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

2. What are Bonds?
Bond Basics
Bond Investing

3. 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!

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

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

11. 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

12. 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.

13. 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.

14. 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

15. 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

16. 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

17. Considerations for Bond Investing?
Bond Basics
Bond Investing

18. 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

19. 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

20. 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

21. 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

22. Disclosures
This presentation is for informational purposes only and may not be copied, reproduced or redistributed in whole or in part without the prior written permission of South Texas Money Management, Ltd. This presentation contains no recommendations to buy or sell securities or a solicitation of an offer to buy or sell securities or investment services or adopt any investment position. This presentation is not intended to constitute investment advice. Market and economic views are subject to change without notice and may be untimely when presented here. You are advised not to infer or assume that any securities, sectors or markets described in this presentation were or will be profitable. Securities identified in this presentation do not represent all of the securities purchased, sold or recommended for advisory clients. You should not assume that any securities recommendations made in the future will be profitable. Index information is included merely to show the general trend in the markets for the periods indicated and is not intended to imply that client accounts will be similar to the index either in composition or risk. Due to timing issues, tax considerations or other individual portfolio characteristics, some client portfolios may not hold the securities mentioned in this presentation. None of the graphs, charts, formulas or other devices in this presentation are, in and of themselves, sufficient to form the basis of a trading decision. All material and information presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Past performance is not indicative of future results. There is always a possibility of loss. Individual securities described herein do not represent all of the securities purchased or sold by STMM. They are intended merely to illustrate certain industries discussed. For a complete list of securities purchased, please contact STMM.
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