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Investing in the Future

Using the Australian Fixed Income Markets

By

ContentsPart 1 – Australian Bond Market Characteristics1. Investments available2. Explanation of Securities3. Who issues Bonds4. Ratings - Standard and Poor's, Fitch, Moody's

Part 2 – How it works1. Underlying investment premise2. What affects yield3. What causes credit risk premium to change4. Yield curve5. Markets – Supras, Federal & Semi Government, Govt Guarantee Bank Fixed &Floaters, Corp Fixed & Floating and CPI Indexed Bonds

Part 3 – Market Changing1. Changes in the Market2. Current Disconnect with Deposits3. Current disconnect with Discounts4. Current disconnect with Bonds

Part 4 –The Future - Issuing Bonds1. Debt Capital Markets Intro2. What is a debt strategy3. The debt strategy process4. Critical Areas That Will Affect Outcome

Part 5 - How does Gilt Investments Pty Ltd fit in ?1. Who is Gilt Investments Pty Ltd2. Criteria for consideration3. Reasons for setting up your portfolio4. Deposits part of Fixed Income market5. What to Look for6. Contact Details

PART 1Bond Market Characteristic's

Less than 1 year to maturity … Discounted investments (Short term money market)

Greater than 1 year to maturity … Bond investments(Long term capital markets)

Investments available in the Australian interest rate markets

Less than 1 year to maturity

Cash & Short term deposits with: Major Bank

Foreign Bank

Regional Banks

Credit Union

Building Society

Discount Securities issued / sold by: Bank Bills

Promissory Notes

Negotiable Certificate of Deposit (NCD)

Treasury Notes

Discounted & ‘yield’ investments

Greater than 1 year to maturity

Greater than 1 year to maturity

Floating Rate Notes (FRNs)

Bonds (fixed rate) Government

Semi government

Corporate

Inflation linked

ASX listed hybrids Income Securities

Convertible Notes or Preference Shares

Structured products Collateralised Debt Obligations

(CDOs)

Bond Investments

Less than 1 year to maturity

Explanation of Securities

Cash - is the most liquid of investments generally referred to as a “24 hour call deposit” or “11am term deposit” -funds can be accessed any time.

Term deposits - all approved deposit taking institutions (ADIs) will quote interest rate yields on set, fixed maturities (terms) for deposits.

Discount securities - in order to provide investors with the ability to sell their investments, institutions will issue securities to investors. The securities are offered at a discount to their face value using a discount formula. The full face value of a discount security is paid out on maturity.

- More on discount securities next…

Discount Investments

Bank Bills (or Bills of Exchange) - A bill of exchange that has been accepted or endorsed by a bank. This puts primary liability for repayment of the bill onto the bank which accepted the bill.

Negotiable Certificate of Deposit (NCD) - is similar to a bank deposit, but instead of the ownership being recorded in a register by the bank, there is a certificate issued. Again - it is negotiable in that whoever holds the certificate owns the claim on the cash flow at the end. The terms of NCDs can range over many years, but we usually only refer to those that mature within 1 year.

Promissory Note - An unconditional promise to pay to the holder of the note a fixed amount (face value) at a fixed date (maturity date). Defined more fully in the Bills of Exchange act as: "an unconditional promise in writing by one person to another, signed by the maker, engaging to pay on demand or at a fixed or determinable future time a sum certain in money for or to the order of a special person or to bearer"

Treasury Note - Commonwealth Government issued short term securities for 5, 13 and 26 week periods, issued at a discount from face value

Explanation Continued

Floating Rate Note Bonds (FRNs) - Similar features to bonds except that the periodic coupon payments are not equal. Payments are reset in line with a given market indicator each period. Usually set as a margin above the bank bill rate.

Fixed Bonds - Term to describe a fixed-rate transferable debt instrument that is an financial obligation for the issuer to pay, a fixed sum (face value) at a specified date (maturity date); and a series of equal periodic payments called coupon payments.

Hybrids - These securities are subordinated in nature and convertible to shares either at maturity or at a given date in the future. Before conversion pay either a fixed or floating coupon.

Structured products - Collateralised Debt Obligations (CDOs) - are complex structured products typically arranged by investment banks with a range of tranches that are independently rated by a credit rating organisation.

o If none of the underlying portfolio of securities default over the life of the CDO, investors will receive their capital back in full. If more than a handful defaults, investor’s capital is at risk.

Bond Investments

Commonwealth Government via the Reserve Bank

State Government

Australian Companies

International issuers

Banks Finance Companies

Special issuers e.g. infrastructure, mortgage backed

Who issues bonds to borrow from market

Standard & Poor's long-term ratingsThe following are considered investment grade assets.

AAA - The borrowers capacity to meet its financial commitment on the obligation is extremely strong

AA - The borrowers capacity to meet its financial commitment on the Obligation is very strong

A - The borrower is more susceptible to the effects of changes in economic conditions. The borrowers capacity to meet its financial commitment on the obligation is strong.

BBB – A borrower shows adequate protection parameters. However, lowering economic conditions are more likely to result in a fragile capacity by the borrower to meet its financial commitment.

Standard & Poor's long-term ratings

The following are considered non-investment grade – i.e. considered to be speculative and investors should seek advice or be aware before investing.

BB - Less vulnerable

B - More vulnerable

CCC - Currently vulnerable

CC - Currently highly vulnerable

C - Payments are still being made but bankruptcy proceedings have been filed.

D - In default

PART 2How it Works

“The greater the risk the greater the return”

Risk

Return

What affects the Yield

• Before you buy any fixed income investment you need to know what affects the yield. This then guides you towards what to buy, after an investment policy has been put in place;

• Inflation Premium• Credit Premium• Liquidity Premium• Market influences

To get the yield the risk premium needs to be added to the nominal rate of interest

Real Yield + Inflation Premium = Nominal Yield

Nominal Yield + Risk Premium = Security Yield

What causes credit risk premiums to change

• Industry volatility• Term to maturity• Financial stability & gearing• Liquidity• Management decisions

The Yield Curve

What is it?

How can it move?

What effect does this have on bond values?

How do I manage it?

%

5

6

7

8

9

10

1 2 3 4 5 6 7 8 9 10

Years

Yield%

Normal yield curve

Yield curve changes shape

5

6

7

8

9

10

1 2 3 4 5 6 7 8 9 10

Years

Yield %

10 yr - Yields up 0.1%Price down approx. 1.0 %

2 yr - Yields up 1%Price down approx. 2 %

The yield curve changes again

5

6

7

8

9

10

1 2 3 4 5 6 7 8 9 10

Years

Yield %

10 year - gains 5 %in value2 year - loses 1%

in value

4 year - no changein value

Supranational Bonds

Federal & State Government Bonds

Bank Government Guaranteed Fixed

Bank Government Guaranteed Floating Rate Notes

Corporate Fixed Bonds

Corporate Floating Bonds

CPI Indexed Bonds

PART 3Market Changing

Changes in the Bond Market

• New Basel Rules guiding Banks capital adequacy, stress testing and market liquidity risk.

• Foreign Bank Branches• Wholesale Pricing vs. Retail Pricing – Retail get above

benchmark• Compliance on Financial Planners• Shrinking Competition and Dominance of the Majors

Banks • Shadow Banking influence

Current disconnect to Deposit Markets

Current ‘disconnect’ to Discount Markets

Current ‘disconnect’ in Bond Markets

PART 4Issuing Bonds Into The Market

Debt Capital Markets - IntroductionContext

Every business should have a sound understanding of debt capital markets, including: The role of debt in funding a borrower’s assets; The benefits and risks of using debt compared with other sources of capital (equity); The different types of debt available; Potential sources of debt; Pricing of debt; and Covenants, reporting requirements and review processes required by debt providers.

Why is this Important? A borrower can minimise its capital cost (taking into consideration its risk profile) by optimising

its debt to equity ratio; A borrower can reduce its bank interest, fees and charges and increase the flexibility in which it

operates by optimising the facility’s styles and structures (pricing, covenants, security, conditions etc.);

Borrowers are often not aware of the different types of debt and potential sources of debt available – many borrowers rely on their existing provider to advise on their capital needs;

Debt instruments are at least as complex and diverse as equity products.

What is a Debt Strategy?A good debt strategy: Delivers the optimum mix of debt and equity which minimises the weighted average cost of capital,

maximises return on equity and helps manage risk; Is integral to implementing and achieving a business’s strategic plan – particularly in terms of funding

growth; Aligns with and supports the business’s strategic plan, facilitates growth; Is structured to match cash outflows (principle & interest) with cash inflows and business cycles; Is competitive on terms, conditions and pricing; Has tailored, relevant covenants and reporting requirements that add value to the business as valid

lead indicators; and Aligns with the risk appetite of the borrower.

A poor debt strategy can: Exposure to loss of control - increase business risk; Constrain growth; Trigger breaches if poorly structured covenants (i.e. are not matched to business’s cash flows); Create an unnecessary administrative and reporting burden; Cost more than it should if its terms and conditions are not competitive in the current market; and Create stress if it does not match the risk appetite of the borrower.

“Debt Strategy Analysis” - The Process

Nature of contracts and customer profile;

Board and Senior Management;

Recent financial performance;

Business drivers; Competitors, suppliers, barriers to entry;

Tangible and intangible assets;

Working capital and cash flow requirements;

Financial forecasts; Strategic planning; Current debt arrangements;

Risk appetite; Key risks.

Existing equity structure;

Capacity and inclination to further invest;

Current types, sources and costs of debt;

Covenants, reporting requirements and review processes;

Security over current debt;

Other sources of funding currently in place.

Market attitudes towards debt versus other sources of capital;

Different types of debt available;

Indicative pricing of different types of debt;

Providers of debt; Covenants, reporting requirements and review processes;

Timing; Obstacles or other matters to consider.

Types and sources of capital to achieve the identified growth strategies;

Risk analysis; Developing a plan to transition to an optimal capital mix

All of this analysis is based on deep relationships with both debt and equity providers, and extensive experience in arranging capital raising from various sources

Some Critical Areas That Will Affect The Outcome

1. Borrowing entity? – Investors will want to know who they are lending to, is it syndicated if so where is the security.

2. What is the security? – Are the bonds secured by property, are they Government Guaranteed, what is the history of performance, has there been defaults, are there any non-performing loans…

3. What is the rating? – Apart from professionals, others don’t have any means to assess risk.

4. How liquid are they? – Can investors get out, are there other buyers

5. What are the custody arrangements? – Can they be transferred or held in custody.

6. Does the yield match the risk? - Market, liquidity and credit risk

PART 5How Does Gilt Investments Fit into

The Picture?

Who is Gilt Investments Pty LtdGilt Investments is a privately owned business that specialises in providing clients direct access

to the interest rate markets, in particular the bond markets.

Provides access to the fixed income markets Assists with liquidity Not aligned to any financial organisation Simplified transaction procedures Offers all institutions products custody arrangements Provides valuations Constructs portolio’s Updates on markets Single asset focus Experienced specialists Weekly Newsletter

Criteria for consideration…

Credit Rating (A risk measure e.g. by Standard & Poor’s)

Term to maturity (Short term < 1 year or Long term > 1 year)

Liquidity

Return - Fixed or floating

Cash flow

Reasons for setting up your own portfolio

Management expense ratios

Better control

Skills retained

Capital back on maturity

Indication of risk free rate of return (benchmark)

Fixed and floating

Active and passive

Deposits Service

MELBAIRPORT vs WESFARMERS – both

Australian, same rating & maturity but

different yield – (possibly due to amount on issue, Industry, Coupon)

LSPLAN compared to

Mirvac 15/03/15 – same industry, better rating but a lot higher yield

CIBC & BNS - both are covered bonds, both AAA,

same maturity (approx) but different yield

How to contact Gilt Investments Pty Ltd

Phone 617 3123 7132 Fax 617 3123 7142 Mobile 0414 411 087 Email [email protected] Web Address www.giltinvestments.com