Size opportunity in the covered bond universe

on Jun 28, 2012 in Fixed Income, Home | 2,363 comments

Weak global economic growth, coupled with fears of a recession in the eurozone, is expected to keep interest rates for the time being artificially low. Therefore the expected real return on a defensive fixed income investment is likely to be negative. Under these conditions, what are fixed income investors supposed to do? Faced with a difficult choice between accepting low yields, and the increased tail risk surrounding the banking system and the debt spiral, the need to find alternatives to this asset class becomes imperative. So what alternative is given? Covered bonds can be part of the solution as they provide an attractive spread over government bond yields and additional security relative to unsecured bank debt. For the investor, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer’s financial book, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer book. Basically a bank buys a bunch of cash-generating investments, combines them, and issues a bond that is supported by the cash from the investments. The cover pool consists of either mortgages or public sector loans. In that sense, covered bonds create cashflows for investors in exactly the same way that asset backed securities do. A covered bond, in other words, is a standard corporate bond, issued by a financial institution, but with an extra layer of protection for investors. Given the credit enhancements generally offered by the presence of a cover pool, covered bonds are considered to be some of the safest fixed income securities available. Indeed, the covered bond structure offers a considerably lower risk profile than asset backed securities. From the issuer’s perspective, the purpose of issuing covered bonds is basically to use a pool of high quality assets in order to achieve cheaper funding. For investors, the appeal of covered bonds lies in their security and the pick-up in yields over government bonds. Searching for covered bonds in this environment may be a strong option to...

Protect your fixed income portfolio against rising interest rates

on Jun 7, 2012 in Fixed Income, Home | 2,181 comments

The relationship between interest rates and bond prices is a fundamental concept in the fixed income universe. Specifically, when interest rates rise, a bond’s price will fall by an amount approximately equal to the change in interest rate, times the duration of the bond. For most investors, the primary importance of bond duration is that it predicts how sharply the market price of a bond will change as a result of changes in interest rates. In other words, investors use duration to measure the volatility of the bond. For instance, a bond with duration of 5 years would be expected to fall 5% in price for every 1% increase in market interest rates. Fixed income investors need to be mindful of the strategies that may be employed to protect a portfolio against the threat of rising interest rates. For the investor concerned with the damaging consequences of rising interest rates, there are a variety of fixed income strategies that may be employed to construct defensively positioned bond portfolios having reduced interest rate risk, while still maintaining adequate cash flow characteristics. A portfolio of short to mid-term maturity, high yield bonds, callable bonds, along with floating-rate securities and having issuers of diverse credit quality would likely do well to provide meaningful levels of coupon payments while offering decent principle protection in an era of volatile and rising interest rates. While chasing an yield pick-up in your portfolio, put the credit quality of the issuer in the balance before taking an investment decision. As a gentle reminder, the popular adage: “There’s no such thing as a free...

What is the yield curve telling investors?

on May 7, 2012 in Fixed Income, Home | 4,938 comments

The yield curve is a simple comparison of short term, mid term and long term bond yields. In other words, the yield curve is a reflection of the collective wisdom of investors on the likely direction of the economy. A bond’s yield is how much it will return to you on an annualized basis from the time you purchase it until it matures. The yield curve will change over time and these changes can be very important indications for what investors think about the market today and what they expect in the future. A normal yield curve slopes gently upward, reflecting a gradual increase in interest rates as maturities lengthen out. A normal yield curve indicates lower short term yields and a mild increase between mid-term and long-term debt. For example, if 85% of the yield on a 30-year bond is available on a 10-year bond, you will probably be best served by buying the 10-year bond. The yield curve tells you that you will not be adequately compensated for the additional risk inherent in the long-term bond. This is a very common scenario and indicates a normal level of confidence about the future. An inverted yield curve exists when short term rates are significantly higher than long term rates. That is extremely bearish because it means that investors are expecting yields to drop significantly in the long term and that short term risk is high as well. An inverted yield curve has a striking correlation to bear equity markets. A flat yield curve indicates also a lack of investor confidence in the future. A flat yield curve exists when the yields on short and long term securities are nearly identical. It is often an early warning sign that the economy is moving into recession. With their inflation fears quelled by the threat of recession, investors will often buy long term bonds to capture  higher yields. This causes prices of these bonds to appreciate and their yields to move down closer to short term rates, resulting in a flattened yield curve. In a steep yield curve environment, yields climb much more rapidly than normal. This type of curve is correlated with rallies in the stock market. This can occur when the economy is starting to pick up speed and investors’ inflation concerns cause them to sell longer term bond, depressing the prices of those bonds and driving their yields higher. As a means of protecting against inflation, investors might consider altering their fixed income portfolio allocations and shifting some of their holdings into securities that are immune to inflation, such as inflation linked bonds that pay a principal at maturity that is adjusted for inflation and they also pay coupons as a percentage of the adjusted principal. From a portfolio strategy standpoint, investors can look at the yield curve for clues to what direction the market thinks interest rates are headed and determine the best segment of the curve to hold. In summary, a yield curve shows you how a bond’s yield is related to its maturity. A careful look at the yield curve can help you determine if you are being adequately compensated for the risk you are assuming with your bond portfolio, and thereby increase the return of your entire...

The LIBOR OIS spread

on May 4, 2012 in Economy, Fixed Income, Home | 1,922 comments

The LIBOR-OIS spread is an important concept to understand because it plays a vital roll to determine the health of the credit markets that many economists and analysts watch regularly. So let’s take a look at what the LIBOR-OIS is all about. Three-month LIBOR is a floating rate of financing, which fluctuates depending on how risky a lending bank feels about a borrowing bank. The term overnight indexed swap (OIS) rate is the rate on a derivative contract on the overnight rate. The OIS is a swap derived from the overnight rate, which is generally fixed by the local central bank. The OIS allows LIBOR-based banks to borrow at a fixed rate of interest over the same period. There is very little default risk in the OIS market because there is no exchange of principal; funds are exchanged only at the maturity of the contract, when one party pays the net interest obligation to the other.  Furthermore, former Fed Chairman Alan Greenspan stated recently that the “LIBOR-OIS remains a barometer of fears of bank insolvency.” There is no doubt that changes in the LIBOR-OIS spread reflect counterparty credit risk premiums in contrast to liquidity risk premiums.  It appears that the spreads reflect the market’s perception of increased risk endemic to the economy more generally. These measures are telling investors to be very careful. Since September 2009, the TED Spread has typically ranged between 10 and 20 basis points. During economic crisis it gets much higher. It spiked as high as 457 basis points in the fall of 2008, when Lehman and Bear Stearns were collapsing. In short, the LIBOR-OIS spread has been the summary indicator showing the “illiquidity waves” that severely impaired money markets in 2007 and 2008.  ...

The TED spread

on May 3, 2012 in Economy, Fixed Income, Home |

The Ted spread is an indicator of perceived credit risk in the economy. This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. When the Ted spread increases, it is a sign that lenders believe the risk of default on interbank loans is increasing. Interbank lenders, therefore, demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the Ted spread decreases. The size of the spread is usually denominated in basis points (bps). For example, if the T-bill rate is 0.08% and LIBOR trades at 0.47%, the Ted spread is 39 bps. The Ted spread fluctuates over time but generally has remained within the range of 10 and 50 bps except in times of financial crisis. A rising Ted spread often presages a downturn in the U.S. stock market, as it indicates that liquidity is being withdrawn. In 2008, the Ted spread peaked at 450 basis points after the collapse of Lehman Brothers. In 2010, the Ted spread has returned slowly to its long-term average of 30 basis points, hitting a low of 11 basis points in March, as confidence returned. But as the Greek debt crisis escalated into widespread fears about the health of the eurozone, the Ted spread started to rise again, moving above 45 basis points by mid-June. This morning it’s at 38 basis points, that’s partly because, in the years since the financial crisis, central banks around the world have made funding much more readily available to banks. When the risks are as high as they are today, you want to see financial conditions getting looser, not tighter. Unfortunately this indicator has climbed steadily since the summer 2011. Central banks actions addressing pressures in global money markets are merely buying...

Considering investing in high yield bonds?

on May 2, 2012 in Fixed Income, Home |

High yield bonds – defined as corporate bonds rated below BBB− or Baa3 by established credit rating agencies – can play an important role in your portfolio. High yield bonds are issued by companies whose financial strength is not rock solid. They typically offer higher interest rates than government bonds or investment grade corporate bonds, and they have the potential for capital appreciation in the event of a rating upgrade, an economic upturn or improved performance at the issuing company. In addition, high yield bond investments may continue to offer equity-like returns over the long term with less volatility. Enhanced yields in the sector vary depending on the economic climate, generally rising during downturns when default risk also rises. For example, the overall spread of emerging markets sovereign bonds over US treasuries, measured by EMBI Global is slightly above 350bps and at the same time, the spread of emerging markets corporate bonds decreased to a level around 395bps, measured by CEMBI Broad. But during the credit crisis in 2008, the spread between high yield and government bond was above the 600bps mark. The capital appreciation is an important component of a total return investment approach. Events that can push up the price of a bond include ratings upgrades, improved earnings reports, mergers or acquisitions, management changes, positive product developments or market-related events. Cushion of protection, due to precedence of legal rights over common and preferred stock in the event of the liquidation of the issuer. Low duration, or sensitivity to changes in interest rates, tends to lower volatility. One reason high yield bonds often have relatively low duration is that they tend to have shorter maturities; they are typically issued with terms of 10 years or less and are often callable after four or five years. In a rising rate environment, as would be expected in the recovery phase of the economic cycle, high yield bonds would outperform many other fixed income classes. That said, the high yield sector does not demand great economic times; most issuers may continue to reliably service their debt in a low growth environment. From a portfolio perspective, high yield investments fit into the space between equity and fixed...