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S AWYER F ALDUTO A SSET M ANAGEMENT, LLC. IPPFA/NIU TRUSTEE CERTIFICATION PROGRAM August 2011. Fundamentals of Fixed Income Investing Presented By: Thomas S. Sawyer Managing Partner Sawyer Falduto Asset Management, LLC [email protected] 630-941-8560. Introduction.

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ippfa niu trustee certification program august 2011
SAWYER FALDUTO

ASSET MANAGEMENT, LLC

IPPFA/NIUTRUSTEE CERTIFICATION PROGRAMAugust 2011

Fundamentals of Fixed Income Investing

Presented By:

Thomas S. Sawyer

Managing Partner

Sawyer Falduto Asset Management, LLC

[email protected]

630-941-8560

IPPFA TRUSTEE CERTIFICATION PROGRAM

introduction
Introduction
  • Features of fixed income securities.
    • More specifically those allowed by statute.
  • Risk and return concepts.
  • Portfolio structure and investment policy guidelines.
  • Benchmarking fixed income portfolios.
  • Current market environment.
  • Additional Terminology.

IPPFA TRUSTEE CERTIFICATION PROGRAM

introduction1
Introduction
  • Although stocks seem to get most of the attention, fixed income markets are large, varied and dynamic.
  • Fixed income securities (bonds) represent the lion’s share of police and firefighter pension fund assets.
  • Understand the risks associated with bonds.

IPPFA TRUSTEE CERTIFICATION PROGRAM

what is a bond
What is a Bond?
  • A bond is a contractual obligation between a borrower and a lender.

IPPFA TRUSTEE CERTIFICATION PROGRAM

features of fixed income securities
Features of Fixed Income Securities
  • Issuers:
    • U.S. Treasury
    • U.S. Government Agencies
    • States, Municipalities and Local Units of Government
    • Corporations
  • Coupon:
    • Stated Rate of Interest
  • Maturity:
    • Term of the Loan
  • Redemption Options:
    • Call Provisions (the issuer’s option to pay off the loan early)

IPPFA TRUSTEE CERTIFICATION PROGRAM

features of fixed income securities1
Features of Fixed Income Securities

Description:

$100 Face Amount (Par Value) U.S. Fourth Liberty Loan Bond 4.25% Due 10/15/1938.

Issuer: U.S. Treasury

Coupon: 4.25%

Maturity: 10/15/1938

Call: None

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fixed income securities permitted by statute
Fixed Income Securities Permitted by Statute
  • U.S. Treasury Bills, Notes and Bonds
  • Government Agencies
    • Federal Home Loan Bank, Fannie Mae, Freddie Mac, Federal Farm Credit
  • Municipal Bonds issued in Illinois
  • Corporate Bonds (January 1, 2011)
  • Other
    • Certificates of Deposit
    • State of Israel Bonds
    • GICs
    • Money Market Mutual Funds

IPPFA TRUSTEE CERTIFICATION PROGRAM

a word on public act 96 1495 corporate bonds
A Word on Public Act 96-1495—Corporate Bonds

Allows investment in investment grade corporate bonds.

Bonds must be rated as investment grade by either Moody’s or S&P at the time of purchase.

Bonds must be liquidated within 90 days after the bonds are downgraded by both Moody’s and the S&P.

Corporate bonds count as fixed income investments.

Corporate bonds must be invested through an investment advisor, not through a consultant as defined in the Illinois Pension Code.

Another way that pension funds may diversify their fixed income portfolio.

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permitted investments pension funds
Permitted Investments – Pension Funds

Allocation to Fixed Income

Unlike the allocation to equities, the statute does not impose percentage allocation limitations.

Illinois Pension Code provides a complete list of acceptable investments.

40 ILCS 5/1-113, 113.1, 113.2, 113.3, 113.4 and 113.4a

Pension Code also provides a list of prohibited transactions

40 ILCS 5/1-110

IPPFA TRUSTEE CERTIFICATION PROGRAM

risk and reward
Risk and Reward

Inverse Relationship – Bond Prices and Interest Rates

I = Interest Rates

P = Bond PriceS

I

P

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risk and reward1
Risk and Reward
  • Types of Risk Usually Associated with Bonds:
    • Credit Risk
    • Maturity Risk
    • Price/Interest Rate Risk
  • Duration and Convexity:
    • Measures of the sensitivity to changes in interest rates.

IPPFA TRUSTEE CERTIFICATION PROGRAM

risk and reward2
Risk and Reward
  • Credit and Maturity Risk Spectrum:

Tsy Agy Muni Inv Grade Corp High Yield Corp

Less Risk More Risk

Shorter Maturity Longer Maturity

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risk and reward3
Risk and Reward

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time value of money
Time Value of Money

“The Eighth Wonder should be utilized by all of us to accomplish what we want. It is compound interest.”

- Baron Rothschild

  • Present Value: The amount of money that must be set aside today in order to achieve a specified future value.
  • Future Value: The value of an amount of money set aside today at a specified date in the future.

IPPFA TRUSTEE CERTIFICATION PROGRAM

one math problem sorry time value of money
One Math Problem – Sorry!Time Value of Money

FV = PV(1 + i)n

Or,

Future Value = Present Value x

(1 + rate)periods

So,

$104.25 = $100(1.0425)1

PV = FV

(1 + i)n

Or,

Present Value = Future Value

(1 + rate)periods

So,

$100 = $104.25

(1.0425)1

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risk and reward premium or discount to par
Risk and RewardPremium or Discount to Par

Scenario: A tough winter has caused coal prices to rise dramatically. Due to increased concern over inflation, interest rates on U.S. Treasury securities have moved higher. The yield on bonds maturing in 1938 now yield 5%.

We paid $100 for our bond, with a coupon of 4.25%, maturing in 1938. Because investors now require a higher yield, the present value of the bond is now $99.27. The bond is trading at a DISCOUNT to par.

IPPFA TRUSTEE CERTIFICATION PROGRAM

risk and reward premium or discount to par1
Risk and RewardPremium or Discount to Par

Scenario: The coal mines of Central Illinois stepped up production. Coal prices abated from recent high levels. Yields on U.S. Treasury securities maturing in 1938 declined dramatically to 3.75% as investors turned their attention to an anticipated slow down in the economy.

We paid $100 for our bond, with a coupon of 4.25%, maturing in 1938. Because investors now are willing to accept a lower yield, the present value (price) of the bond is now $100.49 The bond is trading at a Premiumto par.

IPPFA TRUSTEE CERTIFICATION PROGRAM

features of fixed income securities yield isn t necessarily yield
Features of Fixed Income Securities(Yield isn’t necessarily Yield)
  • Coupon: the stated rate of interest. In the case of our bond, the coupon is 4.25%.
  • Current Yield: the ratio of the coupon (4.25% x $100 = $4.25) to price. When our bond was trading at a discount to par, the currentyield was 4.28%. $4.25/$99.27 = 4.28%.

Later on, our bond was trading at a premium to par. The currentyield was 4.23%. $4.25/$100.49 = 4.23%.

  • Yield-to-Maturity: YTM is a better measure as it accounts for cash flows to maturity. Using our bond maturing in 1938, under the discount scenario, the YTM is 5.0%. Under the premium scenario, the YTM is 3.75%.

IPPFA TRUSTEE CERTIFICATION PROGRAM

risk and reward4
Risk and Reward

US TREASURY YIELD CURVE

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portfolio concepts
Portfolio Concepts

Duration

Remember the inverse relationship between interest rates and bond prices…..

Assume the average duration of a portfolio of bonds = 5.

Rates rise by 1% - portfolio value declines by 5%.

Rates decline by 1% - portfolio value increases by 5%.

IPPFA TRUSTEE CERTIFICATION PROGRAM

portfolio structure and investment policy
Portfolio Structure and Investment Policy

Portfolio Concepts

  • Should be a risk management tool.
  • Provide for diversification across issuing sectors.
  • Establish duration and maturity ranges.
  • Be flexible enough to adapt to changing conditions.

IPPFA TRUSTEE CERTIFICATION PROGRAM

portfolio concepts1
Portfolio Concepts

Fixed Income Portfolio Characteristics

Diversification

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a few comments on corporate bonds
A Few Comments on Corporate Bonds

IPPFA TRUSTEE CERTIFICATION PROGRAM

a few comments on corporate bonds1
A Few Comments on Corporate Bonds

IPPFA TRUSTEE CERTIFICATION PROGRAM

a few comments on corporate bonds2
A Few Comments on Corporate Bonds

IPPFA TRUSTEE CERTIFICATION PROGRAM

fixed income portfolio characteristics
Portfolio ConceptsFixed Income Portfolio Characteristics

Quality, Yield and Duration

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benchmarking fixed income portfolios
Portfolio ConceptsBenchmarking Fixed Income Portfolios
  • Benchmark should be a “best fit” with investment policy and objectives.
  • Selected fixed income benchmarks:
    • Government Bond Index
    • Intermediate Government Bond Index
    • Government/Credit Bond Index
    • Treasury Index
    • Short term Treasury Indices

IPPFA TRUSTEE CERTIFICATION PROGRAM

slide28
Current Market Environment
  • Short-term interest rates likely to remain at near 0%.
  • Still, Hints of inflation returning to economic data.
  • What is the shape of the Yield Curve telling us today?

IPPFA TRUSTEE CERTIFICATION PROGRAM

conclusion
Conclusion

Useful Resources:

  • www.investopedia.com
  • www.bloomberg.com
  • www.yahoo.com (Finance)
  • Illinois Compiled Statutes at www.ilga.gov (40 ILCS 5/)

IPPFA TRUSTEE CERTIFICATION PROGRAM

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