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Investment Surgery

Investment surgery

What is fixed income?

Fixed income instruments are also known as bonds. A bond is quite simply an IOU, issued by a borrower raising capital from investors that acknowledges the debt. This IOU is typically issued at par, also known as the bond’s nominal or face value. In the UK, a bond’s par value is usually £100. The IOU promises to pay investors a fixed rate of interest – hence the term “fixed income” – known as the coupon. This coupon is typically paid semi-annually on fixed dates and is expressed as a percentage of the bond’s par value. So a 5% coupon would pay the investor two semi-annual coupons of £2.50. The IOU also provides for the bond’s par value to be repaid at maturity. These are known as the redemption proceeds.

Who issues bonds and why?

There are a wide range of bond issuers:

• Governments around the world issue, so-called, sovereign bonds to finance the difference between the amount they spend and the amount they raise in taxation. Each government bond market is accorded a unique name for its bonds. Bonds issued on behalf of the UK government are called Gilts, whereas US government bonds are known as Treasuries, German government bonds, Bunds, and Japanese government bonds, JGBs. The government bond market is by far the largest of all the bond markets and is dominated by US Treasuries, those issued by Eurozone governments and JGBs.
• Supranational issuers, such as the European Investment Bank (EIB) and International Finance Corporation (IFC) arm of the World Bank issue bonds to raise capital for the less well developed regions of the world economy, on commercial terms.
• Companies issue corporate bonds to raise capital for expansion, sometimes to finance this growth organically, at other times by acquiring other companies. Corporate bonds are also issued to restructure a company’s finances, if, for example, the company wishes to buy back some of its shares in issue. Those companies that enter into Private Finance Initiative agreements to develop or maintain the country’s infrastructure also issue bonds to finance the capital intensive nature of these projects.

What are the main bond types?

The main bond types comprise:

• Conventional bonds represent the majority of bonds in issue in that they pay a fixed rate of coupon and repay the bond’s par value at maturity
• Undated bonds do not have a fixed maturity date for repaying the bond’s par value. In most cases, the par value will never be repaid
• Index linked bonds provide the investor with protection against inflation by linking the bond’s coupons and usually the redemption payment to a retail or consumer prices index
• Convertible bonds are issued by companies and enable the investor to convert the bond into the issuer’s shares at a predetermined price on a series of predetermined dates
• Zero coupon bonds, as the name suggests, are bonds that do not pay any coupons, only a final redemption payment. They are, therefore, issued at deep discount to their par value
• Eurobonds bonds are issued by multinational companies seeking to tap a wide investor base for capital but, despite their name, are not necessarily denominated in Euros. In fact, the Eurobond market predates the creation of the single currency and is mainly centred in London

What are the main risks of fixed income investment?

Bond investment is not without its risks. The key risks comprise:

• Interest rate risk: As most bonds pay a fixed rate of coupon, if market interest rates rise then the coupon becomes less attractive to investors. In order for the bond to become attractive, its price must fall. In so doing, this increases the bond’s gross redemption yield (GRY). The GRY is the annualised rate of return the bond investor can expect to achieve if the bond is purchased at the current price and is held to maturity.
• Duration: The sensitivity of a bond’s price to the change in its yield is measured by its duration. Duration measures the approximate change in the bond’s price to a 1% change in its yield. The higher the bond’s duration, the greater its price sensitivity to a change in yield.
• Inflation risk: With the notable exception of index-linked bonds, most bonds in paying a series of fixed coupons and redemption proceeds at par do not protect investors against the damaging consequences of inflation.
• Credit, or default, risk: Credit ratings, applied by the Rating Agencies, such as Standard and Poor’s and Moody’s, provide an indication of the quantifiable risk of the issuer not meeting its coupon payments and eventual redemption payment.
• Liquidity risk: This is the risk of being unable to sell a bond to another investor at short notice without having to accept a dramatically reduced price. This risk was particularly prevalent during the financial crisis of 2007 to 2009.

Resource centre

Download relevant articles, reports and news items:

	Investment Tutor Training Guide to Fixed Income This guide introduces the fundamental issues and terminology that investment-decision makers need to know. Aviva Investors | 10/0802/300711
	Try this! (bonds) Use this spreadsheet to have a go at the 'Try this!' exercises detailed throughout the Investment Tutor Training Guide to Fixed Income.

	Investment Surgery: Making the case for emerging markets Anne-Sophie Girault, head of fixed income client portfolio management, says trustees should look at emerging market debt opportunities. Aviva Investors/Engaged Investor 11/0397/281011
	Credit investing: Using long/short techniques to maximise opportunities Credit has become a core asset class for many institutional investors but little is known about the framework by which credit portfolios are best managed. In this paper, we put forward the case for sector neutral credit investing, a long / short technique learned from the hedge fund industry but with applications in the traditional investment arena to maximise opportunities and aid in building a robust risk managed investment process. Aviva Investors | Investors Journal 5 | 10/0302/300910
	High yield bank loans: The case for a strategic allocation High yield bank loans can be used successfully to complement a high yield bond strategy or as a standalone asset class. Bank loans can provide superior risk-adjusted returns over several alternative investment classes. They also provide portfolio diversification benefits, a senior claim position with higher recovery potential in bankruptcy, and the potential for strong returns in a rising interest rate environment. To increase the likelihood of capturing these benefits, it is important to actively manage a diversified portfolio of loans. Aviva Investors | Investors Journal 5 | 10/0302/300910
Further reading
	Introduction to Fixed Income Analytics Frank J. Fabozzi and Steven V. Mann A complete fixed income reference.  It contains insights into the time value of money and techniques for estimating yield volatility, as well as for analyzing valuations, yield measures, return, risk, and more.