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Hannah Ray
5 years ago
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This publication is intended for intermediary use Over the past year, the South African bond market has experienced high levels of volatility.

Concerns are often raised by these conservative and cautious investors when they occasionally experience capital losses from bonds in their funds.

losses within their funds are possible. The world of interest bearing investments has made significant advances in the types of instruments available to investors.

1 This publication is intended for intermediary use Over the past year, the South African bond market has experienced high levels of volatility. With conservative and cautious investors usually having a large exposure to interest bearing investments, the increased volatility has had a direct impact on them. Concerns are often raised by these conservative and cautious investors when they occasionally experience capital losses from bonds in their funds. These concerns are reasonable as interest bearing investments are often thought of as a safe haven but an understanding of bond pricing dynamics can help these clients to recognise that capital losses within their funds are possible. The world of interest bearing investments has made significant advances in the types of instruments available to investors. Previously we would describe the interest bearing environment as a suite of fixed income investments. Additional complexities have been introduced into the valuation of bond securities by introducing various characteristics such as credit, inflation-linked payoffs, floating rate instruments, inverse floaters, bonds with embedded options, swaps, swaptions, asset backed securities, collateralised debt obligations etc With this added complexity, it is important to understand how these instruments work. However, before examining these more complex instruments, a solid grounding in the mechanics of traditional fixed income investments is vital. What is a traditional bond? Governments, municipalities, institutions and companies often have certain spending requirements which they fund with either debt financing or equity financing from investors. Equity financing allows investors to purchase an ownership through shares whereas debt financing provides investors with a contractual claim against the debt issuer. In its simplest and purest form, a bond represents a loan. The investor transfers an amount of money at the inception of the loan to the counterparty. In exchange, the counterparty will compensate the investor (or bondholder) by periodically paying interest coupons and also return the initial capital outlay at the end of the loan period. The coupons are intended to provide a return as compensation to the investor for risks borne over the investment period. This type of security is often referred to as a plain vanilla bond or simply a vanilla bond.

Figure 1: Vanilla bond cash flows This differs from the typical mortgage bond or home loan which is an amortised loan. What this means is that no principal is returned at the end of the loan term.

2 Figure 1: Vanilla bond cash flows This differs from the typical mortgage bond or home loan which is an amortised loan. What this means is that no principal is returned at the end of the loan term. Rather, the periodic repayments analogous to coupons in a vanilla bond include both the interest portion and principal portion. In the world of investing, bond issuances have traditionally followed the structure of a vanilla bond rather than amortised bonds. Pricing a vanilla bond The key variables impacting the price of a vanilla bond are as follows: 1) The initial principal (IP) to be returned at the end of the loan term 2) The coupon or coupon rate and the associated frequency of coupons (C) 3) The term or length of the loan (T) 4) The interest rate at which the cash flows are discounted (YTM - the yield to maturity) Bonds are, however, often viewed and quoted not as a price but rather in terms of the yield that the bond will generate until maturity (the YTM). Since the value of R1 today is usually worth more than R1 in a future period, it is necessary to discount future payments by an appropriate rate in order determine what the value would be today or what price would be fair for the bond. Knowing the appropriate YTM at which to discount the future cash flows allows each cash flow to be discounted in order to arrive at a present value for those individual cash flows. The effect of compounding interest over longer time periods means that the further out the cash flows are, the higher the discount factor applied to that cash flow. The individual present values are then summed to arrive at a current value for a bond.

Figure 2 - At inception IP = R1000, T = 6 years, C = R80 or 8% annually At inception, the above bond might have been priced at an annual coupon rate of 8%, given that bonds with similar maturity and

3 Figure 2 - At inception IP = R1000, T = 6 years, C = R80 or 8% annually At inception, the above bond might have been priced at an annual coupon rate of 8%, given that bonds with similar maturity and risk characteristics determined that the fair value for such a bond was a YTM of 8%. This bond would pay a coupon of R80 at the end of every year and return the principal together with the final coupon at the end of the six year period in exchange for an initial R1000 investment. When the bond is initially issued, the coupon rate is usually at, or very close to, the prevailing yields for similar bonds in the market. This leads to the bonds pricing at par. Assuming the other variables as fixed, the price of the bond would vary if the required yields increased or decreased. Figure 3 Yield vs. Price Bond Price vs Required yield (at a point in time) R %, R R R %, R R %, R R R % 4.00% 8.00% 12.00% 16.00% 20.00%

4 The above graph highlights the fundamental relationship between yields and the price of a bond. Holding all other variables constant, as required yields increase, the price of the bond declines and as required yields decrease, the price of the bond increases. At any point in time, the coupons that the bond pays periodically, which are pre-defined, may differ from the prevailing market rates or market yields on similar bonds. This results in the bond having a value which will differ from the par value. In an instance where the bond is paying coupons at a rate which is below the rate at which similar bonds are priced, the price of the bond will fall. The result of the price falling is that the new YTM will be in line with that of similar bonds. The opposite holds true for bonds which currently pay coupons at a rate above which similar bonds are currently being priced. In this case, the price on the bond will rise to a point at which the new YTM will fall in line with the YTM of similar bonds. An interesting point to note is that bond prices do not rise or fall linearly as the required yield falls or rises. In fact, if we compare the change in a bond price for an equal fall and rise of rate we see that the bond will have an absolute increase in price for greater than the absolute decrease in price. In the figure above we see that should the required yield decline by 7% to 1%, the price of the bond will rise by R If the required yield increased by 7% to 15%, the price of the bond will only decline by R This attractive feature of bond is referred to as the convexity of the bond. The price of a vanilla bond will also adjust as a result of the passage of time. Bonds in practice Having seen the basic pricing structure of a vanilla bond, we can now explore how this could potentially translate into a capital loss for an investor. The initial issuance of the bond takes place in what is known as the primary market. Following the initial issue, bonds are also tradable in the secondary market. The secondary market consists of numerous bond securities and investors in a similar manner to how equities trade on the Johannesburg Stock Exchange. The equivalent exchange for bonds in South Africa is the Bond Exchange of South Africa. Interest bearing fund managers provide debt financing to counterparties as a means to generate returns for clients invested in their portfolios. Practically this will begin with these managers having cash balances which they seek to deploy as debt financing. Cash can be from new inflows into the fund, interest coupons received or from the sale of securities. Just as equity investors and fund managers are able to buy and sell stocks based on their views, managers who focussed on the interest bearing market determine their own fair values or views on bond securities. The difference is that instead of focusing on an appropriate price at which to purchase a stock, as equity managers do, interest bearing managers will attempt to determine the appropriate or fair YTM. Securities offering a higher YTM than the assessed fair YTM will appear attractive to the interest bearing manager. How do capital losses and gains occur? At the inception issuance of a vanilla bond, all cash flows are defined and your capital is returned to the bondholder at maturity. How then is it possible for a bond or bond fund to display negative returns? The answer is that these securities are marked-to-market each day. What this means is that gains or losses are recorded and accounted for on a daily basis. Since market expectations and views can change each day, the yield required on each bond adjusts daily to reflect the current views. As these yields adjust, prices change and these gains or losses in price are accounted for each day that the security is held.

5 If the required yield on an issue increases, the price of that bond will fall. The interest rate risk of the bond will determine the magnitude of gains or loss. Since bonds are valued each day for reporting purposes, these losses are essentially locked-in. If the bond is, however, held from that point onward, the new higher required yield at which the bond is now priced will result in future returns being higher. If the bond is sold with these losses locked-in, those losses will permanently impact investors. So while the bond cash flows are pre-defined and fixed, the price changes to reflect the current market expectations. This means that in the short term, bonds and bond funds can experience capital losses. Bond fund managers The key areas where traditional bond managers have added value is in making a call on how to position the fund in terms of overall interest risk exposure and also how to achieve this exposure. Managers have the ability to adjust the bond securities in the portfolio to protect against capital losses and potentially produce capital gains. Duration Although bonds have numerous risks attached to them, a large emphasis is placed on the interest rate risk attached to a bond. Duration is the term which refers to the interest rate risk of a security. Although there are a few variations on the calculation of the duration measure, they essentially all account for the same risk. Interest rate risk refers to the risk that required interest rates may change uniformly across the yield curve which would alter the price of the bond. When market required yields rise, the bond price will reflect an immediate capital loss. When market rates fall, the bond will produce capital gains. Duration for a portfolio of bond securities is determined by taking a weighted average of the individual holdings. If the manager anticipates that yields will rise, he could reduce the duration of the fund in order to minimise capital losses. The opposite position would be taken if the manager anticipated that yields might fall. The yield curve Bonds are issued with different terms to maturity. Some longer dated securities can have maturities in excess of 30 years while shorter dated securities in issue also of course wind down their term to maturity as time passes. The yield curve connects the current yields to maturity or returns of government bonds (y-axis in Figure 4) across the maturity spectrum (x-axis in Figure 4). The shape and slope of the yield curve is often an area of thorough analysis by fund managers as they attempt to identify areas of the yield curve which offer a higher YTM than their fair YTM. As the yields demanded by investors changes across various maturities, the shape of the yield curve will adjust to reflect these expectations. This can be seen in the figure below where it is clear that the yields demanded by investors across all maturities have increased from a year ago. The changing shape of the yield curve implies that yields do change and thus the price of various bonds changes as well. The areas of the yield curve that a manager invests into will determine how he achieves his duration. A manager invested in an area of the curve that rises would experience a loss as bonds held with those maturities would experience a decline in price. The opposite would also hold true for bonds held in an area of the curve that declined. By exploiting the relative attractiveness of areas of the yield curve, a manager could protect against capital losses and even produce capital gains.

6 Figure 4 - South African Yield Curve (as at 20 May 2014) Yield Curve (Years) Today Six months ago One year ago Conclusion In this period of increased bond market volatility, the potential for conservative or cautious investors to experience capital losses on the interest bearing portions of their portfolios has been highlighted. Since the prices of fixed income securities change and are marked-to-market each day, investors have had to stomach this relatively unstable period in the bond market. There is, however, comfort that the South African asset management industry is well represented with experienced and skilled fixed income managers. An astute bond manager could mitigate the risks of capital losses and protect investors from adverse market movements by positioning their portfolios appropriately. References: CFA Curriculum

FIN 6160 Investment Theory. Lecture 9-11 Managing Bond Portfolios

FIN 6160 Investment Theory. Lecture 9-11 Managing Bond Portfolios FIN 6160 Investment Theory Lecture 9-11 Managing Bond Portfolios Bonds Characteristics Bonds represent long term debt securities that are issued by government agencies or corporations. The issuer of bond