numbers ?
  •  Does the investor have a budget for realized losses for the bond portfolio 

Who Are the Borrowers ?
  •  U.S. Government – 35% of the taxable market
  •  U.S. Government Agencies – 11% of the taxable market
  •  Corporations – 20% of the taxable market
  •  Mortgage borrowers – 34% of the taxable market
  •  Cities, counties, school districts, States, et. al – 100% of the tax-free market

Sell Discipline
  •  If the investment mandate allows for the sale of a security before its maturity date, a holding may become a candidate for sale as a result of any of the following:
– The issuer’s credit fundamentals begin to deteriorate
– When the individual security no longer meets the portfolio’s investment objective(s)
– When the account must meet an unknown liquidity need
– When the Yield Curve Model or the Duration Model or the Credit Model signals a change in trend and subsequent market conditions 

What Should An Investor Look For In An Investment Manager?
  •  Expertise in the part of the yield curve specific to the liquidity and risk profile of the funds available for management.
  •  Assets under management specific to maturity profile and tax profile and sector profile of funds available for management.
  •  A manger who has been trained to manage money…be very careful of “managers” who are trained to sell bonds.

Success Attributes
  •  Traditional Yield Curve Decision
  •  Traditional Duration Decision
  •  Careful Security Selection
– Credit Quality Perspective
– Relative Value Perspective
  •  Sector Decisions
– Money Market
– Corporates
– Mortgages
– Municipals
– Treasuries
– Agencies
– Floaters
– Structured Notes
  •  Trade Execution
  •  Trading for Total Return
– Realizing Paper Profits
– Reallocation Based on Model Recommendations 

A Bond Investor’s Creed
  •  A bond investor must accept the fact that month-end custodian prices may, and probably will, be different than the original purchase price.
  •  A bond investor should adopt a philosophy of a buy and hold strategy. Selling a bond before its maturity can be justified in certain circumstances.
  •  A bond investor must be able to tolerate a change in the credit rating assigned to an individual security, by one or more of the nationally recognized credit rating agencies.
  •  A bond investor must have a willingness to tolerate month-end custodian price swings based on market events and based on individual security events, as long as the risk to  income and the risk to principal repayment are deemed negligible