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While many investors are familiar with the main concepts of fixed income investing, some of the finer details may need explaining. This primer covers topics such as returns, price and duration, reasons for investing and the relationship of fixed income to equities. What is fixed income?
Fixed income describes a variety of debt instruments, although it most commonly refers to bonds. Typically, a borrower such as a government or a company may issue a bond, which is a contract outlining the conditions of a loan, to a bond holder (lender). This involves an exchange of principal at inception and at maturity, and periodic interest payments, known as coupons, from the issuer to the holder.
5 6 7 Time (years)
10
11
Price
A B
Par (100)
Issue date
Maturity date
A During the life of the bond, the price may rise above par. The bond holder can sell the bond at a profit. B At maturity, the price of the bond reverts to par as the bond holder receives the entire principal amount from the bond issuer.
Duration explained
The amount by which a bond changes in price is roughly proportional to its duration multiplied by the size of any interest rate change. % Change in bonds price = Duration x % Change in yield In this simplified example, assume that we have two bonds, one with duration of 4 years and the other with duration of 9 years. What happens when interest rates fall by 1%? Duration 4 years 9 years % Change in interest rates -1% -1% = -4 years x -1% = -9 years x -1% Change in bonds price = 4% = 9%
Given a 1% fall in interest rates, the price of the long-duration bond rises by 9%, compared with a 4% gain in the short-duration bond. As such, if an investor expects interest rates to fall, it is more profitable for him to hold long-duration bonds. Likewise, if he expects interest rates to rise, he should pursue a short-duration strategy. Clearly, the calculation of a portfolios duration is essential to determining the return from a change in interest rates.
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Case study: Performance of fixed income throughout the global financial crisis
The global financial crisis highlighted the defensive nature of traditional fixed income and the downside of too much credit risk. In a slowing economic environment in 2008, Asia ex Japan equities dropped in value by 51.63%. In the second half of the year, regional central banks loosened monetary policy to encourage lending and lift growth. China, for example, cut rates for the first time in six years. As interest rates fell, the HSBC Asian Local Bond Index returned 0.98% for the year as investors sought value in higher fixed interest payments relative to the new level of low interest rates. Asian bonds denominated in US dollars, measured by the JACI Composite Index, posted a loss of 9.82%. The index includes exposure to government issuers and Asian companies in which investors saw less value due to an increased concern of default. Less traditional fixed income indices containing lower quality companies such as the JACI Non-Investment Grade Index returned -17.72% amid extreme levels of concern about default. Clearly, fixed income products with duration were effective in diversifying a balanced portfolio whereas fixed income with lower quality credit (hence higher credit risk) behaved more like equities and thus was a poor diversifier.
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The chart above illustrates the importance of diversification. Over the last 10 years, Asian local currency government bonds have posted annual returns of 1%-19%. Equities, on the other hand, have experienced much higher gains, with the market rising by more than 70% in 2009 alone. However, equities also registered three negative years, whereas government bonds were positive in the same periods. Meanwhile, the credit market was also less volatile than equities.
Asian xed income (HSBC Asian local bond index) Asian equities (MSCI Asia Pacic ex Japan index)
Source: Bloomberg, November 2012
The chart above highlights the significantly lower historical volatility of fixed income relative to equities, albeit with a marginally lower return.
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Important information FOR INVESTMENT PROFESSIONALS ONLY - NOT FOR USE BY RETAIL INVESTORS Past performance is not a guide to future performance. The value of securities may go down as well as up and may be impacted by exchange rate movements. An investor may not get back the amount invested. Investments in EMs may involve a higher element of risk and volatility due to political and economic instability and underdeveloped markets and systems. The views expressed herein should not be relied upon when making investment decisions. The above is strictly for information purposes only and should not be considered as an offer, or solicitation, to deal in any of the investments mentioned herein. Aberdeen Asset Managers Limited (the Manager) does not warrant the accuracy, adequacy or completeness of the information and materials contained in this document an expressly disclaims liability for errors or omissions in such information and materials. Any research or analysis used in the preparation of this document has been procured by the Manager for its own use and may have been acted on for its own purpose. The results thus obtained are made available only coincidentally and the information is not guaranteed as to its accuracy. Some of the information in this document may contain projections or other forward looking statements regarding future events or future financial performance of countries, markets or companies. These statements are only predictions and actual events or results may differ materially. Readers must take their own assessment of the relevance, accuracy and adequacy of the information contained in this document and make such independent investigations, as they may consider necessary or appropriate for the purpose of such assessment. Any opinion or estimate contained in this document is made on a general basis and is not to be relied on by the reader as advice. Neither the Manager nor any of its agents have given any consideration to nor have they or any of them made any investigation of the investment objectives, financial situation or particular need of the reader, any specific person or group of persons. Accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the reader, any person or group of persons acting on any information, opinion or estimate contained in this document. The manager reserves the right to make changes and corrections to its opinions expressed in this document at any time, without notice. Issued by Aberdeen Asset Managers Limited which is authorised and regulated in the United Kingdom by the Financial Services Authority.
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