Fixed Income Essentials By: Gabriel PotterMBA, AIFA® 2013.10.03
The Basics on Bond

This will be basic for most investors, but here is a quick summary of bond investing.  In essence, a bond is an I.O.U.  When you’re buying a bond, you are lending someone money and asking them to pay you back in the future. 

So, imagine you are interested in investing in bonds.  In other words, you’re going to be loaning money to institutions, like the U.S. Government or various corporations.  There are three key questions to answer:

1. Why do bond buyers lend money?

Answer:  Whether measured by the coupon (say 5% of the face value) or the current yield (the coupon divided by the ever-changing market price of the bond), the interest payments compensate the lenders for loaning the money to bond issuers.

2. Will bond buyers get their money back?


Answer:  The odds of getting the money back are estimated, by proxy, with the credit quality rating of the borrower, from AAA to junk bond issuers.  Interest payments are higher for high risk borrowers.

3. How long until they get their money back? 

Answer:  The maturity of the last payment is noted on the bond.  Other timing related measures, like duration (the sensitivity of the bond’s value to interest rate changes) are standard but, put simply, interest payments are higher for longer maturity or duration bonds. 

The Traditional Framework

Since interest payments are primarily a function of the credit quality and the maturity of the bonds, traditional bonds are categorized with these metrics and organized into a literal grid.  Investors can see where typical bonds show up in this framework, provided here with some examples:

90 Day Treasury Bills

 

Long Treasury STRIP Bonds

High Quality (AAA)

 

U.S. Aggregate Bond Index

 

Medium Quality

 

High Yield Corporate Credit Bonds

 

Low Quality

Short Duration

Intermediate

Long Duration

Any investor can categorize bond investment vehicles (mutual funds, ETFs, SMAs) by visiting Morningstar.com and researching how a specific fund fits into this framework.  For traditional bond offerings – US Treasuries, Agency Mortgage Backed, Investment Grade Credit - this framework is adequate, but this method for delineating types of bonds becomes less useful once we stretch into less traditional investments.

Off the Grid:  Beyond the Basic Categories

A line - a spectrum - can be used to categorize bonds along a single variable; a grid is useful for visualizing differences along two variables. However, there is an underlying danger to the system:   by presenting investible options in the grid, an investor could be misled into thinking that their holdings are now comprehensive and diverse simply by selecting investments from each sector of the box.   For traditional bond offerings, the grid framework is adequate, but this method for delineating types of bonds becomes less useful once we stretch into less traditional investments with deeper underlying diversity.

International Bonds

Here is a simple variable that many investment houses are now adopting as a bare minimum for diversity – in both equity and fixed income – that simply does not exist in the grid system:  international holdings.  For equities, the home country bias has been steadily easing over the past few decades, but only within the past 5 years have international bonds gained significant attention.  Once seen as exotic, international fixed income is now a common feature to balanced portfolios, such as target-date retirement series or target-risk models. 

Certainly, a simple international fixed income product can on be placed the grid, but the risks and opportunity sets are clearly different than US-only portfolios.  For instance, imagine two companies with similar quality rankings - a Canadian energy utility and a German automaker – are both issuing bonds with the same maturity and coupon.  These two bonds might end up in the same square within the grid, but the risks may be different depending on the fundamental forces affecting each company or the currency effects if the bonds are paid with local currency.  (Foreign issued bonds can pay bond-owners in multiple currencies; e.g. a Eurodollar bond pays, naturally, in US dollars.).   International bonds have continued to segregate into even smaller categories – emerging market vs. developing market bonds – as the investors become comfortable differentiating funds based on risk profiles.  Soon, this may split further with Emerging Market - Corporates claiming a category.

Categorization Error:  fixed income components within a larger strategy

Amateur investors might see a mutual fund placed on the fixed income grid and assume, wrongly, that the product must therefore be a fixed income strategy. There are many products that get placed on the fixed grid, but they defy simple categorization.  For example, ultra-short equities or leveraged debt products may have short term fixed income (cash equivalents) to hedge or to finance the underlying strategy; real-return products, designed to best inflation, often buy futures contracts for real assets (i.e. - precious metals, agriculture commodities, etc..) and they may use high-quality bonds to collateralize these purchases, often structured to coincide the final bond maturity with the futures contract expiration date.  So, these exotic products have fixed income components within the entire portfolio that could, rightly, be placed on a fixed income grid.  However, the overarching strategy is not remotely a reflection of the fixed income market. 

 

Categorization Error:  incomparable strategies in the same box

Even within the traditional core bond holdings, traditional bond managers often rotate their holdings between different sectors to find the best relative value for their investors.   For example, Treasury Inflation Protected Securities (TIPS) are structured to provide protection against inflation, but their underlying quality (and maturity) could be identical to the most basic US Treasury bond.  Thus TIPS and Treasuries can end up in the same grid box.  However, the differences between the yield, aka the “TIPS Spread”, reflects the underlying market assumptions of inflation during the time horizon; the mere fact that the spread changes reflects the existence of relative value between the two, superficially identical, assets.

Beyond traditional core bonds, there are also strategies with fundamentally different mechanics which should be recognized. For instance, short-duration, low credit quality debt currently share the same grid box with Bank Loan funds.  However, Bank Loans have the ability to change the underlying rate of interest being charged and, for this reason, they are popularly known as Floating-Rate funds. Thus, Bank Loans are materially distinct from other debt funds because they have the ability to protect investors from rising interest rates. 

Active Management Mandates:  another spectrum for differentiation

Active management adds another element of differentiation that isn’t accurately reflected by the grid.  The declared goal of a portfolio manager – his mandate – often prescribes a scope for their behavior.  Many traditional managers may end up with their products within the same space of a grid, but they may have defined their mandate as Core or Core-Plus.   A core portfolio is almost exclusively traditional investment grade fixed income debt, but a Core-Plus fund can add a portion (say, 25%) of more aggressive, or at least idiosyncratically risky, fixed income instruments like high yields (which often correlate more to equity rather than debt markets) or emerging market debt.

For investors willing to accept greater risk diversity, there are funds in the Multi-sector category with an even greater proportion of atypical assets like foreign government & corporate debt or exotic mortgage backed securities.  Although technically open to a variety of strategies, multi-sector bond funds generally have some relation to a universal bond index.  For those funds that have eschewed any adherence to an index, Morningstar created the non-traditional bond category late in 2011 to describe products that diverge drastically from conventional mandates.  Non-traditional funds often are described themselves as “unconstrained” to any index and often focus on an absolute return strategy rather than a relative return strategy.  In other words, non-traditional funds try to make money no matter what any particular bond index is doing while a more traditional fund is generally trying to outperform, while keeping risk and return characteristics on par with a benchmark. 

Core

Core-Plus

Multi-Sector

Non-Traditional

Traditional Risk

<---------------------------------

--------------------------------->

Exotic Risk



Problems with the traditional grid

The grid itself is worthy of scrutiny.  Let us consider the vertical axis: credit quality.  Prior to the financial crash of 2008, the credit worthiness of municipals, US Treasuries, and select tranches of sub-prime mortgage pools was often equally high, with tragic results.  Furthermore, credit quality ratings themselves warrant a challenge since there is a well-documented conflict of interest between statistical rating organizations (e.g. - S&P, Moody’s) and the bond issuers who pay to get a credit rating for their bonds.

The horizontal axis of the grid is duration.  Without delving into the complexities, there are a variety of bond duration measures that don’t fit into the grid structure.  As a very clear example, there are many non-traditional products that, given the current low-interest rate environment, have set up portfolios of bonds with negative Empirical Duration.  A negative empirical duration portfolio would literally be placed off the grid; it simply can’t be depicted in the traditional diagram.

Moving Forward

As we’ve implied in our previous newsletter, “A Sea Change in Fixed Income”, there are reasons to expand fixed income exposure beyond the traditional framework.  We hope, having read this paper, that our readers understand a little more about what some of their options are and how they fit together.  Please feel free to contact us for details or with any questions you may have.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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