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0:00
hello welcome back my name is Patrick Boyle and I'll be teaching applied portfolio management today and so this is class number four of my series and as I mentioned earlier the first half of the series is all about traditional asset management and the second half of the series will be about alternative asset management and so this is lecture number 4 the final one of the first half so so the next classes after this will all be about alternatives so today we're
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going to be learning about fixed income investment management now obviously if you haven't seen the other the other videos you should watch those ones first of what we covered risk and return asset classes and equity investment management today we'll be learning all about fixed income and fixed income basically is bonds but unfortunately not these bonds not James Bond but investment bonds it's it's a less exciting video than you you might have hoped for so we'll learn what
1:07
is fixed income we'll learn how fixed income securities are valued we learn about the sources of risk in fixed income portfolios and then we'll also learn about passive active and other investment strategies that people might follow when investing in bonds so the first thing we're going to talk about is just what is a bond and a bond is alone usually it's it can be alone to a company and we call that a corporate bond or it can be alone to a country and then we'll call that a government bond
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and basically there's a lot of terminology around bonds but originally they would have been issued as paper securities like what you see on the screen here right now and and and we have terms like the coupon payment of a bond and the reason they were called coupons is originally bonds had these little coupons attached to them where the interest could be paid and so you would cut off these coupons bring them into the bring them into the issuer and they would send you the money that related to
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the interest payment on that bond so these were coupon bearing bonds and and that is how they worked and that's why they're actually called coupons where we talk about the interest payment on a bond as being a bond coupon and so you'd bring all of these one by one in as they mature and you would receive that interest payment and then finally when the bond comes due when our expires you bring the the top half in and you would receive back both your principal and the
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final interest payment so that is a bond so fixed income refers to all securities to provide our promise to provide contractual payments during their lifetime so instead of being like an equity that we talked about in the last class which is ownership of a company this is a loan to a company from an investor and the investor has bought these bonds lending money to the company with the idea of getting these fixed income payments so getting contractual payments that will arrive over the life
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of the bond and so fixed income securities often make regular payments of interest so they might be quarterly semi-annually or annual coupons now not all bonds do pay coupons we also have a thing that's called a zero coupon bond and that is a bond that's issued at a discount so it might be will say issued at nine hundred dollars and in a few years time when that bond matures you can you can get you can redeem the bond for we'll say a thousand dollars its face value so it's bought at a discount
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and then then the when it matures you get a larger sum of money back but there's no interim payments there's no coupons so what else have we got here bonds notes and some money marketing instruments are all classified as being fixed income instruments some are variable interest so even though they're called fixed income the payments may not be fixed an example of that would be something like what's known as tips which are Treasury inflation protection securities and the
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the the coupon that you receive on those those type of bonds relates to the level of inflation that's observed in the economy over the life of Treasury inflation protection security or tips so that is sort of a quick introduction to what bonds are and so let's now talk about why someone would want to own these well there's a few reasons we've got up here diversification income and opportunity so diversification is essentially that within an investor's portfolio there there might be a bunch
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of different securities and we talked about that in in yesterday's class which was on the topic of asset allocation but essentially high-quality bonds are often painting play an integral role in an investment portfolio simply because they tend to not be correlated to other investments like we'll say equities for example and so that might overall reduce the risk of a portfolio both from the diversification point of view and also just because often bonds are lower risk
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than stocks now that's not always the case there's also things like like a high-yield bond which are often also referred to as junk bonds that's sort of a kind of a slang terminology for them and they will be bonds that are issued by riskier issuers and those bonds will have quite high yields and might actually give you a similar return to equities but equally in in a good economic environment they'll do well in a bad economic environment they won't do well so that is the first argument as to
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why you might own bonds which is simply diversification the next reason that you might want to own bonds is income and that's sort in the name fixed-income securities and there's a lot of investors that just want to receive a certain cashflow from their investment so we'll say certain investors like that they might invest in bonds they might invest in things like rental properties or they might invest in high dividend stocks but the reason they're investing in any of these three
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things are at least one of the reasons is that they aim to receive these these cash flows that are associated with it and we'll say for example a retired person might quite like having a portfolio of bonds because it simply means that they'll receive maybe a quarterly or semi-annually that they'll receive a cash flow basically that they can maybe spend in order to fund their lifestyle so that is a big reason that certain investors like to invest in in bonds now another reason is just
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security and that often bonds are a safer investment than stocks because they are a loan to a company and as I explained in the last class when we talked about asset classes the idea of that is that a lender to a company usually gets paid first before the owners of a company get paid so they're higher in the capital structure and thus a safer investment usually than done a stock so if a company's issuing bonds on stock usually the the bonds are a safer investment but equally they'll
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have a lower expected return and then finally we have here opportunity and so at certain times certain sectors of the financial market might be more attractive than others and so as the economy is changing investors might feel it's reasonable to invest in bonds simply to take advantage of a likely change in interest rate so if you own a bond and the interest rates go down the value of those bonds that you own would be expected to go up and we'll talk about that a little bit more later
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but that is another reason people might invest in bonds is basically to to get our earn out of their prediction of likely future interest rates in the economy and so bonds can add a measure of stability to a diversified portfolio while potentially delivering steady ink and that's kind of how people think about bonds when they invest in them so our next slide is on the basic features of bonds so what how how are how do people look at bonds how are they differentiated from each other so a bond
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is usually a contract where there's an interest payment and an unexpected maturity of that bond now that's not always the case there are certain things like credit card receivables that are really more of an asset-backed security than a bond but they would usually be classified as fixed income as well and they they don't ever mature but most bonds do they can be senior or junior bonds and so a senior bond means that it's higher up in the capital structure and will be the first to be repaid while
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a junior bond might have other bonds ahead of it in the capital structure and so whenever that is the case the senior bond is the safest investment but will usually earn a lower rate of interest in it than a junior bond so junior bond is higher risk higher return the a bond can be collateralized or be a debentures of collateral is when certain assets are set aside as being there for the bondholders and they're essentially to make the bonds more secure and the
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debentures is essentially an unsecured bond so there's no assets necessarily underlying the the bonds are nothing has been set aside as being there to securitize the bond and so a debenture is really purely its value is purely based upon the creditworthiness of the issuer there can be things like a sinking fund where for example if if money is coming in we'll say a good example of a sinking fund bond would be there's a lot of me the bonds in the United States and as
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the the municipality brings in money they set it aside and it goes into a fund to eventually pay off the the the bond and so that can be part of the structure of a bond the bonds can be callable or portable so a callable bond this is sort of relating to options that are embedded within the bond and if if you don't know much about options I do have a series a class on derivatives so you can watch learn what a : apud is but with regards to bonds a callable bond is
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a bond that if you are the borrower you're able to pay off that bond early if you wish to we call that a callable bond usually the interest rate will be higher on a callable bond but the borrower is able to pay it off early should they wish or a bond can be portable and that means that the investor gets to demand early repayment of the bond and so these are two features that can be part of a bond and obviously they will affect the value of a bond now an example of a callable bond
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is often an awful lot of mortgages are callable and that really just means what when someone borrows money in order to buy a house they they take the money and they buy the house but we'll say for example if interest rates fall a lot that borrower is often able to pay off that mortgage and refinance at a better interest rate so that would be a callable loan a mortgage would be and so a bond can be structured similarly where it's callable and so if interest rates
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go down the the borrower is able to refinance at those lower interest rates and will pay off the pay off the lender now of course that's an attractive feature to a borrower and an unattractive feature to a lender and so will demand a higher interest rate to compensate them for the fact that should interest rates fall they're likely to be paid off in full and then they'll have to reinvest their capital at the new lower interest rate there's other types of bonds like convertible bonds of where
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the bond can be converted into equity in a company and we'll we'll talk about that in a little while as well and then there's all kinds of other things there's floating rate bond zero coupon bonds that I've already explained tips which are Treasury inflation protection securities that I've already explained and other features like a ratchet bond which will we'll talk about in a little of water so bond ratings so a bonds usually are issued by either a company or by a government and often they are
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rated by a ratings agency now that this has become more of an issue in recent years since the credit crunch because during the credit crunch an awful lot of highly rated bonds turned out to not not to warrant those good ratings and the ratings agencies have been sort of called into question by an awful lot of investors but the the rating is essentially an assessment of the creditworthiness and the quality of these bonds it's worth noting that issues are rated not company so there's
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no such thing really as a triple-a company if there might be a company that issues a triple-a bond but a company often issues a lot of bonds and based on the features of those bonds they will have different credit ratings so the credit rating that you hear with regard to a bond is for a given bond issue not for an issuer there are a bunch of different read ratings agencies the well-known ones are Standard and Poor's Moody's Fitch and so on and there's there's dozens of them in truth the
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best-known ones are often the that that get the most volume of transactions now it's worth noting when we talk about bond ratings who pays for the rating of the bond well it's actually not the person who's investing in the bond they don't you know go to a ratings agency and ask will you rate this bond that I'm considering buying instead the issuer of the bond goes to the ratings agency and asks for a rating on that bond now of course there is a bit of a conflict of interest in there
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and we saw that during the credit crunch when a lot of credit derivatives were were rated by these ratings agencies and and it turned out to be problematic and so there there is this issue associated with with bond ratings where the person issuing the bond pays for the rating and you have to imagine then that the problem is that the the issuer but you know the rating agency will view the bond issuer as their customer rather than the user of that rating and so that
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can be problematic it's there there is a conflict of interest in there there's a bunch of different the classification of different rankings of these bonds or ratings and certain ones are considered investment grade and others are considered junk or speculative grade bonds now you might think well why does that matter there are certain investors and they are required to only invest in investment grade bonds so we'll say things like insurance companies and pension funds may not be allowed to
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invest in speculative grade bonds and therefore this rating will matter an awful lot and should a bond get downgraded from being investment grade to junk rating certain types of investor will be required to actually sell that bond because they're not allowed to own it what else ratings changes in value so sometimes a bonds rating will change it might be issued as we'll say a triple-a or a Double A or a high-quality bond and we'll say for example if the company
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goes through hard times things aren't going well that bond might be downgraded and that both happens for corporate bonds and for government bonds and we'll talk about that again in a few minutes so here we have the two biggest credit rating agencies Moody's and S&P or standards and Poor's and so they have different ratings that they use you know the triple-a it's kind of from Moody's its capital a lowercase a lowercase a on first under pours it's three capital A's
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is the highest rating for either of these rating agencies and then as we move down it's sort of B a or BB and below that are classified as being the high-yield or junk bonds or speculative bonds and so that's sort of our big difference now the different rating agencies like I said they use different sort of letters are the different capitalization or whatever it might be to describe the quality of the bonds of people sometimes need to translate between these two things but you'll
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often hear people talking about a triple-a bond and that is the highest the highest quality so we've got triple a double a a for certain standard and poor's the next one is called a and for Moody's it's a one and then a and then we move to be a a 1 and B a a and so on with with Moody's well with with standards and Poor's it moves to triple B BB so on and so forth so that is bond ratings and they matter an awful lot and when a bond gets gets moved up a rating
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that means that it's a better bond and you would expect its value to increase and when it gets downgraded you would expect the bonds value to decrease so then this us to the idea of credit or the four C's of credit and said the four C's of credit you'll often hear you know fixed income people talking about the four C's and they are character capacity capital and collateral and these are the four things that make up you know I I guess an indication of the quality of a bond
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so character refers to the financial history of the borrower what kind of financial citizen is this business and it's almost like a credit score of an individual for example it's the it is essentially tied to the willingness of a company to repay and their history of being a good credit and so that's character the next one is capacity which refers to their ability to generate the cash flows in order to pay off the bonds and so so the first one I guess is do they want to pay in the second one is
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are they financially capable of paying the next one up is capital which is the capital assets of the business and that's essentially you know it might be things like machinery and equipment within a manufacturing company or it might be inventory or something like that for another type of business but it is the the the stuff that's there that's a value within that business and now that that is different to collateral which is our next thing because collateral is cash and assets that are
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pledged to secure a loan okay so collateral is something that's been pledged to secure a loan in the in a prior slide I explained the difference between a debenture and a collateralized bond so sometimes you might capital is there as something that exists that can of course be liquidated in order to pay off the bonds but it's classified differently if classified as collateral when it's been specifically set aside maybe for a specific bond and so this kind of rates by our links back to what
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I explained I think I'm the law we're we're a company doesn't have a credit rating a bond does and the reason for that is that maybe one bond is collateralized and another bond might be a debenture which is an uncollateralized bond and so it's reasonable even though it's the same bond issuer to to rate those two bonds differently because their their structure is quite different so that is the four C's of credit so bond ratings this is the outline from Standard & Poor's as to how they rate
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bonds and so we've got up here the first thing they do is industry analysis where they look at the industry risk the market position of the company and the operating efficiency of the company so that's the first thing they do is an industry analysis then they look at management they evaluate the quality of the management of a company and then finally financial analysis which will look at earnings protection financial leverage asset protection cash flow adequacy financial flexibility and
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accounting quality so these are the things that standard & poor's tells you they look at when they are rating a particular bond so this slide here is a slide I usually I teach this class every year in each year I had a different version of this slide and this one here is news from what is this February 21st 2020 Lebanon slumped by double downgraded as bond default looms so and this is essentially something that happens every year it's just usually a different country I think last year
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South Africa was my example and Lebanon was downgraded deeper into junk by two of the three biggest credit rating agencies on Friday as the nation's bondholders braced for a potential default next month so sometimes you know certain issues get downgraded I mentioned that earlier this is an example of it that's happening in the news right now and if you're interested you can follow the news about Lebanon's economy and what's going wrong there but essentially it looks like Lebanon will will not be
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capable of paying off a lot of the bonds that they have issued and so this is a thing that happens from time to time in fact it really just happens all the time and it's worth paying attention to and so just because you buy a bond that is highly rated now I Lebanon spawns we've never been highly highly rated but they would have been higher rated than they are right now and then just because you buy that doesn't mean it stays that way and so obviously as Lebanon's financial
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position looks shaky ur in this current economic environment the bonds get downgraded and when the bonds get downgraded they are less valuable and of course the downgrade is just tied to the fact that it seems very unlikely they'll be able to pay off their debt and so that is something that happens now equally other countries or other issuers will get upgraded from time to time and of course an upgrade means that the bonds become more valuable and so if you're an investor you always want the
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bonds that you have invested in to be upgraded because they increase in value and not not downgraded because that will that will decrease the further and it says here Lebanon's bond rating is now below the likes of Argentina Mozambique and the Democratic Republic of Congo and so you know this is this is what is happening in the news right now and so a bond investors will of course be following all of this news so here we have kind of an interesting slide this
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is the most recent when I was able to get but it's I think a year or two old from Moody's and this is a one year transition matrix and if you're interested in this you can also google Moody's have a five-year transition matrix on there their website as well but let's just take a look at this so up here we have a current rating and rating one year later so it's really about what percentage of bonds get upgraded or downgraded over time and so if we look here so this years are the
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current rating of triple-a roughly one year later 89% of bonds are still triple-a so that means some of them are falling now got 3% get downgraded to a a1 which is down one step and another 3% move down two steps to a a2 and then there's no big gaps down other than that now you'll see over here W or which stands for without rating and to explain that there's certain bonds that just sort of disappear because they've been paid off or something like that so 5% are just no longer available okay so
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that's nothing bad has happened Bob has probably been paid off or it might have been a callable or potable bond and it's been called or a PUD and it's gone and so it's roughly 89% stay the same but it's really just 6% that actually got downgraded there the rest of just we don't know what's happened with them we've got here an a1 which is the next step down and you can see that 3% god upgraded to triple-a 5% got downgraded to a a - another 5% got downgraded to a
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a 3 and 5% are listed as WR so it's 82% stayed the same so as you can see you know there's a few interesting things if they're obviously a triple-a bond is the safest bond but the only thing that can happen to that is it can be downgraded it can never really be upgraded because it's at the top the as we move down will say if we move to a a to a 79 percent stay the same 3% move up one step and one percent move up two steps and so I won't read out this entire chart to you
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but as you can see here most of the bond typically stay roughly the same one year later some get upgraded some get downgraded and of course as I said earlier you want your bonds to be upgraded not downgraded if you own them so that is that credit spread so the next thing we'll talk about is is credit spread and credit spread is obviously a big part of fixed income investing now the credit spread is I guess I won't read it off the slide I'll just tell you the credit spread of
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a bond is the yield difference between a risky bond and a risk-free bond so we'll say for example if we've got a government bond that's a yielding 3% and there's a corporate bond that's yielding 5% now the difference between 5 & 3 is 2% and we call that difference to credit spread because it's the additional interest that has to be paid in order to compensate an investor for taking that additional risk of moving from a risk free bomb to a risky bond so that is
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that roughly the idea of credit spread but of course there's a bunch of different ways that we can analyze credit spread or look at it so what's my definition here you know credit spread is the yield spread or difference in yield between different securities do two different credit quality and the credit spread reflects the additional yield an investor can earn from a security with more credit risk relative to one with less credit risk the credit spread on a particular security is often
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quoted in relation to the yield on a credit risk free benchmark security and as I mentioned there are several measures including Z spread and option adjusted spread and so I'll try and explain this quote ez spread is a type of spread that adjusts for the fact that each coupon should in theory be be earning adieu should be present valued at a different interest rate than the the final prints because if you think about a bond if it's paying coupon coupon coupon coupon
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and then principle plus coupon the the interest rate that you get on that bond will be a weighted average of the applicable interest rate for each of those different holding periods and so the Z spread adjusts for that the the option adjusted spread adjusts for bonds that might be callable or potable because as I said earlier you know a callable bond you you would have to pay a higher interest rate if you were borrowing with a callable bond because the fact that you're able to prepay that
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bond to pay it off early and refinance should interest rates fall is attractive to you as an issuer but then the person who's gonna buy that bond from you that's that's unattractive to them and so they will want a higher interest rate to compensate you for that and of course if you're going to compare the credit spread on that bond to a risk-free bond that is not callable the problem is that we need to strip out how much of the the interest rate differential is due to the
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colorful nature of the bond and how much is just due to the credit risk of the bond so that is option adjusted spread and then for portable bonds it'll work in the other direction but the same idea so yield curve so if we look here at this is just a yield curve so we have yield to maturity of bonds on this axis and on this axis we have the number of years of 5 10 15 20 25 and so usually under normal market circumstances the the the term structure of interest rates
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will be sloping upwards like this and so we have this is a government Treasury so that the red one here's the risk-free rate and then we have a medium risk bond and a high risk bond and so as you can see across all of the different maturities the interest rate is always higher on riskier security on the riskier bond and so so that is credit spread so the difference between the interest rate paid by the risky bond and the risk-free bond and the greater the risk the
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greater the credit spread hopefully that makes sense to you other credit spreads so the Z spread an option adjusted spread and unfortunately I just explained those on the prior slide rather than waiting for this one but I'll explain it again so Z spread is the number of basis points that you need to apply to a series of zero rates such that the present value of the bond accounting for accrued interest equals the sum of all the future cash flows so that's essentially that's a more
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complicated way of saying what I just said which is the Z spread just adjust for the fact that that different coupons will be will be discounted at different applicable interest rates and then option adjusted spread adjusts for callable and portable bonds so bond valuation so the the value of any bond is the present value of the expected future cash flows and that's sort of a standard idea in finance that almost anything the value of any financial instrument is the present value of the
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expected cash flows and usually adjusted for risk right and so the credit spread adjust for the risk and everything else is just present valuing of cash flow so if we have here a bond and there's three payments we'll say there's a coupon a coupon and principal and interest of the coupon plus the principal amount they will all be discounted to the present value and that is the value of the bond now there will be different interest rates applicable to we'll say if this
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occurs in one year that's a year and a half and that's in two years we'll discount this at the one year or interest rate this will be discounted at the one a half-year interest rate and that will be discounted at the 2-year interest rate and so and that just makes sense and so that is how a bond is valued and it's really just this present valuing of cash flows so bond prices and interest rates move in opposite directions they'll run through this quickly it's
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probably reasonably obvious to you but it's no harder to run through this idea anyhow so if the bond was issued yesterday at $100 okay so a loan or a bond occurred yesterday at a 5% interest rate and the next day the an interest rate cut occurred so the new going rate of interest is 4% now obviously if you would issued that bond at 5% for $100 every year you're paying $5 in interest honored that bond is now more valuable right because someone would rather have that 5% bond than a 4% bond so what
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what's happened is interest rates have gone down and the bond value has gone up now how much will the bond value have gone up it'll have gone up an amount that makes the effective yield on that 5% bond 4% which is now the going rate of interest so we just need to adjust the price up so that whatever five dollars a year in coupon is will will be 4% of the value of the overall bond so so the value of the bond would have to rise such that the price now implied a yield
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of 4% so as I said the best way to think of this is these kind of little seesaw diagrams where if interest rates go up bond prices go down if interest rates go down bond prices go up and hopefully that makes sense to you it's just sort of how it has to work because the it wouldn't make sense if that 5% bond that was issued for $100 yesterday and now every bond that's going to be should will be issued at 4% obviously people would rather have the 5% button and so the value of that
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has to be worth more than $100 because a rational investor would pay more for it than they would for the 4% bond and the amount more is really just the amount that that price has to go up for the effective yield to be 4% which is the new market rate of interest so that is bond prices and interest rates so callable bonds now I've talked a little bit about this but let's explain in a bit more detail so a callable bond is a type of bond that allows the issuer to
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retain the privilege of redeeming the bond at some point before maturity so if you are if you are the if you are the issuer the bond which means the borrower of money you get to pay that bond off early should you wish to do so now when would you choose to do that this there's a few reasons but the main reason is of course if interest rates have gone down you're able to pay that bond off early and you're able to refinance now it can equally be if your credit rating has
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improved right if your credit rating has gotten better and interest rates have stayed the same you should still be able to borrow at a lower rate with its new better credit rating and so you might want to call those bonds or pay them off and issue a new one to replace it at a more attractive interest rate to you so with a callable bond investors have the benefit of a higher coupon right because no one's gonna give you this call option for free there's going to be you're
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gonna have to if you're if you're issuing a callable bond you'll have to pay a higher rate of interest on that and so that that makes it attractive to an investor who's buying the bond and so it would be it would have a higher coupon than a straight or non callable bond and on the other hand if interest rates fall the bonds will likely be called so to a certain extent if you're buying callable or portable it might relate to your view as to the likely future path of interest rates so
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if you think that interest rates are likely to go down maybe you don't want to invest in colorful bonds because they'll all get called and then you'll have to reinvest at a lower interest rate if you think interest rates are going to go up these things might be more attractive because you're being paid for this call option that you might think is unlikely to be exercised over the life of the bond so sources of risk in fixed income there's a bunch of different types of risks that will exist
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within fixed income or bonds that there's interest rate risk so if interest rates change a bonds value will change and we just explained that if rates go down bond values go up if rates go up bond values go down and so said that will matter to to a fixed income investor this is more importance of interest rate risk is of greater importance to bonds that of high credit ratings than low credit ratings it just moves the needle more for that type of bond the other big source of risk is
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default risk so if the economy worsens all bonds will be affected right because in well actually we're seeing that right now this has been filmed in March 2020 and we have this whole coronavirus thing going on and markets are down an awful lot there's an awful lot of businesses that are closed at the monkey shops and restaurants and so on are closed and in this worsening environment you have to imagine that it's more difficult for a lot of these businesses to pay off the
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the bonds that they've issued or to pay the banks by for any loans they may have taken and so as the economy worsens bonds are affected more important for bonds that are speculative in nature right so obviously a gentle slowing of the market or of the economy shouldn't hugely affect a triple-a rated bond nearly as much as a bond that's right on the border of will say moving from investment grade to speculative grade because obviously if it gets downgraded to speculative grade there's
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a certain amount of selling pressure because the type of investor that's not allowed to own those bonds will just have to dump them the minute the minute they get downgraded so so that will have a big effect and of course default risk is meant to be captured by the bond rating that the rating done by the agencies like Standard & Poor's or Moody's okay so the next thing we're going to talk about here is the term structure of interest rate and so what that means is there's usually a
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different interest rate for different different explorations of bonds so what we have here is this is yield this axis is yield and this axis is time to maturity so essentially in a normal environment the longer you lock your money up for in a bonds if you buy a one-year bond you'll get a lower interest rate than if you bought a 2-year or a three-year bond and you're really being compensated for agreeing to lock your money up for a greater length of time and so that's a normal term
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structure of interest rate this is what's called an inverted term structure of interest rate and so the longer out you go the lower the interest rate that you get and so this is something that does happen from time to time it's something that you know will matter to bond investors and equally it will matter to do welter to general economic analysts and so when we talked about yesterday how an economist might look at the macro economy in order to work out how they might want to invest things
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like the term structure of interest rates will be of interest and there's a lot of people who argue that that the yield curve tends to invert before a recession that's not always true I think that you know there's an expression where people say that the an inverted yield curve has predicted nine of the last three recessions you know so essentially there's a number of you know false triggers of that idea that the downturn is coming but it is something that people pay attention to and care about
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and obviously if you're a bond investor this is a unusual and an unattractive situation to find yourself in so bond price behavior as maturity approaches so there's some bonds that will trade at a premium and other bonds that will trade at a discount so we'll save the bond as a par value of $1,000 but it's trading in the market it will say $900 well what you would expect is that as time goes by as we get closer and closer to maturity this is this axis here is periods until
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maturity the bond that is trading at a discount will move up in value until at maturity it is worth $1,000 which is what you will be paid for it and the bond trading at a premium will fall in value as you move towards towards expiration or towards maturity of the bond now well why don't we talk about with these discount and premium bonds now some of them might be issued as discount or premium bonds so a zero coupon bond as I mentioned earlier it'll be issued at a discount and redeemed at
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par so you might buy a zero coupon bond at $900 you'll receive no coupons over the life of the bond but at expiration you'll get $1,000 back so you would expect that that zero coupon bond each day that goes by will increase in value because there's less time until you're getting that thousand dollars back now let's talk about what would cause a bond to be trading at a premium well we just explained that if rates go down bond prices go up and we had a example of a bomb that was issued with a
45:29
5% coupon and then the next day interest rates fell and the new interest rate would have been four percent so that bond we then said would go up in value so it would now be trading at a premium so so even though it pays off a thousand dollars at maturity maybe you pay more than a thousand dollars for it but you've see fall those 5% coupons and then eventually at maturity you'll get your thousand dollars back but you would expect as time goes by for that bond to slowly fall in value until
46:02
we'll say the day before maturity it would be trading at you know after a thousand dollars per thousand dollars of payoff value and so that is that is premium and discount bonds and hopefully that makes a lot of sense to you so this then brings us to interest rate risk if we've just explained that when rates go up bond prices go down and when but when interest rates go down bond prices go up then let's look at how different bonds are affected by this so we find that
46:39
long-term bonds are more sensitive to rate change uh Stan short-term bonds so a 30-year bond will be affected much more by a change in interest rate than a bond that expires in a few days time and that's simply because you've got more money you've got money locked up for a much longer time that's going to be earning whatever that rate of interest is then a bond that's expiring very soon so let's just look at an example here so we do a quick calculation here and we've
47:10
got three different bonds bond a bond B and bond C and we've got each of them pays a coupon of $90 they have a face value of $1,000 there's their credit rating and the length of time to maturity on the first one is five years second one is ten years and the final one is 15 years and so what we do then is we calculate the value of these bonds and we find that they the first one is worth $2,000 the second one is worth nine hundred and thirty nine dollars and the final one is worth
47:44
eight hundred and fifty six dollars so those are the values of the bond right now then what we do is we decrease interest rates by 10% for each of these holding periods and when we do that we can then just re price the bond present valuing all of these cash flows at these new lower interest rates and of course when interest rates go down bond salaries go up so they should be higher we find that the five-year bond is worth a thousand and thirty six the the ten-year bond is worth a thousand
48:17
dollars and the what is that a 15-year bond is worth nine hundred and thirty one dollar so they've all gone up in value but the the shorter term bond went up by three point six percent the medium length bond went up by six point six percent and the longest bond the 15-year bond went up by eight point eight percent so even though interest rates just moved down by ten percent across the board what happened was that the bond that had the longest term to maturity went up in value the most and
48:55
said that is a thing that we find is that long-term bonds are more interest rate sensitive than short-term bonds and hopefully that just makes intuitive sense to you that that should be the case as well so what if we got next so if long-term bonds are more sensitive to interest rate well bond prices are then also more sensitive to decline in interest rates than a rise in interest rates okay so the price will move more for for interest rates falling then when
49:30
interest rates go up so if if we redid that calculation that we did on the last slide but instead of reducing rates by ten percent across the board we increase interest rates now pushing up interest rates will push down the value of our bond and so the new prices are then 966 882 and 790 and that means they move by a fall of 3.4% a fall of 6.1 percent and a fall of 7.7 percent so if we compare those price changes with the ones we calculated a moment earlier we can see
50:10
that that they are smaller percentage changes than when when the interest rates went in the other direction so so bond prices are more sensitive to a decline in interest rate than to an increase in interest rates and that's just the mathematics of bond pricing that's just the way that works what else can we find out about how bonds are affected by interest rates well low coupon bonds are more sensitive to rate you interest in high coupon bonds okay now that should make sense to
50:47
you once again if we think about it because a low coupon bond is one we'll say the lowest coupon bond is a zero coupon bond where you're getting all of the money back at expiration while with a higher coupon bond you're getting these coupons all along and then finally the principal amount so at least you're getting some cash flow early with those coupon paying bonds so a low coupon bond will be more sensitive simply because the entire payment is stacked out there
51:18
in the future rather than some of it coming periodically so let's do the calculation rather than talk about it so we take two bonds here we've got a bond that pays a coupon of $60 and another one that pays $100 they are both 10-year bonds they both have the same rating and the face value of a thousand dollars and they have a yield to maturity they each of the yield to maturity of 12% the first one is worth six hundred and sixty one dollars and the second one is worth eight
51:52
hundred and eighty-seven dollars if we decrease yield to 11% what will happen is of course if rates go down bond prices will go up and the new prices are now 706 and 942 so as you can see the the lower coupon the $60 coupon bond went up by 6.7% and the the higher coupon bond went up by 6.2 percent so the lower the coupon payment of a bond the more interest rate-sensitive it is so that's another thing we learn about bonds so prices are more sensitive when rates are low than
52:35
when they're high as well so based on all that information usually when I teach this class life or other in a video version of it I ask the class that if you think interest rates are going to increase in the next few months which would you rather own a 30 year zero coupon Treasury or a one year four percent coupon Treasury bond so they're both Treasury bonds they're boat risk-free let's pause for a second and think about which one you would want well let's think about it the we said that the
53:11
longer bond the the longer length to maturity will be more interest rate sensitive and equally a zero coupon a low coupon will be more interest rate sensitive so if you think interest rates are going to go up that means you think bond prices are going to fall and so you wouldn't want the most interest rate sensitive one because it's the one that will fall the most so you would want this one-year 4% Treasury now would you rather it be a callable bond or just a
53:43
regular one well if you think rates are going to go up you might want to be the owner of the callable bond because bonds only get called when interest rates go down right and so you'd rather have this one-year 4% callable bond where 30 years the euro coupon non-callable bond right and so hopefully that makes sense to you alright so duration and so duration is a calculation that we're able to do we we've gathered all this information that different bonds have
54:20
different interest rate sensitivity so the next thing we can do is just calculate the interest rate sensitivity of various bonds so the calculation that we do is called duration we calculate the duration of a bond and there's there's a bunch of different ways of calculating duration there's modified duration dollar duration or Macaulay duration they're really the same thing just expressed differently so modified duration is the one that I find it easiest to understand is the percentage
54:51
change in price for a one percent change in the yield of bonds so we're basically saying how much do we expect the bond to change in value if interest rates go up or down by one percent dollar duration is the same sort of thing but it is the change in price in dollar so rather than in percent it's in dollars and Macaulay duration is the weighted average time until the cash flows are received and so that is measured in years rather than in dollars or in percent but essentially
55:26
they all tell you the same thing which is how interest rate-sensitive a bond is so obviously if you think interest rates are going to go down and you does expect bond prices to go up you'd want to own bonds to have a lot of duration if you think that interest rates are going to go up and thus bond prices are going to fall you'd want to have bonds that have less duration so that is duration and it's kind of quite simply how much does a bond how much is a bond likely to
56:00
change in price for a 1% interest rate change so duration is an indication of interest rate sensitivity and there's also spread duration which is the indication of sensitivity to a hundred percent are two thirty to a hundred basis points change in spreads are optional justed spread relative to constant Treasury yield so these are you know other calculations so duration here let's think a little bit about duration that duration is a linear approximation of a curved function right now how do we
56:39
know it's curved well we know that that bonds have different sense two V two increases and decreases in interest rate so it's not a it's not a flat function there's a curve and we can do that we can just recalculate the the price of bonds for varying interest rates and plot that curve but duration it's it's a little bit like Delta in options if you understand options duration is this linear approximation of a curve function and so the slope in this example is
57:11
duration but as interest rates change duration will also change so that is so what that also means is that duration works quite well for small changes in interest rate for a 1% change but for very large changes it's not as accurate simply because the estimate moves away from the current function that it is estimating and that then brings us to convexity and convexity is the amount of duration changes for 1% change in interest rates okay so it's a second derivative if the first if duration is a
57:52
first derivative of the of the bond price to the to the interest rate the convexity is the second derivative it's how much does duration change for a 1% change in in the interest rate so that is convexity and it is basically the how curved is the is the line so high duration bonds are the most interest rate sensitive high convexity bonds are less interest rate sensitive so duration tells you how interest rate-sensitive it is but if it's God high duration but also high convexity
58:36
it's a little bit less interest rate-sensitive than you'd expect low coupons and long time to maturity bonds have high duration and low coupon also have higher convexity callable bonds will exhibit negative convexity and that should make sense in that the relationship will change for a callable bond because obviously if interest rates go down bond prices go up but only for it to a certain extent for a callable bond because there's a certain point of which the bond will just get called and
59:09
so you'll see negative convexity with in things like callable bonds what else have we got here so duration convexity assumptions so when we're calculating duration and convexity we do this calculation assuming that the term structure of interest rates is flat and not just sort of simplifies the calculation now that's not actually necessarily the way things will work but that is the assumption in in those calculations we assume that the ships are parallel and that means that that
59:41
all interest rates so we said that there are different interest rates for different holding periods the one-year rate will be different in two year three or four year or five year rates but if we're saying that interest rates move up by one percent we're assuming that they all move up by one percent rather than that there's any set of change in the in the curve and we also assume the bonds of no embedded options in order to do this this calculation and that relates
1:00:11
to the prior slide where I explained about negative convexity and so on so that is the calculation of a duration and convexity so then we'll move on to this idea of how do people manage portfolios of bonds well once again kind of like with stocks you can be a passive manager or you can be an active manager and of course usually people charge higher fees if they're an active bond manager and lower fees if they're a passive bond mannered you know a passive manager is
1:00:44
really just trying to index not trying to beat the mark but give you roughly the written not trying to beat the market but trying to give you roughly the return of the the bond market so they'll attempt to control the risk of the portfolio and and index it now that's not as easy with bonds as it is with stock so indexing means building a portfolio that replicates an observable index so they might pick an index that they want to roughly replicate there could be a high grade bond index like
1:01:19
the Salomon Brothers indexed high-yield index like the CSFB high-yield index but there are problems because with stocks there's there's constant buying and selling stocks in there pretty liquid as I explained I think probably in yesterday's class a lot of bond investors just buy a bond and hold on to it until maturity they don't trade in and out of it so when a bond is issued its liquid people can buy it then they put it in their portfolio and it stays there until expiration so if you're
1:01:52
trying to index a bond index you might look at that bond index and see the bonds that are in there but you're unable to buy those actual bonds because they're just not liquid or there might be more money chasing your index than there is available bonds there's there's many ways but it's hard to do this and so then what you're gonna have to do is you're gonna just have to try and find similar bonds and you might try and match the index in terms of industry or
1:02:22
duration and convexity are all sorts of things like that but you can't like with a stock in that you can just buy all the stocks that are in the in the index you can't necessarily do that with a bonded like so you have to you're always maybe a little bit more active as a bond manager than than even if you're an indexer then you would be as a stock manager who's indexing even just things like bonds maturing and so on and you have to pick a new one and it's it's not as easy
1:02:53
building a diversified portfolio so I took this slide from the Oppenheimer funds website that they're a big bond manager and they say that you should build a diversified portfolio within different types upon different ratings of bombs and different expressions and so on and so we've got here at the bottom of their pyramid the biggest weighting is US government bonds then agency bonds that means a government agencies in the United States like Fannie Mae and Fannie Mae and Freddie
1:03:29
Mac and you know student loan bonds and things like that Sallie Mae I think they're called and then we've got non-us developed market government bonds so foreign bonds and mortgage-backed securities high grade corporates bank loans emerging market government bonds and high-yield bonds is their lightest weighting but they're essentially saying you don't just buy some bonds you diversify in terms of the bonds and they're arguing that you should weight them in this pyramid type manner but
1:04:02
obviously you could weight them however you see fit this slide is kind of interesting unfortunately it's a few years old and I can't get a new version of it but this is a bond market history so we're seeing all of these things that have happened in the markets over a period of what is that about 10 or 15 years and we've got interest rates going up we've got the dot-com crash we've got the September 11th interest rates going up going down is what so this green line
1:04:36
is the level of interest rate various news items are listed in there and then we've got all of the different bonds on how they perform and I think this is also from Oppenheimer's website but from a few years ago and we've got different types of bonds so we've got purplish government bonds red as corporate bonds yellow as high-yield bonds black is international bonds and blue is bang clones and as you can see as markets have changed as different things have happened as rates have gone up and down
1:05:07
different bonds have done well and different bonds have done badly in those environments said the best performers are at the top and the worst performers are at the bottom and so the real takeaway of this I guess it relates to the prior slide where they're essentially saying that maybe you want to own a diversified basket of bonds that some will do well in some environments others will do well in other environments so what else have we got some active management the
1:05:39
difference between active and passive is that the active managers presume that the manager can generate some sort of alpha and we talked about alpha and beta in yesterday's class and and that essentially is the idea that the active manager is trying to provide a positive risk adjusted return so beta is the market return and then obviously you can leave for beta if you want to just have high beta but alpha is a return a positive return that is not explained by
1:06:11
the movement of the index or the market in general and so that is the goal of an active fund manager in fixed income so what can they do you can build your portfolio however you want you can diversify however you want you know concentrate in certain sectors or not one of two approaches that are quite common amongst bond managers or this idea of a barbell portfolio where they buy a lot of short term bonds and a lot of long term bonds with nothing really in the middle and so cidade is a barbell
1:06:46
portfolio laddered portfolio is buying equal amounts across a range of maturity so we'll say if you had I don't know a hundred thousand to invest and there are ten years of bonds available tenant and you would put 10,000 in each year's bond and as the 1-year bond matures you would take that money and you would buy another 10-year bond with it so you're always buying long-term bonds with the money that comes in when the bonds mature and that that's called a ladder
1:07:24
portfolio and the idea behind a ladder portfolio is that if you usually get a higher rate of interest for going out longer you're always buying those we'll say the 10-year bond whenever the 1-year bond matures and of course the old ten-year bond is then a nine year bond and the old nine your bond is an 8-year bond so on and so forth let's look at us well the barbell just explained a barbell is like a piece of gym equipment if you're not familiar with that term and the barbells our
1:07:57
strategy for buying short-term and long-term bonds but none of the ones in the middle and the idea here is that you you want to get some of the long-term bonds to get that higher interest rate associated with buying we'll say the 10-year bonds but because you're maybe not convinced that interest rates are you may be hoping that interest rates are likely to go up and so you're keeping a lot of your portfolio in short-term bonds that you'll hopefully redeploy when rates go up that's kind of
1:08:28
the idea behind the barbell portfolio so as you can see here they've bought the bond a and bond B which are 10-year bonds and they bought bond C and bond D which are two-year bonds and they haven't bought anything in the middle so that's a barbell portfolio a bond ladder is a portfolio bonds that mature at regular intervals so that attempts to minimize the risks associated with bonds while managing cash flows for the investors so a wealthy investor might have a portfolio manager who puts them
1:09:03
in a bond ladder and that just means that if you've bought this ladder of different expirations bonds there'll always be something expiring soon and you can use that for cash if you need cash at that point in time or if you don't you can reinvest it but in this longer-term way so it's a multi maturity investment strategy that diversifies bond holdings within a portfolio so this is an example of the bond ladder so you've there's one two three four five six different
1:09:38
explorations of bonds available in this scenario and so you put one sixth of your money into each of those so one sixth is in the 1-year bond when six is in two years the three or the four year the five year and so on and so what happens is that as this as this bond matures as time goes by this one matures and you buy the next bond out here always buying the longer-term bond trying to get that little bit of extra interest that you'll get for buying a long term rather than a short term bond
1:10:13
as long as the yield curve is not inverted obviously and so that is a bond ladder now ladders are a popular strategy for cycling the maturity of bonds and it can help you get that higher coupon of longer-term investments while allowing you to reinvest a portion of your funds every few years so that's the idea behind a bond ladder and so that is our last slide I guess we're about an hour and 10 minutes into this class so we'll take a couple of days break this is plus number four and then
1:10:48
next week I will release the next class that and we'll be moving from traditional asset management into alternative asset management at that point so see you later and have a have a great few days talk to you soon bye [Music] you [Music]
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