Nuts and Bolts: Fixed Income Part 2

So how does fixed income get priced? How is it placed on markets? And how do we invest in it?

Fixed income pricing can get wrapped up in array of terms to describe its ‘price’ – is it its yield? Is it its value? What is the value of a fixed income’s security?

To explain this further, let’s define fixed income as an asset versus the cash asset class.

Fixed income is an asset that has both a capital portion and an income portion. That means it can have capital appreciation and depreciation, and has a moving yield depending on the price at which you buy it.

Cash assets on the other hand (i.e., a term deposit) has no capital movement and a completely fixed yield. This is why cash is seen as a lower risk asset than fixed income on the risk-return scale and why they are seen as different assets.

The next thing to remember about fixed income pricing is what it means when its yield is rising and when it’s falling.

Here is the equation for calculating yield

This means that as prices go up, yields get smaller, but as prices fall, yields get higher.

Here is the fixed income ‘seesaw’ analogy most use to remember this fact:

There are a whole range of reasons as to why the price of treasuries move (i.e., interest rate changes, inflation, geopolitical issues, sovereign rates etc. etc) but for now, just remember that a higher yield will mean a lower price and vice versa.

How are treasuries sold in the market? And who buys them?

Just like equities, there is a primary and secondary market for treasuries.

The primary market

The primary market for treasuries is similar to an initial public offering (IPO) but is conducted slightly differently.

Since 1982, Australian treasuries in the primary market go through a tender process which involves investors offering (bidding) a price on a government security (treasury) to set the yield to maturity.

An example which illustrates the tender process is:

Let’s say there’s a new Australian 10-year T-bond (see part 1) being issued with the following characteristics:

• Face value is $100
• Coupon payment is $1.50 p.a.
• Initial yield is 1.5% (using yield equation)

However, the buyer wants 1.8% p.a. which is the current yield on the Australian 10-year bond in the secondary market.

Under the primary tender system, the buyer would bid 1.8%, meaning they are placing a capital bid below face value to achieve 1.8% per annum (think of the seesaw).

Remember, the bid is yield to maturity, that is, the buyer will get $1.50 per annum for 10 years then a capital gain at maturity, making the total yearly yield over 10 years, including the capital gain, 1.8%.

So, who is involved in the primary market transactions? And who is the biggest holders of treasuries?

According to the RBA’s latest holdings report, the RBA itself leads the pack as the largest holder of treasuries, followed by the banks, life and general insurers, state and federal governments then other holders. The take from the primary market interaction is that gaining access to treasuries requires large capital sums to participate.

The primary market is handled by AOFM. Click on this link to find out more https://www.aofm.gov.au/ or go the RBA website for more information on treasuries www.rba.gov.au

The secondary market

Again, the secondary market in fixed income is conducted just like equities with on-exchange transactions. In Australia, the ASX handles the majority of on-exchange transactions putting together buyers and sellers.

Disappointingly, you can’t buy and sell treasury bonds individually as they are likely to be bundled into a contract. The size of a standard treasury contract remains very large.

On average, one contract of an Australian bond tends 1,000 bonds meaning it has a value of $100,000 – a large outlay for one investment and completely out of reach for most retail investors.

Thankfully, over the past decade, fixed income has seen a rise in exchange traded funds (EFTs) which has allowed retail investors access to treasuries at a fraction of the outlay. This is because providers such as BlackRock and Vanguard that can participate in primary and secondary markets package up the full suite of treasuries into one simple product that is transacted on-exchange with no real minimum size, meaning any retail investor can gain access.

For more information about retail investment in fixed income, visit this page: https://www.investsmart.com.au/invest-with-us/investsmart-interest-income-portfolio 

Nevertheless, the volume of the on-exchange transactions is very low in comparison to off-exchange transactions.

Off-exchange is where the buying and selling of securities is done by what is called over-the-counter (OTC) transactions.

There are three ways this is done:

1. Direct dealings – buyer and seller directly transact without a broker or intermediary.
2. Broker dealing – transaction is arranged through a broker who may act as an agent between the buyer and seller or as a principal in the transaction.
3. Intermediary dealing – where a financial intermediary can enter into a transaction on its own behalf with its clients.

All these transactions are settled electronically and by the Australian clearinghouse known as Austraclear which is part of ASX Ltd. For more information follow this link: https://www.asxonline.com/public/documents/austraclear-technical-documents.html