Fixed-Income Securities: A Foundation for Success

Wespath Investment Management continues to view today’s investment marketplace through an optimistic lens. We seek investment opportunities using a cautious, well-reasoned approach while following the tenets of diversification and prudency. The fixed-income market has been, and will continue to be, a viable avenue for achieving our objectives. Therefore, in order to better navigate today’s economic landscape, we feel it is important for all stakeholders to understand fixed-income securities, to be aware of their history, and to have a basic comprehension of their fundamental principles.

In architecture, attention is drawn to the façade of a building.

People focus on aesthetic flourishes—the cornices, trefoils and

friezes that give a building its character. Few think about the

foundation—the one element that most determines the strength

and ultimately the longevity of a building.

A sound investment strategy is much like a building. While

flourishes attract attention—in this case high-profile investments

which offer lucrative returns (and correspondingly high risk)—most

likely it is the fixed-income investments which should comprise

a suitable portion of your investment strategy foundation.

The noted 14th century biblical scholar, Thomas á Kempis,

said it best: “The loftier the building, the deeper the foundation

must be laid.”

Fixed-Income Securities Primer

According to the Investopedia definition, fixed-income securities

are “an investment that provides a return in the form of fixed

periodic payments and the eventual return of principal at maturity.”

In its most basic form, a fixed-income security is a loan between

a borrower and investors. The borrower—otherwise known as the

issuer of the security—agrees to pay back the amount of money

borrowed by a specific date. The issuer also agrees to pay interest

or income to investors to make the investment worthwhile.

There are three primary aspects of a fixed-income investment.

Par value, otherwise known as face value, is the principal amount

of the investment. This is the amount the issuer promises to pay

back at the time the security comes due. The maturity of the

investment is the term of the agreement; determining how long

the payments will take place. Finally, the coupon rate is the rate

Stephen Kroah

Stephen Kroah joined the

General Board of Pension

and Health Benefits’ Wespath

investment management

division in January 2011 as director

of fixed income. Previously, he

spent much of his career as

a principal and senior portfolio

manager at Lotsoff Capital,

a Chicago-based investment

firm. Stephen also spent four

years in the United States

Marine Corps. He graduated

magna cum laude from

Northeastern University with

a B.S. in International Business/

Finance and has an MBA from

the Tepper School of Business

at Carnegie Mellon University.

He is also a CFA Charterholder.

by Stephen Kroah, CFA

“The loftier the building, the deeper the foundation

must be laid.”Thomas á Kempis, 14th century

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used to determine the periodic interest to be paid on the

principal amount.

Much like equities, most fixed-income investments are traded

in the marketplace, with a rise and fall in price as factors—such

as change in interest rates or change in credit spreads—affect

the investment. Therefore, investors may realize a capital gain

or loss if they sell the security before maturity. Unlike stocks,

they are generally traded by investment banks and not on

a central exchange.

Origins of the Fixed-Income Market

The fixed-income securities market in America dates back to the

very beginning of our nation. In 1790, the federal government

combined state and federal Revolutionary War debt and issued

$80 million in bonds. Alexander Hamilton, the nation’s first

Secretary of the Treasury, believed it was the responsibility of the

new government to take on the individual states debts. He also

wished to establish credit in the event the U.S. needed to borrow

money from a foreign nation.

Two years later, the Buttonwood Agreement formalized the

securities market in our country. Meeting in New York City,

twenty-four merchants and brokers signed the agreement, which

authorized the sale of securities for a commission. Five securities,

three government bonds and two bank stocks were initially

traded. From these humble beginnings our system of selling

and purchasing stocks and bonds began.

Manifest Destiny Spurs Market

The expansion of our country westward fueled the growth of bond

markets throughout the 19th century. During the 1820s, it became

apparent that tax revenue alone was not sufficient to fund the

building of the Erie Canal—the state of New York issued a series

of bonds to finance the venture. These bonds were well-received

by professional speculators and the general public, and marked the

beginning of a vigorous market in municipal and corporate bonds.

Transportation bonds were at the forefront of an increasingly

active corporate bond market. Not surprisingly, the railroads

dominated this market. Hundreds of railroad companies were

established seemingly overnight. With millions of dollars needed

to build the lines and purchase the equipment, it became

necessary for the railroads to hire intermediaries—Wall Street

financial firms—to help raise the necessary funds. These

intermediaries became rich acting on behalf of the railroads and

in their own interests. Unfortunately, many individual speculators,

lacking the necessary inside knowledge, lost their savings in

proposed railroads that never came to fruition.

Through War and Depression

The bond market in the first half of the 20th century was dominated

by two overriding factors: the need to fund two world wars through

war bonds and the ramifications of the Great Depression.

In an attempt to spur the economy, the federal government

under President Franklin Roosevelt introduced a different form

of fixed-income securities. The newly created Federal Deposit

Insurance Corporation (FDIC) was established to guarantee

depositor bank accounts. This led to insured, bank-issued

“The United States debt, foreign and domestic, was the price

of liberty. The faith of America has been repeatedly pledged

for it…Among ourselves, the most enlightened friends of good

government are those whose expectations of prompt payment

are the highest...”Alexander Hamilton

1790, First Report on the Public Credit

$1000 Pacific Railroad Bond issued by the City and County of San Francisco, 1863

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Certificates of Deposit. Soon afterward, in 1938, the Federal

National Mortgage Association (Fannie Mae) was created to

bring more capital and liquidity to the residential mortgage

market by offering mortgage-backed securities. In subsequent

years, other mortgage-backed securities were introduced

through the creation of Ginnie Mae and Freddie Mac, agencies

created to spur home ownership.

Low-rated, high-yield bonds exploded onto the scene in the

1970s and 1980s and continue today. Moving away from traditional

fixed-income securities, these high-yield bonds offer the promise

of higher returns, with the inevitable increased risk. These high-yield

bonds tend to be more equity-like, and their returns are highly

correlated with the equity markets. They fill up the middle ground

between equities and investment grade corporate bonds.

Peaks and Valleys

The fixed-income market hit its peak during the five-year period

beginning in 2000. While fixed-income revenue of the top eight

investment firms increased by 21 percent, other sources of

corporate and institutional revenue grew by only one percent.

However, to return to our building analogy, this was nothing

more than a house of cards which collapsed with the “subprime

meltdown” toward the end of the decade.

During this time, the Federal Reserve was cutting interest

rates to historically low levels to help offset a struggling economy.

This aggressive action stimulated the housing market, with

lenders becoming creative by developing a variety of mortgage

options. Even people with bad credit joined the party and entered

the market. Interest rates invariably rose, and many subprime

borrowers defaulted when their monthly payments increased as

adjustable rate mortgages were reset. The mortgage lenders

and hedge funds were left holding the bag—in this case finding

themselves possessing property that was now worth less than the

loan value, as the housing market inevitably weakened. Defaults

increased and several lenders went bankrupt as the situation

escalated. Like dominoes falling one by one, the meltdown

precipitated a global financial crisis.

Much has been written, and justifiably so, regarding the

market volatility during this time. A lack of foresight, questionable

financial dealings and rampant greed were three of the

acknowledged contributing factors. The slide of all financial

markets has been well-documented and has continued to be a

drag on the economic recovery.

The Role of the Fed

At this point, it’s important to understand the role the Federal

Reserve System has adopted toward the economy. Since its

creation in 1913, the Federal Reserve System—the central bank of

the United States—has often initiated interest rate cuts to moderate

recessions. During the past decade, the Fed (as it is commonly

known), has taken on an exponentially larger role in boosting our

flagging economy through interest rate manipulation as well as

more aggressive stimulation efforts.

According to a New York Times article dated September 14, 2012,

“Since Wall Street began to wobble in 2007, the Fed has

been engaged in an enormous effort to stimulate growth.” The

article goes on to state that “…the Fed has been moving into

unchartered waters, aggressively intervening in deals to prop up

or sell off failing institutions, making loans available to banks

in new ways and buying vast amounts of assets to help keep

the global economy afloat.”

Amidst political debate and doubts from outside and within the

agency, these attempts have been marked by mixed-results at best.

Federal Reserve Bank, Washington, D.C.

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Fixed-Income Securities: An Abundance of Choices

Fixed-income investments come in a variety of forms from issuers

in the public and private sectors. Generally, these investments fall

under these main categories.

Treasuries

The U.S. government sells Treasury bills, notes and bonds to pay

off debt and raise needed cash for expenses not covered by tax

revenue. These Treasuries are traditionally considered one of

the safest investments, as they are backed by the full faith and

credit of the U.S. government. Treasuries are low-risk and low

yield; interest earned from these investments is exempt from state

and local income taxes (but subject to federal income taxes),

increasing their appeal as an investment. Primarily, the difference

between Treasury bills, notes and bonds is the length until maturity.

• Treasury bills (commonly referred to as T-Bills) are issued

for terms of one year or less. Because they are of such

short duration, they do not pay interest before maturity.

Rather, they are typically sold at a discount of the par

value to create a profitable yield at maturity.

• Treasury notes are issued for terms of 2, 3, 5 and 10 years

with interest paid semi-annually. The 10-year Treasury

is the most common note, and is often quoted when

discussing the U.S. government bond market.

• Treasury bonds have the longest maturity, most commonly

for a 30-year maturity. As with notes, Treasury bonds pay

interest semi-annually.

• Treasury Inflation-Protected Securities (or TIPS) are

inflation-indexed bonds issued by the U.S. Treasury.

These securities are adjusted to the Consumer Price Index

(CPI) and their principal rises and falls correspondingly to

changes in the CPI.

Municipal Bonds

Municipal bonds are issued by states, their agencies and

other municipalities, such as counties and cities. The two main

categories of municipal bonds are general obligation bonds,

backed by the issuer’s power to tax, and revenue bonds, backed

by revenue from a project built with the proceeds of the bond sale.

Municipal bonds are generally exempt from federal taxes and state

taxes for residents of the state issuing the bond.

Corporate Bonds

As their name implies, corporate bonds are issued by companies

to help secure financing for a variety of business pursuits, such

as building new plants, purchasing equipment or growing the

business. The risk of investing in these bonds varies based on

the credit rating of the issuing company. Corporate bonds usually

earn higher interest than government-backed bonds with the

same maturity, but can experience greater price volatility. There

are a number of different types of corporate bonds. These include

investment grade, which are unlikely to default and are highly

rated by outside credit rating firms (which will be discussed later)

and, high yield, which carry a greater risk of default, but also pay

a higher interest rate to attract investors. Some are unsecured

(generally investment grade), while others are secured by assets of

a corporation. Convertible bonds are yet another type of corporate

bond, and can be exchanged for equity at some point before the

bond matures.

Securitized Bonds

Securitized bonds have received a great deal of notoriety during

the past several years, being closely associated with the current

financial crisis. Investment banks take pools of smaller loans—

such as mortgages, credit cards and auto loans—and pool them

in a bankruptcy remote trust. They structure the bonds into

various tranches (specific classes) with different maturities and

loss profiles. This allows the original lenders to move the liabilities

off their balance sheet while still receiving income for servicing

Companies issue bonds to grow their business.

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these loans. These tranches are then sold to investors at various

yields and maturities based upon their structure. Some of the

most commonly known securitized bonds are Mortgage Backed

Securities (MBS), Asset Backed Securities (ABS) and Commercial

Mortgage Backed Securities (CMBS). As mentioned previously,

subprime residential mortgages, a sector of the ABS market, are

credited with the run-up in home prices, the subsequent downfall

of the economy and with the demise of a number of investment

firms, such as Lehman Brothers.

Foreign Bonds

There is a wide-range of securities available in foreign markets,

such as sovereign and emerging market debt. These markets are

similar to the domestic market, but have their own set of risks, such

as currency and political issues. However, they can be a good

source of diversification to the U.S. market, as other economies

may be moving in a different direction than the U.S. market, and

could potentially provide a better return.

Risks of Fixed-Income Market

As with any investment, there are some risks inherent to the

fixed-income market. Three that potential investors need to be

aware of follow.

Interest Rate Risk

Changes in interest rates constitute the biggest risk facing the

fixed-income market. As the general level of interest rates increase,

the value of fixed-rate bonds decrease. This is what ties the fixed-

income market so closely to the Fed: its ability to change interest

rates to battle inflation or stimulate the economy has a direct

impact on the value of these bonds. The sensitivity of a bond to

changes in interest rates is measured by “duration.” Convexity can

also be used to help calculate risk. In mathematical terms, duration

measures the change in price caused by a change in interest

rates, while convexity measures a change in duration caused

by a change in interest rates, making them the first and second

derivatives of price change to interest rate change.

Credit Risk

When investing in municipal and corporate bonds, it is imperative

to know the bond rating. Bonds are rated by firms—such as

Standard & Poor’s and Moody’s—based on their risk of default.

Ratings of “AAA” through “BBB-” are considered to be

investment grade. Ratings can be upgraded or downgraded

accordingly, and investors should be aware of the current rating

before investing. While non-investment grade bonds have their

place in today’s market, investors need to be wary of such

high-risk offerings.

Liquidity Risk

Since bonds are not generally traded on an exchange, it can be

somewhat more difficult to trade or find a potential buyer. This

also makes price discovery problematic. Some bonds are traded

frequently, such as “on the run” Treasuries (the most recently

issued U.S. Treasury bond or note of a particular maturity), and the

spread between where investors are willing to buy or sell, known

as the bid/ask, is very tight. Other bonds, such as higher risk, high

yield bonds, trade in very illiquid markets. This can result in the

inability to sell the bonds when desired. This adds a layer of risk to

the already present credit risk.

Wespath Approach

Wespath’s fixed-income market offerings exist in three funds—

the Fixed Income Fund (FIF), the Inflation Protection Fund (IPF)

and the Multi Asset Fund (MAF), which holds the other two funds

as well as the equity funds offered by Wespath.

These funds are available to annual conferences, plan

sponsors, institutional investors and other United Methodist-

affiliated organizations.

The objective of our Fixed Income Fund (FIF) is a traditional

one—to earn current income while preserving capital by investing

in a broad mix of fixed income holdings. This is accomplished by

investing in fixed income securities (U.S. government and agency

bonds, corporate bonds and securitized products). The corporate

bonds held are primarily from American companies and are

investment grade, that is, securities which have received a rating

of BBB- (or its equivalent) or above from a nationally-recognized

securities rating agency.

Wespath’s FIF may also hold up to 20 percent of its value

in bonds with a rating below investment grade, and up to 20

percent of its value in foreign bonds. FIF also holds loans

secured by mortgages and other types of loans originated

through the Wespath Positive Social Purpose Lending Program,

which invests in affordable housing, charter schools, community

facilities and microfinance.

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Primarily, FIF is designed for investors who seek a greater

portion of their investment return from current income, but exhibit

a willingness to incur some risk for the potential of modest

capital appreciation.

The IPF objective is to provide investors with current income and

to protect principal from loss of purchasing power due to inflation.

This is accomplished by investing in a broadly diversified portfolio of

inflation-protected investments, with 90 percent of its assets in fixed-

income investments such as publicly traded U.S. Treasury Inflation

Protected Securities (TIPS) and foreign inflation-linked securities.

IPF is designed for risk-averse investors who wish to obtain

long-term protection from the loss of purchasing power due to

inflation, but are willing to incur some short-term losses of principal

to do so.

Wespath is committed to a long-term investment strategy

and reviews its investment funds to align with market conditions

and projections.

Building a Strong Foundation

A prudent strategy protects investors from unbridled enthusiasm

and risk-taking. Fixed-income funds are a good diversifying

investment and provide a smart choice even in today’s low interest

rate environment. Investors who understand the importance of

a long-term approach and seek to build upon a strong foundation

should include fixed-income funds in their investment strategy.

Wespath provides UMC-affiliated institutional investors with access to well-managed investment programs that historically have delivered competitive performance while honoring United Methodist Social Principles. Wespath is a division of the General Board of Pension and Health Benefits of The United Methodist Church, a century-old institution with a well-regarded reputation for delivering returns aligned with values.

Wespath is an established investment manager with approximately $18 billion in assets under management.

Our name honors John Wesley, the founder of Methodism and a leader in establishing social principles that outline the tenets of socially responsible business practices. Wespath reflects this heritage, along with the idea of putting clients on the right path to financial growth with a commitment to values-driven investing.

® Copyright Wespath 2012.

Wespath Investment Management1901 Chestnut AvenueGlenview, IL 60025-1604 1-847-866-4100

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