Opportunities & Pitfalls in Today’s Fixed Income Market Josh Hudson, CFA Director of Fixed Income jhudson@stmmltd.com October 1, 2018

What are Bonds? Bond Basics Bond Investing

Definition of a Bond A Bond is an IOU When entities borrow money, from the markets rather than a bank or single lender, they issue bonds When you buy a bond, you are lending money Bonds are typically issued in multiples of $1,000 and pay stated coupon interest semi-annually The initial principal, or par value, is repaid when the bond matures. Maturities can range from overnight to 30 years….and longer!

Types of Bonds U.S. Treasury Bills (4, 13, 26, 52 week maturities) Notes (2, 3, 5, 7, 10 year maturities) Bonds (30 year maturities) Inflation Protection Securities (TIPS) Government Agencies Fannie Mae Freddie Mac Corporations Investment Grade High Yield Securitized Mortgage-backed (MBS) Asset-backed (ABS) Commercial Mortgage-backed (CMBS) Municipal General Obligation Revenue Taxable Municipals Sovereign Yankee Non-U.S. Dollar

How Do Bonds Trade? Primary Market vs. Secondary Market New Issue vs. Inventory Underwriter vs. Selling group OTC vs. Listed Round Lots vs. Odd Lots ($1 million par value or higher vs. less than $1 million par value) Liquidity – round lots have better liquidity than odd lots Bid/Ask Spread – higher markup for odd lots Minimum tradable amount

Yield, or Yield-to-Maturity Because the future is uncertain, investors require higher yield for longer maturity bonds to compensate them for the risk This is often stated in terms of a bond’s yield, or yield-to maturity (YTM) The YTM calculation takes into account the bond’s current market price, coupon interest rate, and time to maturity. YTM is a complex calculation of a bond’s return that helps investors compare bonds with different maturities and coupons

The Yield Curve Normally, since short-term bonds (loans) are less risky than long-term bonds, short-term bond yields (interest rates) tend to be lower than longer-term bond yields (interest rates). This relationship between the maturity of bonds (i.e. “length of the loan”) and their yields is often plotted. This is known as the “yield curve.” Example: Yield Curve Yield Note: The yield curve usually Has a positive slope 15% 10% 5% Maturity in Years 5 yr 10 yr 15 yr

Here’s What it Looks Like in Reality US Treasury Yield 3.0% 2.5% 2.0% 1.5% 1.0% Yield US Treasury 10/01/17 US Treasury 9/27/18 1M 6M 1Y 2Y 3Y 5Y 7Y 10Y 15Y 20Y 30Y Years to Maturity Source: Bloomberg, September 27, 2018

Federal Funds Target Rate Fed Rate Hike Cycle Federal Funds Target Rate September 27, 2006 – September 27, 2018 5.00% 4.00% 3.00% 2.25% 2.00% 1.00% 0.00% 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Source: Bloomberg, September 27, 2018

Bonds Are Subject to Two Primary Types of Risk ONE Interest Rate Risk TWO Credit or Default Risk

Bond Prices & Interest Rates are Generally Inversely Related Point: So bond prices and interest rates move in opposite directions. The value of existing bonds falls when interest rates in the economy rise. And the value of existing bonds rises when interest rates in the economy fall. Rising rates hurt bonds. Interest rates up, bond prices down Interest rates down, bond prices up

Relationship Between Bond Prices and Interest Rates If interest rates rise, people will not pay the same price for existing bonds, because new bonds would pay higher rates. The price of existing bonds will fall until the yield has risen to equal current rates.

If You Fear Rising Interest Rates, Stay Short! The best way to protect against rising interest rates is to buy shorter maturity bonds, hold them to maturity, and reinvest the proceeds at the higher rates.

Default or “Credit” Risk The second big driver of bond prices (and hence yields or interest rates) is the risk of default, that is, the risk that the bond issuer (borrower) can’t repay the loan This is also known as credit risk Borrowers that have less ability to repay loans, like poorly managed companies, have to pay more in interest to borrow money Several rating agencies grade bonds by the degree of default or credit risk

Bond Ratings Credit Risk Moody’s Standard & Poor’s Fitch Investment Grade Highest quality High quality – Very strong Upper medium – Strong Medium grade Not Investment Grade Somewhat speculative Speculative Highly speculative Most speculative Imminent default Aaa Aa A Baa Ba B Caa Ca C AAA AA A BBB BB B CCC CC C AAA AA A BBB BB B CCC CC C

Risk vs. Yield: Further Points High quality bonds are considered safer than stocks and therefore have a historically lower rate of return The greater the risk, the greater the yield Investment grade are safer than high yield Government bonds are generally safer than Corporate bonds General Obligation bonds are generally safer than Revenue bonds Short maturities are safer than long maturities

Considerations for Bond Investing? Bond Basics Bond Investing

Advantage of Individual Bonds vs. Mutual Funds Owning individual bonds removes the risk of price declines because you receive the principal back, as long as you hold the bond to maturity! Mutual funds, on the other hand, can be forced to sell bonds at a loss in order to meet investor withdrawals

Additional Advantages of Individual Bonds Predictable income stream Control over duration, quality, and sectors Transparency...know what you own Control over what you pay for a bond

Disadvantages of Bond Mutual Funds In a rising rate environment, the net asset value (NAV) of the mutual fund falls as interest rates rise Bond mutual funds often are forced to sell into a failing market to meet fellow shareholder redemptions In a fixed income mutual fund, there is no guaranteed repayment of principal

Advantages of Fixed Income Separately Managed Accounts In expected rising rate environment, individual bonds are the most conservative way to own fixed income Owning individual bonds allows the bondholder to ride out the rise in interest rates, collect income, and wait until maturity to get back bond’s principal Reinvest maturities at higher yields

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