 fixed rate bonds recording. My name is Elizabeth Moran. I'm Director of Education and Research at FIG and with me today I have Lee Winton who is our new Head of Portfolio Strategies. Welcome, Lee. Hi, Liz. Thank you. A little bit of background about Lee. Lee has over 25 years experience within financial markets, within the asset classes of fixed income, foreign exchange, derivatives and commodities, and has worked with a number of large banks including J.P. Morgan, Moore Bank of Scotland, Commonwealth Bank and HSBC Midland. You might notice Lee's accent. Lee has a mixture of structuring and product and sales background and his highest form of qualification being an ask for a business in finance from UTX. While at CBA, Lee was the co-head of an investor products business which originated and distributed fixed income products within the various channels. Explaining products and simplistic terms have been a key part of Lee's roles today. We're very lucky to have Lee with us today to share his information and without further ado, thank you very much, Lee. Let's get rolling with the fixed rate bond. Webinar one thing I must mention though that this is the first in a series of two. We also record a webinar on floating rate bonds. This is the first one. It's best if you watch them in order. Thank you, Lee. It's great to be here. I'm loving the role of being the head of portfolio strategies and we'll start looking at fixed rate bonds. I must note that bonds have been around for hundreds of years. There are some bonds that go back in England's Napoleonic times and one of the oldest bonds still in existence is a Dutch bond from 1624 where a Dutch water board raised money to enable the upkeep of their local dykes and that is still in existence today. So we are dealing with a category of asset class that has been around for a long time and has stood that test of time. Fascinating. Thank you. There are three main types of bonds in the asset class of fixed income and they are fixed rate bonds, floating rate bonds and inflation link bonds. Today we're going to look at two of those asset classes being fixed rates and floating rate bonds and another opportunity we will look at the inflation link bonds series. I've chosen fixed rate bonds first of all because they are the most popular type of bonds. They are the oldest type of bonds and they are the easiest for us all to understand as an opening look at fixed income. Why should we invest in fixed rate bonds? Most of our clients at FIG are often investors who are looking for higher yields than cash or deposits but lower risk instruments than equities or sometimes property and fixed rate bonds fill that gap really well. They are really good for predicting future income as the interest payments are regular and stable. Fixed rate bonds almost always pay the same amount of interest every period and they return the face value at maturity. Those interest payments must be paid by the borrower otherwise the company will go down the route and ultimately end up in liquidation i.e. they are higher in the capital structure than equities and that's an important distinction between the bonds and equities. Looking at fixed rate bonds there are some features that I wanted to discuss today and they are the interest payments, the yield to maturity, the running yield also called the income yield and understanding the types of bond prices and how bonds trade after they've been issued in what's called secondary markets and factors that might influence their prices. Let's look at an example of Australian denominated bonds. I've chosen here the RWH at the Royal Women's Hospital. It's a hospital based in Melbourne. It's an essential social infrastructure and it's a bond we use a lot in portfolios because it has a higher yield than people can achieve on deposits and very acceptable risk as being an essential piece of social infrastructure. This bond has a scheduled maturity of March 2017. When it was issued it had a price of $100 meaning that investors pay $100 for every holding or security they buy. The total amount issued or borrowed by the organization was $148 million. There are available parcels of $10,000 for investors to buy and ordinarily the minimum initial purchase is $50,000. Lee, before we go on I just wanted to chat to you about that maturity date. It's quite interesting because it's not quite two years. I think that's an important point about bonds and that is that they are traded. You can still buy once they've been issued and they start trading in the secondary market. There's a wide range of maturity dates available to investors. Absolutely. This March 2017 actually has less than a year to run. I make it very comparable with a deposit and try and say to investors it might be higher risk theoretically than a deposit because it hasn't got an implicit government guarantee for $250,000 but the risk is acceptable and often you're getting yields on these bonds that are in the higher forwards over 5%. You might be getting twice what you can achieve on a deposit. Great. I thought I'd just spend a moment telling clients how we calculate the amount we pay for a bond. So bond markets similar to equities have gone through an exercise where we've moved the settlement date to a T plus two period. This happened in the last couple of months and you might have seen notification that when people are buying or selling security then money is credited or debited to their accounts two business days after the purchase or sale date. In bonds, our settlement amount is derived from the face value i.e. how many holdings or securities you buy times the purchase price and that is divided by 100. At issue price almost all bonds have $100 as the level at which you buy but thereafter prices go up and down and we might discuss the reasons as why they go up and down a bit later. But I looked just today at where that RWH sample bonds has been trading. That is trading above 100, we would say it's above par, its price is $100.80 and therefore if you wanted to buy 100,000 holdings or securities of that unit it would cost you a bit more than $100,000. It would cost you that $100,800 and you would have to pay that two business days after today. Let's look at how this bond might pay interest and repayment and in this example I actually used the indicative purchase amount of $100,000 rather than $100,800 that I just showed just to make it easier for indicative purposes. So I looked retrospectively at the 26th of March this year because on that date this security had exactly one year left to run and at that time its price was 100, it was par and therefore if you bought 100,000 units it would have cost you exactly $100,000. The interest rate on this bond is 6.2% and that amount of money would be received on the remaining two interest dates for this bond. It's semi-annual, it's six monthly, so the two remaining dates are the 26th of September this year and the 26th of March 2017 and as a fixed rate of 6.2% that means that for the year clients receive $6.2, $6.20 for every $100 invested and because it's a semi-annual six monthly bond that is split down the line and clients receive $3.10 for every $100 invested every six months. So in the timeline we can see that for every $100,000 invested I've shown this in red to show it's an outflow to buy the bond in the first place, investors receive back $3,100 on the 26th of September this year, another $3,100 at the repayment date of the 26th of March 2017 and in addition they receive their principal, their invested amount back being 100,000 and therefore we can see that for the $100,000 investment on the 26th of March the total amount coming back was $106,200 split into $3,100 after six months and $103,100 back in March 2017. So now it's interesting you have the dates there, they're quite precise and that feeds back into what bonds are and why people like them because you know exactly when you're going to get the interest payments. Absolutely, they're regular, they're constant, they're stable, they have a few conventions so if the 26th of September or the 26th of March was a weekend or a non-business day there would be an adjustment to that date just in normal banking procedure and normally it would be on the next available business date, I'll be accredited to your account but those schedules are known, regular, consistent and constant and they go with the overall concept of bonds being regular and enabling a continual constant income stream. Fantastic. Let's spend a moment looking at how interest is calculated and we use this bond and we saw the interest rate is 6.2% because it's semi-annual that means it happens every six months as we just saw and this amount is called unadjusted and that just means that even if for a varying reason there might be slightly more or less than six months in a particular period there could be maybe 180 days in the six month period or 185 days in the six month period because of a long weekend or otherwise it doesn't matter that coupon is known and continual. So every six months you get that $3.10 for every $300 that was invested in the first place and mathematically that calculation is the number of securities held times the coupon which here is 6.2%, times a half being a half being the six month period being half of one year. And the coupon really is just another way to say the interest payment amount or the interest rate. Absolutely. We're all guilty in fixed income of being overly technical. We know in simplistic terms we want to understand how many dollars might we receive, what is the interest rate and the interest rate is what sometimes called the coupon on the bond. Let's look at a concept called yield to maturity. Yield to maturity is the overall return expected from the bond if it's held until the end and it is the most likely thing that investors will compare to a deposit yield but I like to make the distinction because a deposit has just one payment date when you get interest in capital but with bonds you have a series of dates when you're receiving that interest which is typically every six months and you're getting your principal back at the end and therefore the yield to maturity is a slightly more complex calculation than a deposit but it depends on when you bought the bonds and how much you paid for them and it uses what I call a discounted cash flow or an IRR approach where monies in the future are converted into the equivalent monies as if they received today. Sometimes people call this a present value or net present value approach and it's often the way that analysts value businesses and often the way that value listed companies and understanding what the value of their dividends are going to be. So yield to maturity is the focus for investors who intend to hold the bond until maturity and most of our investors at FIG are clients who do buy bonds and hold them until the end. Next let's look at the running yield, it's also called the income yield and is an indication of how much money, how many dollars will clients be receiving at those regular periods in comparison to how much they paid. This is really important for investors that need income during the life of the bond and investors should be very focused on that income running yield because that is effectively what is going to enable them to understand how many dollars they receive on those interest periods which as we discussed is every six months. If the price paid for the fixed rate bond is the hundred dollars which will always be the case if bought at issue then the income yield or the running yield and the yield to maturity are going to be equal. If however the price paid for a fixed rate bond is greater than a hundred dollars then the running yield is less than the coupon or interest rate and vice versa. If we used the RWH to Royal Women's Hospital at the current price of 180 this income or running yield of 6.151 is lower than the issued interest rate on the bond of 6.2% and that just represents the fact you weren't able to buy it at a hundred dollars at the time, you had to pay more, you had to pay $100.80 and therefore the 6.2% or $3.10 is still being received but looking at it against your cost base, your purchase price of $100.80 the actual yield is less than the 6.2% it's actually 6.151. I would note that using this example it's still far superior to what you might expect on equivalent deposits and similar money market investments. It's a very good return for a one year bond where we expect investors to be repaid their principal and interest in less than a year's time. We think it's really strong and we believe that the Royal Women's Hospital is essential infrastructure. When people look at bond prices it can be confusing because there are two different types of bond price and I want to just spend a moment just discussing in simple terms what those prices are. There is a clean price which is effectively the capital price. It is the component of a bond that the investor is paying and represents their true cost base. However when you buy a bond you normally buy it during an existing interest period and the holder of the bond on the date the interest is paid is allowed and does receive interest for the whole period. So for example if you bought a bond three months through the way of a six month interest period at the end of that six month period you would receive interest for the whole of that six month period and therefore the dirty price is the amount of extra interest you're paying to reflect that fact that when you receive that interest at the end of six months you get it for the whole period but as you only owned it for three months of that period for example you are not entitled to interest for the whole of that time. I tend to think it's a bit like an overdraft. You know if you have an overdraft from your bank they're going to charge your interest daily because you owe them money each day. Sort of that same thinking isn't it? Absolutely and we know that we have these accrual periods where banks charge daily and bonds pay interest daily and they catch up to those periods at the end of the six month time frame. So there are a couple of factors that can influence prices of bonds and I'm talking about bonds now after issue because if you buy a bond at issue and you pay a hundred dollars for it and you hold it for the whole length of time received your regular interest every six months to get your hundred dollars back you're probably not terribly interested in what happens in the meantime. But people who want to observe bond prices after issue will see that there are two driving factors that influence their prices and they are interest rates and they are credit spreads and we'll talk about those two now. Firstly if we talk about interest rate risk on a fixed rate bond there's a really good diagram here that shows a seesaw and how the seesaw has to stay balanced. I would note on it that it does mean that the two participants on a seesaw have to be a reasonably equal weight and that's relevant for our bond here. If we have a scenario where a bond is paying a coupon of five percent that's that interest rate of five percent that two and a half dollars every six months for every hundred dollars has more or less value depending on the overall level of interest rates. So if interest rates go down then earning five percent becomes relatively more valuable than if interest rates go up and this seesaw is explaining that balanced equation that balance scenario and that means that bonds will trade at a price level of more or less than the original hundred dollars invested depending on the overall level of which interest rates are trading. And also the term to maturity because the longer the term to maturity the longer the differential so that's another key point there. Absolutely so Liz made very good points and I actually often think about this as making sense to me because we know that if there's a shorter time to maturity there is going to be a smaller ability for prices to change very much because effectively they're going to repay a hundred dollars whereas it makes sense to me that for longer instruments that move more in dollar terms as prices change because there's a far greater time for their pricing to move down to ninety dollars or go up to a hundred and ten dollars. And then we might talk about credit spread and what does credit spread mean? I always found it a bit difficult but when I started working I remember I had an uncle of mine who told me it's really important to pay your bills on time otherwise you might be deemed to be less credit worthy and so we might understand that people, organizations and governments can have different levels of risk associated to them and the stronger the individual or the company, the organization or the government is the cheaper it will be for them to borrow money and that's effectively exactly what we're talking about here. So the stronger and more credit worthy the borrower is, the lower the fixed rate will be on the bonds and the closer the rate will be to a very high quality issuer like a state or government and these state or governments are often available to be seen as in England what we used to call guilds and here we just call government bonds and their pricing is available, interestingly enough we do not use many government bonds in our portfolios and find our investors are very much attracted to them because they yield them on them are so low. But on that note they can really outperform when interest rates are moving lower or there's a risk off sentiment in the marketplace, government bond prices rally so I think they're quite a protective bond if you can accept the lower return, ultimately they are one of the best defenses because of course they're not influenced by the economic cycle. Absolutely and what we see in times of stress and times of crisis and if we look back to the global financial crisis in that 2008 period it was really high quality borrowers the treasuries and the governments, the super nationals that performed best because nobody wanted risk, everyone wanted safest possible instruments. That's right and the demand for them set the prices up. Absolutely. So this fixed rate that is on a bond can often be compared to a benchmark bond like a government and we might look upon it as saying well this is the risk over the risk free instrument that investors are taking. They could look to buy a government bond that will be lower yielding but if they buy a corporate bond that extra yield they're getting is a differential they're being paid for assuming credit risk. And that's called the credit spread. That's the credit, absolutely that's the credit spread. If we look now at the way that bonds trade in the secondary market I thought let's look at a specific example for our RWH bond. So if the credit spread that was attributable to the Royal Women's Hospital bonds narrowed that would mean that an investor would be prepared to lend at less than the fixed rates on the bond of 6.2%. Maybe investors thought this bond is doing pretty well. I understand the credit. The hospital is an operational phase and therefore I think that the real risk will be reflected at a rate that might be 5.9%. That fixed rate bond will trade above its $100 price meaning that investors have to pay more than $100 to buy it and therefore the real yield they're getting is say 5.9% instead of the 6.2% that was available at first issue. So that's because the investor has to part with more than $100 to buy the bond. Conversely, if the spread widens, if investors need more than that initial 6.2%, then the fixed rate bond will trade below par, it will trade below the $100 that was its price at first issue and that would reflect a higher yield that was available maybe it'd be 6.5%, the price might be $98 instead of $100. So in summary, fixed rate bonds are really great. They're really, really good for investors to want regular, constant interest. They're really good in times of stable to lower interest rates because the rates that investors get do not change and that is different to have a floating rate notes work which we'll come to in the next presentation. Fixed rate bonds change in price as a function of both interest rates and the underlying perceived credit worthness of the company who's the borrower or issuer. Fantastic Lee, I hope that you've all kept pace with us, what's great about having a recording is that you can go back and listen to it again. Thank you very much for joining us and I hope you'll stay on or listen to the next webinar, the floating rate bonds. Thank you. Thanks, Liz.