Fixed Income Fundamentals of Inve$ting Garcia Hamilton & Associates Presented By: Jeffrey D. Detwiler, CFA, AAMS Partner/Portfolio Manager Fixed Income Fundamentals of Inve$ting 5 Houston Center 1401 McKinney, Suite 1600 Houston, TX 77010 Tel: (713) 853-2359 Fax: (713) 853-2300 Ruby@GarciaHamiltonAssociates.com www.GarciaHamiltonAssociates.com Awards/rankings may not represent client experiences and are not indicative of future performance. Go to www.garciahamiltonassociates.com/awards/ for additional information on each award.

Fixed Income Basics Interest Rate Risk Credit Risk Market Environment Table of Contents Fixed Income Basics Interest Rate Risk Credit Risk Market Environment Conclusion

What are Bonds? Bonds 101: What are bonds and why do they exist? A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to an issuer. In return for that money, the issuer provides you with a promise to pay a specified rate of interest during the life of the bond and to repay the principal when it comes due. Sources: US Bond Market Outstanding: www.sifma.org/research/statistics.aspx, www.investinginbonds.com, www.treasurydirect.gov

Types of Bonds Corporate Securitized Treasury Agency Sources: www.theinvestorsnews.com, www.dailykos.com, istockphoto/RichardCano, www.forbes.com

Types of Bonds 1976 2018 $456 Billion $20.3 Trillion Source: Bloomberg Barclays Live Chart Data as of 12/31/80 and 9/30/18 Bloomberg Barclays U.S. Aggregate Index

Coupon: Features: Coupon A feature of a bond that denotes the amount of interest due, and the date payment will be made. A bond is normally an interest-only loan, meaning the borrower pays the interest every period, but none of the principal is repaid until the end of the loan. Source: www.investinginbonds.com

Maturity: Features: Maturity The date when the principal amount of a security is due to be repaid. Generally, bond terms range from one year to 30 years. Short-term bonds generally offer lower yields. Long-term bonds generally offer higher yields. Source: www.investinginbonds.com

Rating: Features: Rating Designations used by credit rating agencies to give relative indications as to opinions of credit quality. Generally speaking, a higher rating means less risk but a lower potential return and vise-versa. Source: www.investinginbonds.com

Understanding Risks All investments carry some degree of risk, which is linked to the return that investment will provide. A good rule of thumb is the higher the risk, the higher the return. Two types of Risk related to fixed income: Interest Rate Risk Credit Risk Conversely, safer investments offer lower returns. There are a number of key variables that comprise the risk profile of a bond: its price, interest rate, yield, maturity, redemption features, default history, credit ratings and tax status. Together, these factors help determine the value of your bond investment and whether it is an appropriate investment for you.

Interest Rate Risk Interest rates and bond prices are like a see-saw – when interest rates rise, bond prices fall (and vice versa). How much interest risk a bond has depends on how sensitive its price is to interest rate changes. Duration is a measure of the sensitivity of price change to interest rate changes.

Interest Rate Risk Duration Example Duration Portfolio A 5 Portfolio B 2 Interest rates, in general, RISE by 100 BPS (1.0%).  Which portfolio LOSES value the most? Portfolio A would lose approximately 5% Portfolio B would lose approximately 2% Interest rates, in general, FALL by 100 BPS (1.0%).  Which portfolio GAINS value the most? Portfolio A would gain approximately 5% Portfolio B would gain approximately 2% Dates and data used are for illustration purposes only and may not reflect actual data as of the dates shown.

Less Interest Rate Risk More Interest Rate Risk HIGHER LOWER SHORTER LONGER HIGHER SHORTER If the Coupon Rate is If the Maturity Source: www.web-books.com

Credit Risk The risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do.   Credit risks are calculated based on the borrower’s overall ability to repay. Ratings agencies such as S&P, Moody's, and Fitch evaluate the credit risks of thousands of issuers on an ongoing basis. Conversely, safer investments offer lower returns. There are a number of key variables that comprise the risk profile of a bond: its price, interest rate, yield, maturity, redemption features, default history, credit ratings and tax status. Together, these factors help determine the value of your bond investment and whether it is an appropriate investment for you.

Credit Risk Why quality matters… A bond’s yield is calculated assuming that all the promised payments will be made. As a result, it is really a promised yield, and it may or may not be what you will earn. If the issuer does not make the promise payment, your actual yield will be much lower. Conversely, safer investments offer lower returns. There are a number of key variables that comprise the risk profile of a bond: its price, interest rate, yield, maturity, redemption features, default history, credit ratings and tax status. Together, these factors help determine the value of your bond investment and whether it is an appropriate investment for you. Source: www.theguardian.com

Credit Ratings* Strongest Weakest MOODY’s STANDARD & POOR’S DESCRIPTION INVESTMENT GRADE Strongest Aaa AAA Highest Rating Aa AA Very Strong A Upper Medium Grade Baa BBB Lower Medium Grade NON-INVESTMENT GRADE Weakest Ba BB Non-Investment Grade B Highly Speculative CCC Caa Substantial Risk CC Ca C D Issuer is in Default *These credit ratings are reflective of obligations with long-term maturities. Conversely, safer investments offer lower returns. There are a number of key variables that comprise the risk profile of a bond: its price, interest rate, yield, maturity, redemption features, default history, credit ratings and tax status. Together, these factors help determine the value of your bond investment and whether it is an appropriate investment for you. Source: www.investinginbonds.com

Credit Risk 1980 2018 $178 Billion $5.1 Trillion Source: Bloomberg Barclays Live Chart Data as of 12/31/80 and 9/30/18 Bloomberg Barclays U.S. Corporate Index

Credit Spreads AAA AA A BBB Ratings Examples % of Index* Microsoft, Johnson & Johnson 1.9% AA Berkshire Hathaway, Apple, Wal-Mart 8.4% A JP Morgan, Wells Fargo, Pepsi, Pfizer 40.6% BBB AT&T, Xerox, McDonalds, General Electric 49.1% *Percentage of Bloomberg Barclays Investment Grade Corporate Index Source: Bloomberg, Barclays Live Last Update: 9/30/2018 **Option Adjusted Spread

Market Environment The Federal Reserve has begun the process of Monetary Policy “Normalization” As a result the yield curve has “Flattened” Corporate bond spreads have recovered to “pre-crisis” levels

Yield Curve Changes Dec 2013 Sept 2018 3m 6m 2yr 5yr 10yr 30yr Dec 2013 Sept 2018 US Treasury Actives Curve 12/31/2013 US Treasury Actives Curve 9/30/2018 12/31/13 9/30/18 Difference 3 Month 0.07 2.19 2.12 6 Month 0.09 2.36 2.27 2 Year 0.38 2.82 2.44 5 Year 1.74 2.95 1.21 10 Year 3.03 3.06 0.03 30 Year 3.97 3.20 -0.77 Source: Bloomberg Last Update: 9/30/2018

Average Option Adjusted Spreads (OAS) U.S. Credit Downgrade Greece Gulf War MW 5/18/2018 -LEAVE END OF MONTH CHART AS BACKUP. **REMOVE ALL MID MONTH DATA WHEN END OF MONTH NUMBERS ARE AVAILABLE. Source: Barclays Live Last Update 9/30/2018

Conclusions It is important to understand how both interest rate risk and credit risk might impact your portfolio. The importance of having an investment manager who can successfully navigate both types of risks has risen as the market dynamics have changed. Looking forward, expect short term rates to continue to gradually move higher as the Fed continues on the path of monetary policy “normalization” Conversely, safer investments offer lower returns. There are a number of key variables that comprise the risk profile of a bond: its price, interest rate, yield, maturity, redemption features, default history, credit ratings and tax status. Together, these factors help determine the value of your bond investment and whether it is an appropriate investment for you.