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THE AUSTRALIAN STOCK REPORT FIXED INTEREST REPORT

Who are the players in the fixed income market?

Any market requires buyers and sellers. In debt markets it is easier to consider the participants as borrowers and lenders. Australian governments, from a local to a federal level, issue securities to fund budget shortfalls or individual long-term projects. Similarly, Australian Corporations issue securities to cover their longer-term expansion or for liquidity purposes. By issuing securities the borrower agrees to certain terms and conditions acceptable to the holder (lender of funds) of those securities. The major investors in this asset class are fund managers and therefore indirectly almost every Australian has a fixed income investment.

What types of securities are issued?

The types of securities issued vary from case to case and are determined by the nature of the project they are financing and/or prudential requirements. Traditionally fixed income securities have a maturity, a coupon flow (or a stream of payments) and a yield. Companies use debt markets as an alternative to equity raisings, an obvious benefit being no dilution of ownership. Issuing bonds or fixed income directly to investors is an alternative to traditional bank funding.

Generally speaking the lender of funds or investor in the fixed income asset class will receive a steady income stream commensurate with the risks involved in lending to the institution issuing the security and the ranking of that security in terms of other liabilities of that particular issuer. This income stream is constant and not affected by fluctuations in the "underlying profitability of the company".

Debt obligations rank in front of the shareholders and as such attract a lower risk profile. Subsequently their fixed returns are not as great as the potentially high returns sometimes associated with the direct equity investment in a corporation. Like shares, ownership of these assets can be transfered in the marketplace. The ASX has recently introduced trading in these assets through the Chess system.

Investing in fixed income

A key factor in making investment decisions is diversification among different asset classes, amongst different companies and market sectors. This can help ensure that the effects of shifts in market conditions have minimum impact on the long-term performance of a portfolio.

The Australian Stock Exchange released the following information regarding the make up of Australian investors' portfolio weighting. "To achieve an acceptable level of diversification, professional fund managers currently invest approximately 20 per cent of their portfolio in interest-bearing securities (APRA Bulletin June 1999). The average Australian Do-It-Yourself superannuation fund, however, invests a much lower 2 per cent. To maximise the benefits they receive from investing, Australians should learn to minimise their exposure to avoidable portfolio risk; a basic way to minimise risk and protect a portfolio is by diversifying."

Access to fixed income

There are two avenues for investors to gain access to fixed income products. The first is via a new issue. These issues are usually brought to the market by a panel of banks or intermediaries and an issue lead manager. These companies organise the structuring and marketing of the product according to their market research and the issuer and investor\'s requirements. In return for the placement of these assets into the investor\'s portfolios the lead manager and panel members will receive a fee in the form of an underwriting payment or a placement fee from the issuer of the securities.

There are certain guidelines that need to be followed when issuing securities of this nature into the market. A new issue is called a primary issue. In order to comply with the Corporations Law in Australia, most corporate bond issues are available to "sophisticated" investors. If the minimum investment is $500,000 face value, the potential investor is deemed to have the required expertise or understanding of the product requiring the issuing institution to issue an investment memorandum outlining the product. If the minimum investment is less than $500,000 the issuer is required to issue a prospectus document. This is to ensure the retail investor or the general public are fully informed about the product.

The other avenue is through the secondary market. Once a security has been issued it can be bought and sold on what is called the secondary market. Secondary market trading is an important consideration for the majority of issuers. They wish to have liquidity in their securities, giving comfort to the investor should they wish to buy or sell the asset prior to maturity

Most of the benchmark wholesale issuers have specific maturity buckets (timeframes) that they reopen when they need to raise further funds. This is not possible for the retail issuers of debentures etc. because each asset has individual characteristics. A complete list of the securities available to investors can be obtained by contacting your FIIG representative.

In the wholesale or professional market, securities are offered exclusively to institutions and professional investors who are regarded as sufficiently experienced and informed not to require the level of detailed information included in a prospectus.

Variables that make up a fixed income security

When a company issues a debt instrument, it enters into an agreement to pay interest to the buyer of the bond at a certain interest rate for the use of their funds until a defined date (maturity).

Short dated debt instruments usually have just two cash flows. A purchase (cash out) and a refund at the maturity date (cash in). The difference between the two amounts, on an annualised percentage basis, of the initial purchase cash flow (cash out) is the return achieved. These assets are bought at a discount to the maturing value or face value.

Longer dated securities have more complex cash flows They will usually have periodic payments of interest at predetermined interest rates or margins over benchmark interest rates (for example the 90 day bank bill) in the case of floating rate notes. Interest payments are paid to holders of bonds on predetermined dates. These are called the coupons. The frequency of the coupon payment will also affect the return of the bond. The coupon income stream over the life of the bond and the face value of the bond (the payment on maturity) make up the cash flows in these longer term assets. These flows are discounted at the market yield of the bond to obtain a price for the asset as at today. This will determine the amount of money an investor will need to outlay today in order to receive the face value and the coupons over the life of the bond and achieve a desired percentage return or yield.

This exercise obtains Net Present Value (NPV) of the cash flows and represents the price paid for a bond at any given time.

Premium and discount

Fixed income assets with fixed coupons that are higher than the yield used to discount the cash flows will have a price in excess of face value. Conversely, bonds with a coupon less than the yield used to discount the cash flows will be priced at a discount to face value.

Face value

The term Face Value is the value of the bond as literally described on its face. This is an out of date definition but essentially it means the amount payable to the holder on redemption by the issuer of the security at maturity. Market convention uses a face value of $100 when referring to the price of a bond.

The final coupon and the face value of a bond is repaid to the investor on its maturity date. Some bonds have no maturity date, for example, perpetual income securities.

Some bonds, notably perpetual bonds, have a call provision attached. This gives the company the right, but not the obligation, to buy back the bonds from investors at a particular point in time at a certain price.

Accrued interest

Accrued interest is the amount of the coupon interest payment accumulated in the current coupon period. Given the coupon payments are made periodically and to one holder at the time of the coupon payment, an important component of the value of a fixed income asset at any point in time is the accrued interest component. When the price of a bond is calculated it looks to the future cash flows and obtains a net present value of these cash flows. This component of the total price of a bond is called the capital price or the clean price. However if a bond is between coupon payments when it is purchased or being valued, its value is a combination of the future cash flows and the accrued interest of the current coupon period to date. These amounts when added together make up the total price or dirty price of a bond. The reason why the accrued component must be included is to reimburse the previous holder for the interest earned that he will not receive when they transfer the ownership of the bond.

Transferability

Unlike other forms of interest rate products, such as term deposits and cash management accounts, interest rate securities are negotiable instruments. Investors are able to transfer their securities to other investors. Ownership of bonds is recorded on a register in exactly the same manner as shares. Specialised companies operate registries for bond issues and make interest and maturity payments to bondholders on behalf of the issuer. To standardise the payment procedure for the coupons of a fixed income asset, the issuer will usually set a cut off period 7 days prior to the actual coupon payment date. The holder of the security on that date will receive the coupon. If a bond is purchased during this seven day period it is said to be ex interest and the purchaser will need to be compensated for receiving no coupon payment for the period between the ex interest period and the payment date of the previous coupon. When this is not the case a bond is said to be cum interest.

Consistent income as opposed to speculation!

One of the key benefits of fixed income securities is that they offer predetermined income streams. This is very important to investors, particularly retirees.

Changes in yield

One of the hardest things to explain to retail investors is the relationship between yield and price. Most fixed income assets are discount securities therefore if interest rates go up prices go down and vice versa. This can best be explained by example.

To make a comparison in other markets such as the retail clothing market. If I buy any goods from an outlet at a 10% discount to normal market price in the morning and discover by the afternoon that the same goods can be obtained at a 20% discount, I would be disappointed. The higher the discount the cheaper the goods. Therefore having already purchased the goods at the lower price I have lost money given their new price.

Another example can be yields on property. If the rental income stays the same and the price of the property falls the yield will increase. The opposite is also true.

Key concepts for investors

Investors should become familiar with some key concepts before investing in interest rate securities.
Fixed income is traditionally a conservative asset class but products are available where investors can leverage capital significantly. This of course will increase the potential for capital loss or gain. Generally speaking the higher the risks incurred, the higher the yields demanded in compensation; conversely, the lower the risk, the lower the yield. Due to short-term liquidity or supply considerations some fixed income assets can have lower yields than theoretical fair value.

Fixed income investors seek real returns, which are returns above inflation. Some fixed income products are tailored to guarantee a return above inflation for example CPI capital index bonds.

The longer an investor holds an interest rate security, the greater his or her exposure to the risk that market conditions might change with regard to that security. The relationship between the yield of a fixed income asset and the maturity is called the yield curve. In a normal situation investors are compensated with a higher yield the longer the maturity of the bond. This is called a normal yield curve or a positive yield curve. As, over time investors' holdings become shorter in maturity, the yields will fall correspondingly if the overall yield curve level stays the same. This is called riding the yield curve. The investor is repaid over time for the risk in terms of maturity taken if all things stay the same. The difference in yields is most marked in the yield curves of the corporate issuers, as you would expect. The likelihood, albeit remote, of a credit event will be greater over a longer period of time.

Fixed income markets can also have inverse (negative) yield curves. This usually occurs during periods where central authorities are tightening monetary policy and the outlook for the economy is a slow down going forward.

The frequency of interest payments, whether they be in the form of a coupon or just payments on deposits, is important when calculating the actual return on an asset. If I were to invest funds on a semi annual basis for 1 year at 7%, this rate can be expressed in a number of ways. For example this rate is expressed quarterly, monthly and annually below.

All of these rates are equivalent to 7% paid semi annually.

6.90% monthly
6.94% quarterly
7.12% annually

Reinvestment of interest is the key assumption in this comparison. The relationship is therefore not linear. The higher the interest rate the greater the divergence between equivalent rates.

Liquidity

Fixed income markets are generally very liquid. Investment grade issuers are usually very supportive of their own products in the market place. The liquidity or marketability of an asset is determined by the difference between the bid, the price at which the market is willing to buy the security and the offer, the price at which the market is willing to sell the security, more commonly known as the bid-offer spread. If a market is liquid it will have many participants at any given time competing to buy or sell the assets, resulting in a narrow spread, and if it is not liquid it will be very difficult to buy or sell the asset without adjusting the capital price paid or received for the asset significantly, creating a wide bid-offer spread.

Most of Australia's benchmark government and corporate bond issues are extremely liquid issues. Conversely, debentures issued by the finance companies are not liquid. This is because they are not generic. Most or all debentures have different characteristics from each other reducing the number of suitable buyers. This ensures that each debenture has to find its own specific market. Subsequently, the issuer or the underlying credit quality of the debenture issue plays an important role in providing liquidity to the asset.

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*Important Information:

Our performance refers to the potential performance which could reasonably be achieved by members who bought and sold CFDs with the leading CFD providers as suggested in our CFD Report. All returns shown in the table above are leveraged returns based upon the margin specifications of IG Markets Australia.

Transactions suggested in reports were not actually executed by Australian Stock Report, but the entry and exit points flagged in our Report were however able to be achieved in the market under actual market conditions and prevailing liquidity.

Fees and charges:

Due to the significant diversity in the fees charged by brokers, this data does not include any execution or settlement costs such as brokerage or financing fees. In other words, the data reports performance which doesn't take into account transaction costs. You should check with your Stockbroker or CFD Provider what fees might be incurred in executing the trades suggested by our Reports.

Future Performance:

Note that past performance of trades suggested by Australian Stock Report is not necessarily a reliable indication of future performance. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program.

One of the limitations of hypothetical performance results is that they assume a certain level of transaction fees that may or may not be available to a particular investor. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results.

There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results, and all of which can adversely affect actual trading results.

What is the Fixed Interest Report?