Describe about the Interest-bearing Securities and their role in Portfolio Management.
To explain the terminology of interest bearing securities, it would be simple to say that securities on which a predetermined rate of interest is due to be paid to the security holder or instrument owner. The time cycle of the payment of interest could be anything half-yearly, annually or at maturity. Portfolio management in itself is a vast area of financial market and we will be going analyzing all the areas step by step to ensure the clarity on the concepts. Securities in the financial market are of different nature depending upon their return abilities and risk bearing slots.
In this analysis of financial markets, the focus country is Australia
To understand the interest bearing securities and their role in portfolio management, there is prerequisite to comprehend financial market, classification of financial market into sub-divisions of money market and capital market. Financial market is all about taking decisions which are based on the information of truth and right equations rather going on hysteria situations. That the financial management issues are diverse and need elaboration and here in our analysis, we are making efforts to present the intuitions and knowledge of financial management in summary exploration. In terms of investors prospective, good returns on investment are expected but no sure shot portfolio could be set in order maximize returns or minimize risk associated with securities. The only reason of suspiciousness over returns is because financial markets are risk –filled and imperfections and as output of these imperfections, inconsistency with the expectations is obvious. “Risk” associated with the securities is the crucial benchmark in evaluation of investment decision making as risk is directly proportional to returns. In a nutshell, better returns are expected when risk associated is high and low returns are expected when risk is minimal. There can be different multiplicities of risk such as business risk, interest risk, and market risk. Among them, the market risk is with highly vulnerable because no predictions can work out in situations of recession or market flip-down. In general terms, risk means that actual outcome will differ from the expected outcome and is unpredictable.
Portfolio management refers to the process of creating pool of securities with different risk factors and return factors and then setting the overall expected return in combination of all requirements. Under portfolio management, aim is to select right kind of securities to invest and money is directed towards right channels. It can be observed that portfolio management is right and calculative step towards personalized investments i.e. tailored as per financial needs. (Drago , 2014)
Importance of portfolio management:
1-It provides better decision making sense to investors and with better returns, decisions prove to be successful.
2- With various securities in the pool, the risk associated is lower. The only condition is not to select all the investments of high risk because portfolio is mix of lower, moderate and higher risk associated securities.
3-It also results in maximizing the control and efficiency of resources invested.
4-It brings sense of accountability for portfolio managers and they cannot easily get away with their decision of selection of certain categories.
5-Investors often are caught with financial resources crunch and PM (portfolio management) is the solution to this problem.
6-Under portfolio management, it is easy to see linkages of returns with market conditions and observation over dependencies in those portfolio which are long term.
7-With the change in business environment and economy holding better grasp over business operations, investors anticipate better decision making from the management. Investors have sole expectation to see growth in their portfolios.
8- Portfolio management provides “big picture” of the financial investment opportunities. (Basu, 2014)
Now that we have clear understanding over portfolio, its management, uses and benefits that can be short term or long term, it is easy to move to very important divisions of financial markets-money market and capital market. Australian financial markets have by 27% since 2009 and overall volumes are even higher than the percentages itself. The AFMA (Australian Financial Management System) have integrated various reforms since the era of recession keeping the interest of the investors in good faith. With AFMA integrating the financial markets in collaboration with global markets is the initiative that essentially brought regulation and promoted efficiency towards economic growth.
Basics about the Australian money market and the capital market:
Money market refers to the arcade where money or its equivalent (securities) can be traded. One of the strong characteristics of money market is that here high liquidity securities are dealt and in all market situations, trading is short term. (Short term maturity). Securities such commercial papers, treasury bills, CDs (certificate of deposits), RAs (repurchase agreements) and so on. Capital market is the one where financial securities are created and dealt with the long term maturity period for the purpose of nurturing the long term needs. Shares, debentures, bonds, Euro issues, asset securitization are few examples which are traded in capital market. (Lee, 2015)
All investment and securities are controlled and eyed by ASIC (Australian Securities and Investment Commission).
ASIC performs the following functions:
1-It ensures right and timely information of the companies is available to the investors so that investors can make calculative decisions with their investments.
2-Prolong, simplify and improve the performance of Australian financial markets.
3- Organize events for consumer awareness and by doing this, it is valuing the hard-earned money of the investors.
4- Supervision of the market regulations and facilitating investors and dealers with minimal process requirements of trading in the financial market.
With the clarity over interest bearing securities, following presumptions and facts need to be covered before studying the effect of interesting bearing securities on portfolio.
1-Risk factors affect the market value of interest bearing securities.
2-Market conditions cannot be stable in any scenarios and are volatile because of global events, news and government stability.
3-In the event of market interest rates going up, fixed interest securities will fall because new securities will be issued at higher rate than existing ones. Contrariwise, fix rate securities will increase in their value in the event of market rates coming down.
4-Inflation, business cycles and other domestic or international factors are there in the mind of investors and this become obvious cause of ups/downs of prices and interest rate of securities.
5-Reserve Bank of Australia usually intervenes in the market at the time when market conditions are very volatile either interest rates are digging the ground or touching the sky. It is necessary step to by RBA to ensure money allocations are appropriate.
6- There are also interest bearing securities which are protected against market volatility and therefore, guaranteed returns are expected from the investments with no plus/minus of any events.
There are various interest bearing securities which are dealt in financial markets and below is the discussion for few important ones:
Bonds are the debt security which are issued by the borrowers to raise money from the investors and there is timeline of maturity of bonds which is declared at the time they are issued. Types of Australian bonds are as follows:
Fixed rate bonds- By the name it illustrates that bonds which offers fixed rate of interest are fixed rate bonds. Though fixed rate bonds are sure shot investments, but they do carry the risk associated with the goodwill of the bond issuer which is directly proportional to financial condition of the bond issuer.
Floating rate bonds- Floating term denotes continuous change. Floating rate bonds are those bonds which are issued at adjusted price but that price is not constant over a period of time. The reason of this change is market interest rates which changes as per financial factors.
Government bonds- Australian government bonds are issued by “The commonwealth of Australia”. Since they are government bonds, they offer more security, stable and regular income and the best is choice of maturities.
Corporate bonds- Corporate bonds traded on ASX (Australian Securities Exchange) are issued in the multiples of $1000 or $5000 for raising funds for expansion or new projects. They are debt onuses issued by private and public corporations.
Salient features of bonds are:
- Details contained in the indenture.
- Administered through a trustee.
- Secured versus unsecured.
- Senior or junior or subordinated.
- Call features of the bond
- Bond rating.
Take a bond with three years to maturity, a coupon rate of 8%, and a $1000 face value. If the current market rate is 10%, what is the price of the bond?
$80 $80 $1080
P = + +
(1.10)1 + (1.10)2 + (1.10)3
P=$80(0.9091) +$80(0.8264) +$1080(0.7513)
T-Notes are the safest forms of marketable investments and are termed between one to ten years with fixed interest rate and are backed full faith and credit by the government.
Characteristics of T-Notes are as follows:
1-They are issued as promissory note at discount and the discount is calculated over the face value of the bond.
2-T-notes are short term and are generally issued to meet short term financial needs of the government.
3-T-notes are negotiable securities.
4- Issuing T-notes is cost friendly because transaction cost is very low.
5-They are investments with assured yields. (Amadeo, 2016)
A debt security, secured by fixed asset such as real estate property in exchange of funds with the obligation to pay them back is call mortgage. Over the period of time, interest is paid that gets accumulated as per timeline of the mortgage.
1-The state rates on mortgage is determined by market rates, term of the mortgage and discount factors.
2-The legality of the mortgage is complex and usually protects the lender from losses.
3-Credit ratings play important role in mortgage securities
4-To free cash to be utilized in other projects, most of the mortgages are another investor by the originator.
5-With securitization of mortgages, risk is lowered and access to national capital is enhanced.
Debenture is a loan instrument which is issued by the companies with the aim of generating long term funds. Issue of debentures help companies to avoid load on their existing share capital.
Features of debentures:
1-It can be either category secured or unsecured.
2-No voting rights are given to debenture holders.
3-Debenture holders get paid with interest even in event of loss.
4-After a fixed period of time, debentures is redeemed.
5-Interest on debenture is tax deductible expense because they are charge against profit. (Trisha 2015)
With analysis on interest bearing securities and their features, it is easy to analyze the impact of interest bearing securities on portfolio:
Risk Free bonds increases value of the portfolio- Those bonds which comes with low risk factors and are immunized reduces the volatility and increases the value of portfolio.
Credit risk associated with bonds- Indexed bonds are generally issued after the credit history check and then pitfalls in the validation of credit is negative onto entire portfolio.
T-Notes offers stability along with good yield- T-notes comes with short maturity period but offers good value on money invested because of stability against market conditions.
T-notes enhances portfolio value using features of negotiability- Bonds are negotiable and this adds to flexibility option for buy/sell. Thus, impact is better bond valuation.
Mortgages offers long term financial assistance- Mortgages are long term assets and they offer firmness to the portfolio with the long term financial strategy of investing money in projects with lower payback period and higher NPV.
Positive impact of free cash over other projects- In bonds, cash usually is free by changing the ownership from originator to other and thus, cash is used in other projects giving dual benefit of returns.
Debentures are paid in case of loss even- Best in portfolio are debentures because they stay unaffected in all market conditions of downfall. Losses by the company do not affect return on debentures.
The term asset allocation means diversification of investments over different ranges of assets and geographical reasons with the purpose of reducing the risk, increase the value and maximizing the potential for higher returns. Diversification is always beneficial because there may be situations where asset performance is not backed by current projects but secondary asset value may appreciate to maintain the overall rate of return required to continue the project or use the asset. In a nutshell, the up moving asset neutralizes the volatility caused by non-performing asset.
In financial language, valuation is the process to determine the net present value of the asset. Going briefer on the topic, it is the process of determining the worth of the company or any project or asset. The market value of a company is generally calculated by multiplying number of shares in the market into current share price. The transaction is only concluded when buyer and seller agree on a deal price. Intrinsic value of the company creates an assumption on how l=much worth of the company will grow in future. (Vital, 2013)
Duration refers to the process of measuring the price volatility of the bond which is the effect of fluctuating interest rates.
With the time period associated with the maturity of the bond, there are certain factors which needs presumptions:
1-All bonds are price sensitive and are affect by market rates.
2-The effectiveness of the bond is associated whether bond is short term or long term.
3-Zero coupon bonds are traded at deep rebate.
4-Duration only records small changes of market linked to bond price.
Convexity refers to the process of capturing the relationship between the change in the market rates and price of the bond. This uneven change of market mechanism can also be carried away if bond issued are premium bonds. When the change in bond price is towards negative, it is generally effect of small market change and it will be more if bond price is positive in change.
A portfolio is immunized when it is “unaffected” by interest rate changes. It is a technique of making the portfolio immune against the risk and uncertainty. Immunizations is strategized to ensure the good worth of portfolio with the amount of return by the investor. It formulates the cash flow basis to ensure better returns with low cost.
With critical analysis on managing portfolios, it is clear that results are fruitful only when calculative steps are taken in deciding the securities which are to be invested and other that need to be kept on hold. Portfolio management requires that securities invested must be variable in terms of return yield, risk associated and life span whether those financial instruments are short term or long term. The benefit of going with the diversity is that losses from one can be offset by other instruments of the portfolio and in totality, the goal of portfolio management is sure to be achieved.
In regard to portfolio management specifically with interest bearing securities, recommendations are as following:
1-Selection of the securities should not be only based on current market situations but historical performance should be considered for making better decisions.
2-Valuation and asset-allocation are beneficial for projects with high payback period and thus must be implemented on such projects.
3-Analysis of historical yield vs current yield can be result of currency fluctuations and investors should never be carried away with market hype. Instead, investors could do market analysis with their portfolio managers to ensure better value of money.
4- Few of interest bearing securities are rating based such as bonds and thus, rating should be should as one of the criteria of portfolio finalization.
5-Risk management is must for interest bearing securities because market fluctuations affect them in most prominent ways.
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Basu,C.(2014), The Importance of a PMO in Portfolio Management,Chron, accessed on 13 August 2016, https://smallbusiness.chron.com/importance-pmo-portfolio-management-36411.html
Lee, S. (2015). What is difference between money market and capital market, Quora, accessed on 13 August 2016 https://www.quora.com/What-is-difference-between-money-market-and-capital-market
Amadeo, K. (2016). What Are Treasury Bills, Notes and Bonds, About money, accessed on 13 August 2016 https://useconomy.about.com/od/bondsfaq/f/Treasury_Bonds.htm
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