FIRC Fixed Income, Rates, and Credit

January 15th, 2014

Think FIRC & Think Trading

“Fixed Income” is too narrow of a definition for

what we can invest in for “income” purposes.

Income portfolios need to be looked at on a

total return basis as much as any equity

portfolio.

Benchmarks & Managers Matter

How much were stocks up in 2013?

• 22% if you invested in DJIA, 25% if you invested in SPY,

and 35% if you invested in QQQ. Big differences based

on the index you track.

• If you move outside the US, the question of how much

were stocks up varies even more.

• What about the last 6 months? Spain’s 39% gain

dwarfs the S&P 500’s 10%.

Where are Rates Headed?

What rate?

• 10-Year Treasury? Long bond? 3 Month LIBOR? High-

yield bond yields? High-yield bond spreads? Spanish

bonds? European corporate bonds?

What time frame?

• Over the next few days? Weeks? Months? Years?

Timing is even more important in the income world

where coupon and interest payments are an important

factor in total return.

Where are Rates Headed?

Intermediate Yields

• Stable to slightly lower as the growth story fails to

develop sufficient strength and a steep yield curve

slowly drives short positions out of the market

Credit Spreads

• Tighter as there is sufficient growth to support the

market, and the “chase for yield” encourages

structured products in addition to CLO’s creating

greater demand for credit

Managing Bond Market Risk

Complex but Simple

• Bonds have their own terminology that is confusing at

first, but you will soon realize it is more about job

security for fixed income professionals than anything

that is truly difficult to understand

• Think in basic “building blocks” of risk and you can’t

go wrong.

• Fixed Income portfolios can be customized to express

risk views in ways that equity portfolios can’t.

Bond Market Risks

Complex but Simple

• Bonds have their own terminology, which while

confusing at first, you will realize it is more about job

security for fixed income professionals than anything

that is truly difficult to understand.

• Think in basic “building blocks” of risk and you can’t

go wrong

• Fixed Income portfolios can be customized to express

risk views in ways that equity portfolios can’t.

Bond Market Risks – Rate And Duration

Rate Risk

• Typically Treasury or sovereign debt risk. The “risk-

free” rate.

• LIBOR, a benchmark for short-term rate risk, typically

tracks Fed Funds and Bank Credit Spreads.

• TIPS are traded on a “real yield” where investors can

lock in a real rate of return above CPI.

• Rates are expressed in yield, or bps (basis points),

where 1 bp (basis point) is simply 0.01% in yield

terms.

Bond Market Risks – Rate And Duration

Duration Risk

• Bonds with longer maturities generally have more

interest rate risk. For a similar change in yield, a bond

with a longer maturity will typically have a larger price

move.

• Callable bonds, typical of high-yield bonds and

preferred bonds, cap their upside as they can be

called, so they face “extension” risk where the

effective maturity increases as prices decline

Bond Market Risks – Rate And Duration

SHY and FLOT barely move, while TLT has much larger swings than IEF asthe underlying portfolio has a much longer average duration

Bond Market Risks – Rate and Duration

This simple table illustrates a lot of what you

need to know about bond “math” or bond

pricingYield Price Change Yield Price Change

1.20% 101.45% 2.41% 2.40% 103.10% 4.39%1.45% 100.24% 1.20% 2.65% 100.87% 2.17%1.70% 99.05% 2.90% 98.71%1.95% 97.87% -1.18% 3.15% 96.59% -2.11%2.20% 96.70% -2.34% 3.40% 94.53% -4.18%2.70% 94.42% -4.62% 3.90% 90.55% -8.15%3.70% 90.80% -8.25% 4.90% 83.16% -15.54%

5 Year Treasury 10 Year Treasury

Bond Market Risks – Curve Risk

Curve Risk

• Bond yields have changed with the curve “steepening”

which means that longer rates have increased faster

than short term rates.

• U.S. Treasury Yield Curves remain very steep.

• Forward rates have priced in a lot of weakness as the

“fair” rate for the 10 year bond yield in 1 year is about

3.35% or 0.45% than the current 10 year rate.

• This process of “bootstrapping” is a key element of

understanding curve risk.

Bond Market Risks – Bootstrapping

How high can 10-year yields go?

• This is a question on everyone’s mind as it is driving

the corporate bond market, mortgages, and some

days, even equities.

• The 10-year rate will be a function of growth

expectations, inflation expectations, and Federal

Reserve Policy, and the shape of the curve.

• While growth and inflation expectations change and

investors have a wide array of views, Fed Policy and

the Curve are easier to analyze, and very important to

the bond market.

Bond Market Risks – Bootstrapping

Start with the 2-year Bond

• The two year bond has spent the past 6 months

trading in a narrow range: 0.25% to 0.5%.

• The Fed remains committed to keeping Fed Funds, the

overnight rate low for the foreseeable future, in spite

of creating negative real short term rates for longer

than any other period in recent history.

• It seems safe to assume under the current Fed the 2

year yield should stay stable around 0.40% where it

currently is trading.

Bond Market Risks – Bootstrapping

Next, Look at the 5-year Bond

• The 2-year bond is at 0.4% and the 5 year bond is

trading at 1.7%, towards the high end of its recent

range, but well off the 0.65% low we saw last May

• The 2’s 5’s spread is 1.30% or 130 bps. That is high.

• For these rates to be “fairly priced” the 3-year

treasury would have to yield 2.55% in 2 years. The 3-

year treasury currently yields only 0.83%. That is a

large rise in yields. So those that say not much is

priced in, are wrong

Bond Market Risks – Curve Risk & the 10 Year yield

The 2’s 10’s Spread going back to 1990

Bond Market Risks – Credit Risk

Credit or “Spread” Risk is Similar to Yield Risk

• Duration impacts change in spreads the same way

duration impacts changes in rates.

• There are credit spread “curves” which can be steep

or flat and tend to invert if a credit runs into problems.

• High-yield and EM spreads are typically more volatile

than Investment Grade Spreads.

Bond Market Risks – Credit Risk

Credit Spreads are often inversely correlated to Treasuries as in an improving economy makes Treasury yields go higher, but makes spreads improve. The recent extremely high correlation is unusual.

Bond Market Risks and the ETF’s

Market Rate Duration CreditShort Maturity Treasuries Yes Low LowIntermediate Treasuries Yes Medium LowLong term Treasuries Yes High LowTIPS Some Medium LowInvestment Grade Bonds Yes High MediumHigh Yield Corporate Yes Medium HighFloating Rate Notes No None LowLeveraged Loans No None MediumMunicipal Bonds Yes High MediumPreferred Shares Yes High HighEmerging Market bonds Yes High High

A Deeper Look into Leveraged Loans vs High Yield

High Yield Bonds Leveraged Loans

Credit Risk High Yield CompaniesSecured Debt of High Yield Companies

Interest Rate Risk

Yes, average maturity is about 5 years

Somewhat as LIBOR floor has turned many loans into fixed rate for forseeable future

LIBOR Risk Not Directly

Due to LIBOR floors most loans will not see coupon increases even if LIBOR increases

Best Case

Lower yields, improved credit spreads, with some M&A Activity for large total return

Current Coupon since most loans are callable at or near current prices

Worst CaseYields rise or we see a return of real credit risk

The oversupply due to CLO demand comes back to haunt the market

FIRC Risk Management In Action

YTD Performance based on ETF’s is 0.9% and 1.7% since October 1 launch.

“Beta” selection, whether an ETF or mutual fund or closed end fund is critical opportunity to outperform this basic strategy as we mentioned earlier – not all indices or managers are created equal.

FIRC Risk Management In Action

YTD Performance based on ETF’s is 1.2% and 2.5% since October 1 launch.

This is designed to be a little more frequently traded, making it more difficult to execute via mutual funds but still something that needs to be considered as the performance disparity between top performing mutual funds and ETF’s grows.

Contact InformationTF Market Advisors, LLC

135 East 57th Street, 23rd Floor

New York, NY 10022

Peter Tchirtchir@tfmarketadvisors.com