1. History of the bond market
LAPERS
September 18, 2017
Jeff Detwiler, CFA, AAMS
Partner/Portfolio Manager
1401 McKinney, Suite 1600, Houston, TX, Office: | Fax:

2. Table of Contents Market Quiz Basics and Key Features
Evolution of the Bond Market
Current and Historical Valuation
Market Developments

3. Question: Which asset class provided the highest return over the past ten years?
REITs
Large Caps
Bonds
International
Small Caps
Ten Year
Annualized Returns
7.18%
6.92%
6.21%
4.48%
1.50%
Source: eVestment
Last Update: 6/30/2017
Asset classes represented by the following indices: Bloomberg Barclays U.S. Aggregate, S&P 500, Russell 2000, FTSE/NAREIT All Equity REITs, MSCI EAFE-GD

4. Answer: Large Cap Stocks provided the highest return over the past ten years
Annualized Returns
Asset Class
Large Caps
REITs
International
Small Caps
Bonds
7.18%
6.21%
1.50%
6.92%
4.48%
Source: eVestment
Last Update: 6/30/2017
Asset classes represented by the following indices: Bloomberg Barclays U.S. Aggregate, S&P 500, Russell 2000, FTSE/NAREIT All Equity REITs, MSCI EAFE-GD

5. Why is Return not enough??
Return alone doesn’t account for the risk required to achieve that return
Investors must be compensated for risk
Therefore, we should measure returns on a risk adjusted basis

6. Sharpe Ratio
The return earned in excess of the risk-free rate per unit of total risk
Sharpe Ratio = R - Rƒ σ
A higher sharpe ratio equates to better risk-adjusted total returns

7. Question: Which asset class provided the highest return per unit of risk taken?
REITs
Large Caps
Bonds
International
Small Caps
Ten Year
Sharpe Ratios
1.21%
0.44%
0.32%
0.23%
0.05%
Source: eVestment
Last Update: 6/30/2017
Asset classes represented by the following indices: Bloomberg Barclays U.S. Aggregate, S&P 500, Russell 2000, FTSE/NAREIT All Equity REITs, MSCI EAFE-GD

8. Answer: Investment Grade Fixed Income produced the highest return per unit of risk taken
Ten Year
Sharpe Ratios
Ten Year
Annualized Returns
Asset Class
REITs
Small Caps
Bonds
Large Caps
International
1.21
0.23
0.32
0.44
0.05
6.21%
6.92%
4.48%
7.18%
1.50%
Source: eVestment
Last Update: 6/30/2017
Asset classes represented by the following indices: Bloomberg Barclays U.S. Aggregate, S&P 500, Russell 2000, FTSE/NAREIT All Equity REITs, MSCI EAFE-GD

9. 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.
It takes a lot of money to keep the U.S. Government running and a good deal of it is borrowed money. That’s where we come in. Our job is to borrow the money needed to operate the federal government and account for that debt.
Source: US Bond Market Outstanding:

10. Types of Bonds Treasury Agency Corporate Securitized
Source: istockphoto/RichardCano,

11. Features: Coupon 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.
Examples:
Suppose I want to borrow $1,000 for 30 years and that the interest rate on similar debt issued by similar corporations is 12 percent. I will pay .12 × $1,000 = $120 in interest every year for 30 years. At the end of 30 years, I will repay the $1,000. The $120 regular interest payments that I promise to make are called the bond’s coupons.
Source:

12. Features: Maturity 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
Examples:
Suppose I want to borrow $1,000 for 30 years and that the interest rate on similar debt issued by similar corporations is 12 percent. I will pay .12 × $1,000 = $120 in interest every year for 30 years. At the end of 30 years, I will repay the $1,000. The $120 regular interest payments that I promise to make are called the bond’s coupons.
Source:

13. Features: Rating 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.
Examples:
Suppose I want to borrow $1,000 for 30 years and that the interest rate on similar debt issued by similar corporations is 12 percent. I will pay .12 × $1,000 = $120 in interest every year for 30 years. At the end of 30 years, I will repay the $1,000. The $120 regular interest payments that I promise to make are called the bond’s coupons.
Source:

14. Bloomberg Barclays Aggregate Index
1976
$456 Billion
Source: Barclays Live

15. Bloomberg Barclays Aggregate Index
1976
1986
$456 Billion
$2.1 Trillion
Source: Barclays Live

16. Bloomberg Barclays Aggregate Index15
1986
Tax cuts without spending cuts
Collateralized Mortgage Obligations (CMO) invented in 1983
15-year Mortgage-Backed Securities (MBS) added to the index in 1985
$2.1 Trillion
Source: Barclays Live

17. Bloomberg Barclays Aggregate Index
1986
2001
$2.1 Trillion
$6.9 Trillion
Source: Barclays Live

18. Bloomberg Barclays Aggregate Index17
2001
Tax increases and “Dot Com” bubble
Asset-Backed Securities (ABS) added in 1991
Mortgage Balloons added in 1992
20-year MBS added in 2000
$6.9 Trillion
Source: Barclays Live

19. Bloomberg Barclays Aggregate Index
2017
$19.6 Trillion
Source: Barclays Live
Last Update: 6/30/2017

20. Bloomberg Barclays Aggregate Index
1976
2017
$456 Billion
$19.6 Trillion
Source: Barclays Live
Last Update: 6/30/2017

21. Corporate Credit Quality Distribution
$178 Billion
Source: Bloomberg

22. Corporate Credit Quality Distribution
1980
2017
$178 Billion
$19.6 Trillion
Source: Barclays Live
Last Update: 6/30/2017

23. Valuation by Quality AAA AA A BBB Ratings Examples % of Index*
Microsoft, Johnson & Johnson
2.1% AA
Berkshire Hathaway, Apple, Wal-Mart
9.8% A
JP Morgan, Wells Fargo, Pepsi, Home Depot
39.3%
BBB
AT&T, Xerox, Waste Management, McDonalds
48.8%
Source: Bloomberg, Barclays live
Last Update: 6/30/2017
*Percentage of Bloomberg Barclays Investment Grade Corporate Index **Option Adjusted Spread

24. Historical Corporate Bond Market Valuation
Average Option Adjusted Spreads (OAS)
Lehman Brothers
— Investment Grade Corporate Index
Bear
Stearns
U.S. Credit Downgrade
Accounting Scandals
Asian/Russian Financial Crisis
Greece
Gulf War
Current
109
Source: Barclays Live
Last Update: 6/30/2017

25. Market Developments
Electronic Trading
TRACE Data

26. Electronic Trading Price transparency and operational efficiency
Diminished relationships and less proactive sales force
Dark pool liquidity

27. Voice vs. Electronic Communication
Source: Bank for International Settlements (2016). Electronic trading in fixed income markets submitted by a study group established by the Markets Committee

28. Percentage of Trades Executed Electronically
Source: Bank for International Settlements (2016). Electronic trading in fixed income markets submitted by a study group established by the Markets Committee

29. TRACE Example - Corporates
Source: Bloomberg
Last Update: 6/30/2017

30. TRACE Example - Mortgages
Source: Bloomberg

31. Conclusion
Historically, investment-grade fixed income has provided a high risk-adjusted return relative to other asset classes
The composition of the market has changed over time, which has created both risks and opportunities
Recent market developments have increased transparency in the bond market