1. The different types of bond issuer in the market
2. How to calculate the price of a bond
3. The impact of credit, inflation and interest rate risk on bond pricing
JULIAN HINCE: Good question Mark. The key reason we need to talk about it is the sheer weight of assets under management now over the last 10 years. Fixed income year after year has been the second largest asset weighting in clients’ portfolios. Last year for instance it accounted for just over 80% of net fund flows into the industry. And of course it’s performed exceptionally well. And we know how investors can behave when as asset has performed exceptionally well. They continue to chase it. So I think it’s a really opportune time now to address that.
PRESENTER: Do you think most investors know what they’ve bought?
JULIAN HINCE: Probably the answer to that is yes and no. I would argue that fixed income is probably one of the more technical asset classes. So, in truth, do all investors understand all of their exposure? The answer to that is probably no.
PRESENTER: But should you be confident buying fixed income even if you don’t have a PhD in maths? How complex is the complexity of the maths behind it?
JULIAN HINCE: It can be relatively complex. I think some of the instruments that can be used, some of the expressions of risk etc. that can be used within a portfolio can be relatively complicated. But in essence of course the reason we’re talking about it today is because for the last decade or so not only have, as I said before, a lot of investors supported it as an asset class, it’s behaved incredibly well. It’s behaved as they expected it to. That doesn’t mean that’s necessarily the case going forward. So I think our job now is to say look make sure that you do understand because it can still be an appropriate asset class but there are inherent risks.
PRESENTER: Yes. So I suppose this does raise the issue, not just the mechanics of how a bond works but some of the terminology around it. So a little earlier we got Julian to come into the studio to run us through that. Let’s take a look.
JULIAN HINCE: With so much money invested in fixed income I thought today would be a great opportunity to lift the bonnet and look at the key features and characteristics to ensure that we fully understand who it is that issues debt, the characteristics and indeed some of the risks associated.
So, first of all, as you can see at this slide, there are a number of organisations, number of institutions that borrow money. Let’s start with corporates. Why is it that companies borrow money? Well clearly to raise capital in the same way that they issue equities. And they are using the credit markets to raise money in a very flexible and often in a cost effective way especially in this past few years with low yields etc. Governments are doing the same thing. Effectively, they’re borrowing money to plug that gap between expenditure, relative to taxation receipts. And indeed states and regions, as it says here, in other words local authorities, if a local authority is suffering a significant central budget deficit gap then what they can do is look to borrow money to plug that gap.
The same with supranational, supranationals, we’re talking about the IMF, The World Bank etc., and actually just after the financial crisis they were looking to borrow a great deal of money in the markets. But how else can they be classified other than just who it is that’s issuing the debt. Well the really crucial thing here is how the coupons themselves, how the income is paid and how we classify that because fixed income is a very broad investment. There are a number of different assets that are included within this spectrum, this investment spectrum. So let’s just focus now on the coupons.
First of all, it’s the vanilla coupon; in other words it does what it says on the tin. The coupon, the income that you receive is set at issue. So if you’re a lender at issue that is what you receive assuming you hold that through to maturity. Zero coupon bond, again does what it says on the tin. There is no coupon, there’s no income stream. So what is it you’re buying? You’re effectively buying a discounted bond; in other words, you’re buying an investment which is issued at a discount and then at maturity you’re receiving back par. You’re getting that capital growth. You know, in financial planning terms for instance, as you know these can often be used for high net worth individuals etc.
Convertible bonds enable you to convert for instance to the equity of a business; if the circumstances, if the environment is right for you to do so then that is an option available to you.
Inflation-adjusted, quite a topical asset class here in the course of the last 12 months or so. If you have concerns, if you have issues with regard to a pickup of inflation, you may wish to protect your investors by owning inflation-linked debts. And a lot of governments as you know issue linkers, as we call them, and that enables you to protect an investor from the ravages of inflation.
Floating rate notes, again, if you’re not entirely sure which way you think inflation’s going, but you believe that it’s likely to move and indeed interest rates are likely to move, what you can do is lend money to an organisation that effectively links the coupon to things like Libor for instance and they will rebalance that for each quarter.
And callable debt finally is debt that the issuer is able to call back, i.e. repay you at a set time over a period. It might be two, three, over a five-year period etc. whenever they think it might be right in order for them to refinance and maybe reissue that debt with a lower coupon if interest rates are falling for example.
So with all of this choice, which one would you choose, under which circumstances and at what time? So I thought it’d be a great idea to just look at an example. And it’s not a real life example but it’ll give you an idea. And I want you to start thinking about which of these organisations, i.e. the US government, or Ford, you would lend money to? So, as you can see on this slide, some of the key features of these debt instruments.
So, the US government, now typically the US government will be seen to be the world’s safe haven: when we have either economic risks, geopolitical risks in the market place, capital tends to flow into US treasuries, and you can see here the US government are saying lend us money for the next 10 years and we’ll pay you a coupon of 2%. OK, nice and safe but a low coupon. Or you can lend Ford money. Now that depends on your view, your credit view of Ford, and they’re saying to you lend us money over the same period of time and we’ll pay you a coupon of 8%. Now on the base of that which one would you most likely lend money to?
Now that really depends on a number of things doesn’t it. Depends on your view for instance of inflation, of interest rate sensitivity – and we’ll talk about interest rate sensitivity a little bit later on in relation to lending governments money – or the credit risk that you think is either inherent or not as the case may be in lending an organisation such as Ford money, because clearly as with any aspect of investment management where there’s a higher number it’s typical of a higher level of compensation for a higher level of risk. So we’ll look at these in a bit more detail.
Now, before we do that, we need to ask ourselves what are the sort of selection criteria we would use if we were looking to buy a bond. And indeed I would argue that this is very similar to you looking to choose a fixed income fund: similar sort of selection criteria. Now it’s not exhaustive but this slide here just gives you some of the sort of the key foundations, the key questions that you may wish to ask. So let’s start with the coupon.
What is the coupon? How high is it? How low is it? Is it appropriate? Does it match what my investors are looking for? Do I think that coupon is reflective of the risk and more importantly is it the coupon that I’m actually going to receive? Because of course the coupon is the income that you receive if you lend at issue.
Now the majority of the market obviously operates in the secondary market. If you’re a buyer of a mutual fund the fund manager is probably buying this debt in the secondary market and therefore it’s not the coupon necessarily that the investor is receiving. They’ll be receiving the yield. And the yield is simply a reflection of the coupon relative to the price. And we’ll look at some of those dynamics in a little bit.
Then credit. Now credit is specific to lending a company money: credit risk. What is the risk that I don’t either get my money back at maturity or indeed I don’t get the coupon stream? So how do I feel about the credit risk? And then maturity and this is a really important one: how long am I willing to lend money for, how long are they asking to borrow money for – because the question there is what could happen to the value of my money during that period? So for instance if you’re lending a government money over a 20/30-year period your question is how much will that money that I lend them be worth in that 20 or 30-year time period. And am I being adequately compensated for that risk, for instance of the devaluation through inflation?
And then finally and we can’t get away from this: evaluation the price. What price is the market asking me to pay? Am I being adequately compensated and more importantly do I agree with that price? Do I think it’s worth that? And how do we calculate that? And that’s what I want to look at next.
I would argue actually fixed income is a pretty technical asset class, and one of the technical aspects of fixed income of course is working out the price. How on earth do you work out the price of a fixed income asset class? How do you know what you should be paying for both the coupon and the capital at the end of repayment?
Now, do you remember good old fashioned discounted cashflow modelling? Well that’s exactly what we use when we’re pricing a fixed income asset class. What we’re looking at and what we’re looking to try and understand is how much today are we willing to pay for that future income stream? So for instance if we’ve got a three-year bond with a coupon of 10%, as you can see here, we’re asking with a simple discount calculation just how much are we willing to pay for those income streams today? And as you can see here with this calculation that that three-year bond today, to us, the present value is worth £7.51.
Now, what we do of course with that information is ask ourselves if we think it’s worth £7.51, what does the market think it’s worth? If the market thinks it’s worth more than that or less than that that might help us come to some form of conclusion around whether we think it’s fairly priced or not, whether it’s an asset class we’d be looking to either offload if we already owned it or indeed add it to a portfolio. But this an incredibly useful and very flexible calculation and it’s probably one that you’re already using. For instance if you’re looking to understand how much a client needs in a pension fund, I suspect you’re using discounted cashflow modelling. So no need to panic with this and we’re not asking you to get your calculators out now but just understand that is the form, the basis, the foundation of calculating a price: it’s all about today’s present value.
Now, the price that you pay really determines effectively the coupon relative, sorry the yield even, relative to the coupon. Remember I said the yield is an expression of the coupon relative to the price. So depending on the price of the fixed income instrument itself, it will tell you a very different story in terms of whether you’re actually going to be receiving more than the coupon that is at issue or less than. So for instance, an example here, a three-year bond again with a 10% coupon but a yield of 9% straightaway should tell you that you’re having to pay a premium for that because the yield is lower than the coupon.
Now, bearing in mind if you own this asset to maturity you are then guaranteeing a capital loss as well of £2.51 for every £100 that you’ve lent in par value. So that is a really important point to make. Likewise, a very simple example, if the yield matches the coupon then you’re paying par, you’re effectively paying your £100 par value. And on the other hand if the yield is higher than the coupon, well then you’ve got a double whammy. You’ve got a higher yield than the coupon at issue and you’re paying a discount for that. So, again, if you own to maturity you’re getting a capital uplift and in this example you’re paying £97.56 for an 11% yield and you’ll get £100 back.
So it really depends and remember that’s all down to this inverse relationship that I’m sure you’re familiar with, with regard to the coupon, rather the yield and the price of a fixed income instrument. It is effectively a binary relationship in that sense. And that helps us understand then exactly what we’re buying. So if you look for instance at a mutual fund, a fixed income mutual fund and look at the yield calculations at are often on the fact sheets or in the monthly reports etc. they will state very clearly what the yield is, the running yield, relative to what we call the gross redemption yield, which is the total yield to maturity and that’s taking into account the price that we pay, in other words whether there’s any capital loss or gain and built in relative to the price that we’ve paid for those funds.
Now before we come back to that question remember who is it you’d lend money to, US government or Ford, let me just take you through the yield spreads. And the yield spreads are simply an expression of how much effectively risk if you like there is in the market between lending a company money, corporate debt, to government debt. OK, remember yield is the expression of the income that you’re likely to receive relative to the price that you’ve paid.
Now what you can see here on these wiggly lines effectively is the coupon that we spoke about earlier on, from Ford at 8% relative to that 2% coupon being paid by government, US government. Now typically what we use as a benchmark, a 10-year government debt, so either 10-year treasuries, 10-year gilts etc., and that is our benchmark yield. And above that what we price in is the yield that’s being paid on various levels of corporate debt, whether it be investment grade, non-investment grade etc. and what we’re looking for there is just how much the market is asking for in order, relative to the amount of risk that it believe is in the market. Remember that risk when it comes to corporate debt is the risk of default, credit risk.
And so for example in the financial crisis you saw that credit spread blow right out to about 900 basis points relative to government debt. And of course that has come in over time. Now if you’re really clever what you’re really looking to be able to do is to try and buy that corporate debt if you believe that you are being overcompensated effectively at the top of that spike and ride that yield in, OK that yield suppression in. Because remember the relationship between yield and price, so as the yield drops the price will increase. But of course it spikes because of the assumption of risk in the marketplace, so you need to do your homework.
So I thought that was a useful exercise just to take us through before then we come back to our key question which is who is it you would lend money to. Now let’s go back to that original slide and add in a further piece of information which indeed is the yield, because I didn’t give you that information initially. I just said to you, you could either lend the US government money at 2% coupon or Ford at 8% coupon, but look at the yield. Because actually you’re not lending them this money at issue, you’re lending them this money in the secondary markets. And what we can see here is that the US yield has blown out to 3% and therefore as a result, remember the relationship between the price and the yield, you’re paying a discount. You’re actually only paying £91.47 for that increase in yield.
So you’re buying that yield, you’re lending the US government money at a discount. Whereas, as you can see here with Ford, even though that initial coupon looked very attractive, the yield is a little bit lower, it’s still 7%. It’s still more attractive for instance than lending the US government money but you’re paying a premium for it. So if you were to work this through to its natural conclusion what you’d probably find in effect is that because you’re paying a discount there’s not a lot for US debt, there’s not a lot in it. And if there isn’t a great deal in it it then comes down to risk. And if it comes down to risk bearing in mind that US treasury’s the world’s safe haven, you may well be more inclined to actually lend money to the US government in this case.
So hopefully what you can see from this example is to not judge a book by its cover. Don’t just be attracted by like those headline figures. Make sure that you understand what goes on beneath the bonnet. Make you’ve got possession of all the information because actually as you’ve seen here it might lead you to a slightly different conclusion.
PRESENTER: Well that’s the pricing and the mechanics of bonds. Julian, if we could, we talked quite a lot about the reward there. You did touch on risk but can you talk us through the risks in a bit more detail.
JULIAN HINCE: Yes sure I think the risks Mark are very much associated with, number one, who it is you’re lending money to, whether it be a company or a government. So for instance if you’re lending to a company, you’ve got credit risk or risk of default, and the compensation you receive from that as I said to the piece in the camera is a higher yield, a higher coupon. And we bucket that sort of level of risk if you like or we label that risk in terms of either investment grade or non-investment grade. I’m sure the viewers would be familiar with that. So who is least likely to default on either the repayment of the debt or indeed payment of the coupon through to, you know, higher levels of risk. And our job is to make sure that we understand, you know, whether we think we’re being overpaid, overcompensated for that risk or not.
And when it comes to a government, lending money to a government, it’s a very different level of risk actually. It’s more related to inflation and interest rates, because you can lend money to a government over a much longer period of time than you can a company. So for instance you could lend the UK government money up to 30-50 years or so. So the money you’re lending them now won’t be worth the same in 30-50 years’ time for instance. So you need some form of compensation for that. The risk is if inflation begins to pick up and central banks response to that then is to hike interest rates, you really won’t be getting the same back. So it’s really important to understand and have a view if you like on where you think interest rates and inflation are likely to be.
PRESENTER: So how do you go about categorising what some of these longer term risks are in the government bond market?
JULIAN HINCE: Well, the, as I said before the key risk there is your expectations of future inflation and interest rates. And the key measure of that is duration. Again, a lot of your viewers will be familiar with this term duration but what does it actually mean? Duration, as a standalone figure, if I said to you this fund, this portfolio, this index has a duration of 10, let’s say, it simply means if interest rates we to rise by 1% overnight, you’d lose 10% of your capital overnight. So it’s a direct correlation between a rise in yields and a drop in capital value.
Now the truth is and the way that this works is the longer you lend money, you know, the longer a maturity value that you have within the portfolio, the longer that you’re lending money over and the lower the coupon actually you’ve got a much higher level of duration. So if interest rates move, it’s a bit like, I suppose, twanging a ruler on your desk. It’s the end of that ruler that moves the most. And it’s the same if you had only long-dated gilts in your portfolio and you thought interest rates were likely to rise, you’ve got a lot of duration risk in that.
So it’s really important to understand how that duration risk is managed within a portfolio, if it is indeed managed at all, and that’s I would argue especially where we are in the cycle that is a key risk.
PRESENTER: And is it an absolute rule that if your duration is 10 then if interest rates go 1%, capital falls or is it a sort of guestimate with some clever people behind you? Because we’ve heard of things like value at risk which works until it doesn’t. What happens in stress points?
JULIAN HINCE: It’s a good question. Again, it’s an absolute rule to a degree in that of course if you lose capital within fixed income you’ll get some form of compensation through a rise in the coupon. But the rise in the coupon will never offset the loss in capital. So yes you will get some offset. So it’s not an absolute figure. And also you’d have to ask yourself how likely is it that interest rates are likely to rise by a 100 basis points overnight, so it’s all, you’ve got to put these things into some form of context.
PRESENTER: Was a useful rule of thumb but don’t, it’s not an absolute.
JULIAN HINCE: Yes it’s definitely a useful rule of thumb.
PRESENTER: Now you were mentioning earlier that the, how bonds are sort of rated whether investment grade or sub-investment grade, but how good are the credit rating agencies? Can we rely on them?
JULIAN HINCE: Credit rating agencies I think if you ask most, you know, sort of active managers of fixed income securities they would very often prefer to run their own analysis. So for instance at M&G we have a large number of credit analysts whose job it is to make sure that when we are being asked to lend money to a corporation that we’re mitigating as much of that credit risk as we possibly can. Now, where you might use a credit rating agencies to either confirm or otherwise your conclusions, to use them as maybe as a sounding board.
PRESENTER: But does it become a self-fulfilling prophecy if everybody else says you’re AAA, you start to move as if you’re AAA. Same way if you’re in the FTSE 100 you’re just a big company, there are certain things that go with that.
JULIAN HINCE: And that’s the role of the credit analysts, because I think one of an investment manager’s job as much as anything is to understand what is noise and what is fundamental and to, you know, to understand the difference between the two and what can really cause valuation anomalies and what is effectively just white noise in the markets that we can ignore.
PRESENTER: Just going back to credit risk, how good is the market on the whole at pricing the risk of default?
JULIAN HINCE: Well, you know, where we’d been really since the financial crisis is a situation whereby in a certain area of the market, certainly in the sort of the high yield end of the market, you could argue you’ve been overcompensated. The actual level of defaults has been much lower than the level of defaults anticipated in the marketplace. So that’s actually an opportunity for investors. As I said in my piece to camera, if you can buy when the markets are spiking, that yield spread is spiking and ride that yield down as markets realise that actually the level of defaults pricing is too high, then you get that capital appreciation, that capital uplift. And it’s again, still in certain pockets of that credit market, you’re still being overcompensated we would argue.
PRESENTER: So the markets actually very conservative at pricing risk. You tend to get overcompensated for taking it.
JULIAN HINCE: You can do. I mean, you know, that’s a broad generalisation, but you certainly can. And that affords us opportunities as active managers in that space to be able to gain value for investors.
PRESENTER: But overall is the bond market a really rational place or is there a bit more chaos in there than we sort of perhaps care to admit?
JULIAN HINCE: What do you mean by chaos Mark?
PRESENTER: Well I suppose we, you’ve talked a lot about sort of the maths of it and it looks like a very sort of Newtonian model of the world, it’s a very intricate mechanism and if you’ve got all the right inputs, you get all the right outputs. But does the world really work like that?
JULIAN HINCE: Well it’s a mixture of the two isn’t it? You know, there’s a lot of sentiment, opinion etc. that are factored into the market which will either be more dominant at times than others. For instance, your view on where we are at the moment in terms of the shift from central bank monetary policy in towards fiscal policy. You know, that might then be a game changer for the fixed income markets. Through to sentiment as we’ve said before around credit risk. And that is often sentiment based. So it’s about striking that balance in terms of, you know, how much of the market has been driven and priced by sentiment and fear or, you know, optimism or whatever it might be, you know, worries about interest rate rises, inflation etc. and then actually the maths itself, so it’s very much a combination of the two.
PRESENTER: But bringing all of this together, what would your calls to action be to somebody who’s watching this? You know, been in the world, bonds have gone up, you’ve had that right up for you and your clients…
JULIAN HINCE: I think it’s relatively clear, which is if you believe that you’ve got the support and resource and etc., and the knowledge to be able to use the various fixed income assets, the spectrum of them as building blocks to create your own portfolio, to express an appropriate level of risk for an investor, fine, do that. Or you can pass that outsource that if you like to a I suppose if you like a master craftsman a fixed income manager who has a broad remit who is able to asset allocate depending on their views on credit risk and inflation etc. across that spectrum. And that is, you know, as the numbers would prove, that is where we’ve seen a huge amount of fund flow into the industry in the last few years.
PRESENTER: What would you say if someone said isn’t this just telling you you’re in the wrong asset class and now is the time not be in fixed income?
JULIAN HINCE: Again, that’s a sweeping generalisation I think. I’ve heard that said a number of times in particular in reference to where we are in the interest rate cycle.
PRESENTER: It’s always by the equity managers as well.
JULIAN HINCE: Well yes. But I think the truth is there are still pockets of value, and it’s about understanding what drives those pockets of value, where the risk is etc., where the opportunities are, there are still some opportunities, certainly not game over.
PRESENTER: We have to leave it there, Julian Hince. Thank you very much.