INTRODUCTION TO WALL STREET: FIXED INCOME & CAPITAL MARKETS MICHAEL WRIGHT

WHAT IS WALL STREET?  The colloquial term refers to the financing of the world’s markets through various ways:  Stocks  Bonds  Private Equity / Venture Capital  Alternative Investments  ForEx, Options, Swaps, Real Estate, Derivatives

STOCKS VS. BONDS  What’s the difference?  Stocks are a form of equity  Bonds are a form of debt  Stocks represent ownership and are bought with the hope that they will appreciate in value, which can then be sold for profit (Risky)  Bonds are essentially loans that you give to those with financing needs, with the expectation of a fixed percentage return, at a fixed point in time, on the principal invested (Less Risky)

KEY TERMS  Face Value = the amount the bond holder will receive once the bond reaches its maturity date.  Coupon = the amount the bond holder will receive in interest payments, expressed in a yearly percentage  Maturity = date that the bond “expires” and the principal is returned to the investor. Maturity dates range, typically, from 1 month to 30 years.  Issuer = the entity that is selling the bond

WHO SELLS BONDS? Countries Corporations Municipalities (States and Cities) Financial Institutions Issuers Include

TYPICAL BOND You US Department of the Treasury $10,000 Ten Year Note (2.7%) Today 10 Years From Now Title to Bond $10,000 Every Year for 10 Years $270 ROI = $2,700

NUANCES OF BONDS  Time value of money: A bond with a 2.7% return is not a real 2.7% return….why not?  Inflation.  Average inflation is around 2%, therefore your real return after 10 years is only.7% (assuming no periodic payments)  The purpose of this investment is basically to hedge the effects of inflation, not to profit  Most bonds have periodic interest payments (usually every six months), which increase the value of the bond because you can reinvest that income

IS THERE RISK?  Yes, that’s where the fun comes in.  The return on bonds are positively related to their risk  That is, higher risk = higher return  The risk comes from the possibility that the company will go bankrupt and “default” on their debt before the bond has reached its maturity date  An established, long time profitable company, such as IBM, has little chance of going bankrupt in the next ten years, therefore it has to pay very little on the debt it issues. These bonds have low returns, but are relatively safe.  A less established company, or one whose profitability has been shaky will have to pay more interest on the debt they issue in order for the risk of investing in one of their bonds to be worth the return. These bonds have higher returns, but run the risk of defaulting which leaves the investor with little to none of the original principal. These are often called “Junk Bonds”.

CAN I KNOW THE RISK?  Yes. This is where the Ratings Agencies come in.  The Big Three Rating Agencies are:

RATING AGENCIES  The job of the ratings agency is to provide their opinion on the risk of default for a given bond.  The rating scale goes from AAA – D  AAA-BBB rated bonds are the most secure and are considered “investment grade”  BB-D rated bonds are more risky and are considered “non- investment grade”

RATING AGENCIES  Companies solicit the services of ratings agencies to rate their debt offerings because without a rating investors would be hesitant to invest in the bond.  This is the case in many countries in emerging markets, often lacking accounting standards, transparency, and other factors that are prudent to ratings.

SECONDARY MARKETS  Once a company has an initial bond offering (the primary market), bonds are bought, sold, and traded “Over the Counter” on the open market by speculators hoping to make profit on fluctuations in the market  In the secondary market bonds are valued by their yield  Yield = (Face Value – Price) / Price Lewis Ranieri “The Godfather” Bill Gross “The King”

SECONDARY MARKETS UBS Trading Floor - Stamford, CT

INTEREST RATE & BOND PRICE  The fundamental rule of bond pricing is:  Bond Prices are inversely related to Interest Rates  Why?  Say a zero coupon bond (bond with the interest sold separately) has a face value of $10,000. Right now it is trading at $9,500. Therefore its yield is 5.26%.  (10,000 – 9,500) / (9,500) = 5.26%  If current interest rates were to rise to 10%, then the demand for a bond yielding 5.26% will be zero. Why buy a bond at 5.26% when you can buy one for 10%.  Therefore, the bond’s price must drop to $9,090 (10% yield) in order for it to sell

CAREERS IN FIXED INCOME  Sales & Trading (S&T)  Investment Banking (IBD)  Asset Management  Ratings

KEY TAKEAWAYS  Bonds are debt financed investments instruments with fixed interest rates attached to them, and a set maturity period  Their return is positively related to their risk of default  Their risk of default is estimated by ratings agencies  Bonds traded on the open market are valued by their yield, the price of which is inversely related to interest rates

INTRODUCTION TO WALL STREET: FIXED INCOME & CAPITAL MARKETS MICHAEL WRIGHT