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Fixed Income Basics, Profit, Style and Management
Over the years (almost 40 if you're counting) we at AQS have noticed a number of misconceptions about the fixed income (bond) market. To some, this is painfully evident; nonetheless, we'd like to set some things straight:
Stocks and Bonds are Different.
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There are a LOT more public bond issues than stocks. In the U.S. approximately 6,000 stocks are listed on major exchanges. By contrast, there are over 100,000 current (not matured) bond issues.
- On any given day, most stock issues can be traded. Most bond issues cannot be traded.
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Stocks are traded centrally - on exchanges. Bonds are transacted dealer to dealer. Because stocks are traded on exchanges, transaction prices are fairly consistent.
- With bonds, pricing is less consistent. In other words, the price is not "the price". The difference can be staggering!
Common Misconceptions About Fixed Income
Premium Income is not Really Income
While premium income shows on the income statement for insurers,
- For annuity companies, premium income is like a deposit. It has to be repaid
- For life and casualty companies, premium is a calculated price of a given risk.
- While underwriting may generate occasional profit for life and casualty companies, the law of averages sees to it that this advantage is slim.
- In other words, premium income is a competitive price for a risk assumed.
Portfolio Income Makes the Difference in Profit
A popular misconception is that most fixed income portfolios yield about the same. Not true! The following make a difference:
- Risk profile.
- Asset complexity.
- Optionality (callable bonds) is frequently mispriced.
- Deal size and dealer distribution: Smaller = more reward.
- Reinvestment of cash flow or active repositioning.
Portfolio Management Styles Are Different
It goes without saying but why?
- Organizational structure. Is staff allocated by asset class or business unit?
- Opportunity set. Larger companies have a smaller opportunity set. Larger companies need more bonds to 'move the needle' - fewer opportunities.
- Portfolio metrics. Book yield, total return or bottom line? Book yield is but one component of income. Total return is great for comparison of disparate asset classes but doesn't translate to statement income. Bottom line removes the noise but can be short-sighted.
- Reinvesting cash flow or actively repositioning. Reinvesting cash flow only requires the least effort. It doesn't take advantage of market dislocations when opportunities present.
- Broad or narrow asset focus. Securities only or loans too? There was a time when most insurers held more loans than securities. Times change.
Choosing a Manager That's Right For Your Company
- Internal or External management? Internal offers a feeling of focus and proximity but frequently limits ideas. It's also expensive. A single professional and the associated data costs about $500k annually. External management offers economy of scale and experience with different asset classes but focus is limited.
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The CFA Institute Model Request for Proposal - Fixed Income doesn't capture any of the above very well.
- References. Many request references but seldom actually check them thoroughly. Still a client? Is the company making money? Accessible? All good questions. References are typically willing. Call them!
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