Fixed Income Securities

Fixed Income Securities IFS Assignm ent

Fixed Income Securities Fixed income refers to any type of investment that yields a regular (or fixed) return. For example, if you lend money to a borrower and the borrower has to pay interest once a month, you have been issued a fixed-income security. When a company does this, it is often called a bond or corporate bank debt (although "preferred stock" is also sometimes considered to be fixed income). Sometimes people misspeak when they talk about fixed income. Bonds actually have higher risk, while notes and bills have less risk because these are issued by government agencies. The term fixed income is also applied to a person's income that does not vary with each period. This can include income derived from fixed-income investments such as bonds and preferred stocks or pensions that guarantee a fixed income. When pensioners or retirees are dependent on their pension as their dominant source of income, the term "fixed income" can also carry the implication that they have relatively limited discretionary income or have little financial freedom to make large expenditures. Fixed-income securities can be contrasted with variable return securities such as stocks. To understand the difference between stocks and bonds, you have to understand a company's motivation. A company wants to raise money, and it doesn't want to wait until it has earned enough through ongoing operations (selling products or providing services). In order for a company to grow as a business, it often must raise money; to finance an acquisition, buy equipment or land or invest in new product development. Investors will only give money to the company if they believe that they will be given something in return commensurate with the risk profile of the company. The company can either pledge a part of itself, by giving equity in the company (stock), or the company can give a promise to pay regular interest and repay principal on the loan (bond or bank loan) or (preferred stock). Robin Kapoor, F-12

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Fixed Income Securities IFS Assignm ent The purpose of owning Income Securities is quite simply the generation of a secure cash flow that can either be spent or reinvested at prevailing interest rates (i.e., compounded) until it is needed. The classical long term goal of an Investment Program is to live off the income produced by one's assets, without ever having to invade the principal. Therefore, it should be clear that it is never smart, or savvy either to defer the receipt of income for any reason, ever, or to put off the development of the income stream until the last minute. This is part of what Asset Allocation is all about! Done using the Working Capital Model, it assures the constant growth of the income contribution to the portfolio. Investing in Income Securities is never a hedge against something that may or may not happen in the future, nor is it a place to stash your stash until some other event takes place. Investment Income comes in just two varieties: interest on debt securities and dividends on stocks and other hybrid securities, such as Preferred Stocks and Closed End Mutual Funds/Investment Companies that are distributed to investors in the form of Equities. Capital Gains income is a real possibility as well, but it is not considered part of the Fixed, Base Income. Rents and royalties can be classified as fixed and/or variable income. Income Investing has always been the orphan of the Investment World because it just doesn't generate the hype and excitement that the "Shock" Market routinely provides. Still, it is important for investors to understand that there is as much of a need for income in the day to day or short run of running an investment portfolio as there is the obvious need for income in a person's retirement years. Income Securities generally trade in larger dollar quantities than stocks, particularly when initially sold to the public, and the mark up on them is both invisible and huge... upwards of 3% in most instances. Many Fixed Income Securities are placed directly with (sold to) mutual funds, insurance companies, investment companies, and other entities which will package Robin Kapoor, F-12

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Fixed Income Securities IFS Assignm ent (even restructure) them for sale to the Individual Investor in some form of Income Product. Government Agencies do the same, particularly with respect to mortgage investments. For the most part, individual investors have to rely upon their advisors to guide them in their selection of appropriate Income Investments where, believe it or not, there is more room for mistakes, ignorance, misinformed advice, inexperience, and general confusion than there is in the Equity Market. The reason for this is that mark-ups are not revealed in transactions, and both investors and their advisors have many misconceptions about these investment vehicles. Fixed Income Yields and security prices generally change much more slowly than Stock Market prices and it can actually takes years for interest rates to move in either direction by a few points. At the same time, a trend in interest movements is likely to last longer than a trend in stock prices. There is abundantly more economics than there is emotion involved with interest rates movements, creating a more stable playing field for the individual investor... theoretically. Income Investing should be much easier than it is, and should rarely produce an anxious moment. If you are thinking long term, as you should be in this area, the rules become simple and few: •

RULE ONE is to always seek out the longest duration, Investment Grade Only, securities with the highest (reasonable) yields.

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So long as you follow RULE ONE, RULE TWO is to focus on the Cost Basis of your Fixed Income Securities and ignore their Market Value fluctuations.

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RULE THREE is to stay focused on the income generated by these securities, and to make decisions that grow that income annually.

All Interest Rate Sensitive Securities are Created Equal... pretty much! This means that if your bonds are up or down in price, so are everyone else's. If your fund is down, Johnny's fund couldn't do better unless there are significant Quality or Duration differences involved. Therefore, don't ever switch from one Fixed Income Security to another for emotional (fear or greed) or other similarly superficial reasons. Robin Kapoor, F-12

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Fixed Income Securities IFS Assignm ent •

Investors should almost never switch from one fixed income fund to another, OR even worse, take losses on fixed income to move into something else entirely, typically a peaking Equity Market.

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Another basic rule is to avoid yields that are a great deal higher than normal. Caveat Emptor! In one sense, Fixed Income Investing and Equity Investing are identical...Junk is Junk.

To be a successful Fixed Income Investor you must get to the point where you understand that: •

Higher Interest Rates are a Good Thing, and

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So, too, are Lower Interest Rates.

Measuring Return with Yield Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield. Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200). Robin Kapoor, F-12

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Fixed Income Securities IFS Assignm ent

Yield to Maturity Of course, these matters are always more complicated in real life. When bond investors refer to yield, they are usually referring to yield to maturity (YTM). YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium). Knowing how to calculate YTM isn't important right now. In fact, the calculation is rather sophisticated and beyond the scope of this tutorial. The key point here is that YTM is more accurate and enables you to compare bonds with different maturities and coupons.

Putting It All Together: The Link between Price and Yield. The relationship of yield to price can be summarized as follows: when price goes up, yield goes down and vice versa. Technically, you'd say the bond's price and its yield are inversely related. Here's a commonly asked question: How can high yields and high prices both be good when they can't happen at the same time? The answer depends on your point of view. If you are a bond buyer, you want high yields. A buyer wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future Robin Kapoor, F-12

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Fixed Income Securities IFS Assignm ent

Price In The Market So far we've discussed the factors of face value, coupon, maturity, issuers and yield. All of these characteristics of a bond play a role in its price. However, the factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons.

Robin Kapoor, F-12

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