Fixed Income

Question 1

What are the three main challenges fixed income investors face?

Answer 1

(i) Generating enough income (ii) Hedging against the effects of rate volatility (iii) Combating the gradual erosion of purchasing power.

J.P. Morgan’s framework for fixed income diversification can help investors utilize fixed income to achieve critical objectives: generating income and reducing overall portfolio volatility. Use of TIPs can be utilized to combat gradual erosion or purchasing power.

Question 2

What is the Fixed Income Triangle and what does it consist of?

Answer 2

An appropriately diversified fixed income portfolio can help investors generate income, provide diversification to equities and lower overall portfolio volatility, while balancing bond market risk and opportunity. It’s important to:

1. Maintain a broad allocation to core bonds to provide diversification to equities
2. Augment with core complements to reduce fixed income volatility
3. Add extended sectors to increase income and return potential

Question 3

Core Holdings?

Answer 3

Provide income and diversification to stocks, but tend to be lower yielding.

Active management and broader diversification within core portfolios can improve risk-adjusted returns.

High-quality short/ intermediate term

Diversified

Question 4

Core Compliments?

Answer 4

1. Can hedge downside risk and reduce fixed income volatility.
2. Absolute return and inflation strategies seek returns with little or no correlation to rates.
3. Ultra-short strategies reduce portfolio duration and therefore volatility.

Question 5

Extended Sectors?

Answer 5

1. Can provide income and/or the potential for higher returns, but may be more volatile.
2. Higher-yielding bonds can improve performance, but have increased credit risk and require frequent evaluation.

Bank Loans

High Yield

Emerging Markets

International/Global

Long Duration

Question 6

Average Annual Return and CAGR?

Answer 6

Mathematically, when comparing two portfolios with the same average annual return, the portfolio with the lower volatility (i.e., the portfolio where each year’s returns are generally closer to the average) will have higher compounded returns over time. The larger the swings in compounded return, the lower the total return over time.

Question 7

What are the Investment Considerations?

Answer 7

Objective

1. Are you seeking capital preservation, income or a combination of both?
2. Could you benefit from the tax treatment of municipal bonds?

Risk Tolerance:

1. How much rate sensitivity are you willing to accept?
2. How much volatility can you weather?

Time Horizion:

1. Are you focused on the short term or long term?

Markets Rate Expectations

1. Will rates change? If so, when and in which direction?

Question 8

Rate Expectations - Falling Rates?

Answer 8

Environment: Slow Growth or Recession

Investment Implication: Add high-quality duration, trim risk and move up in quality.

If you are an Income Seeker:

1. EXTENDED: 20–30%
2. COMPLEMENTS: 10–20%
3. CORE: 55–65%

If you are Capital Preservation Person:

1. EXTENDED: 5–15%
2. COMPLEMENTS: 5–15%
3. CORE: 75–85%

Question 9

Rate Expectations - Range Bound?

Answer 9

Environment: Sub-trend growth and inflation

Investment Implication: A Goldilocks scenario for fixed income. Maintain a balanced portfolio.

If you are an Income Seeker:

1. EXTENDED: 35–45%
2. COMPLEMENTS: 15–25%
3. CORE: 35–45%

If you are Capital Preservation Person:

1. EXTENDED: 25–35%
2. COMPLEMENTS: 15–25%
3. CORE: 45–55%

Question 10

Rate Expectations - Rising Rates?

Answer 10

Environment: Sub-trend growth and inflation

Investment Implication: A Goldilocks scenario for fixed income. Maintain a balanced portfolio.

If you are an Income Seeker:

1. EXTENDED: 40–50%
2. COMPLEMENTS: 30–40%
3. CORE: 15–25%

If you are Capital Preservation Person:

1. EXTENDED: 25–35%
2. COMPLEMENTS: 40–50%
3. CORE: 20–30%

Question 11

Duration and the Importance of Time Horizon

Answer 11

*Rising or falling rates can result in short-term gains or losses. However, in most rate environments, a high-quality core portfolio that is managed to a specific duration is likely to experience a total return, at duration, that aligns with the initial yield. Thus, an investor’s time horizon should determine the duration of their core portfolio, assuming the investor’s holding period is at least the length of the portfolio’s duration.

Question 12

JPMorgan Extended Sectors?

Answer 12

JPGB Global Bond Opportunities 0.50%

JPHY High Yield Research Enhanced* 0.24%

JPMB USD Emerging Markets Sovereign Bond 0.39%

Question 13

JPMorgan Core Compliments?

Answer 13

JPST Ultra-Short Income 0.18%

JMST Ultra-Short Municipal Income 0.18%

Question 14

JPMorgan Core Holdings?

Answer 14

BBSA BetaBuilders 1-5 Year U.S. Aggregate Bond 0.05%

JCPB Core Plus Bond 0.40%

JIGB Corporate Bond Research Enhanced 0.14%

JMUB Municipal 0.24%

JAGG U.S. Aggregate Bond 0.07%

Question 15

What are the Winners Bond Fund Whipsaw?

Answer 15

For this article, the market sell-off time period was defined as March 1 to 23, and the recovery period as March 24 to April 16.

Carillon Reams Core Plus Fund (SCPZX)

1. Leading the group of funds best navigating the market turmoil was the $628 million Carillon Reams Core Plus Fund (SCPZX), one of the better performers of the group. The intermediate core-plus bond strategy lost 5.91% during the sell-off and gained 13.48% during the reversal.
2. The fund’s “hallmark is waiting for market sell-offs to appear divorced from fundamentals and then buying,” said analyst Sam Kulahan.
3. Carillon started off the quarter positioned defensively with roughly 40% in Treasuries, 20% in investment-grade corporate credit, and 30% in agency-mortgage-backed securities.
4. As the turmoil hit, Carillon responded to the market volatility and significant spread-widening by shifting from a defensive stance to a more aggressive stance with respect to overall credit risk. It did so by adding investment-grade corporate credit throughout the second half of the quarter, raising to nearly half the portfolios. The team also ramped up high-yield corporate credit exposure to 19% as of March 31, 2020
5. Meanwhile, the fund cut Treasuries exposure to zero by the end of the quarter and halved its stake in agency mortgages.

Guggenheim Investment-Grade Bond Fund (GIUSX) as well as the Guggenheim Total Return Bond Fund (GIBIX)

1. “Overall, Guggenheim had been comparatively aggressive in recent years, believing that structured product–including nonagency mortgages, CMBS, ABS, and CLOs–was cheap relative to corporate credit and government bonds in particular. They eventually became circumspect though and moved sharply in 2018 to curtail risk in their portfolios.”
2. He noted that, “It’s exceedingly rare for funds to successfully ride a wave of strong returns with aggressive positioning and the pivot to taking so much less risk, and then have it play out successfully so quickly.”

Question 16

What are the Losers of the Whipsaw?

Answer 16

It was a particularly difficult time for investors in a pair of Putnam Investment bond funds: Putnam Income (PNCYX) and Putnam Mortgage Securities (PUSYX).

1. Analyst Benjamin Joseph, who covers both funds, said the strategies carried multiple layers of risks, which played out during the first leg of the bond market sell-off: interest-rate risk, credit risk, and liquidity risk (many of the securities they own are very lightly traded), along with a dose of leverage that is inherently involved in their ownership of some of the mortgage securities in the funds’ portfolios.
2. For example, Putnam Mortgage Securities is focused on investing in mortgage-backed securities–both agency and nonagency debt had roughly 10% of the portfolio in interest-only securities that are very sensitive to changes in interest rates, Joseph said. During a rapid drop in interest rates, such as seen in the first part of March, the value of the bonds can fall substantially.

Question 17

U.S. Treasury bonds and agency guaranteed mortgage-backed securities

Answer 17

were areas that should be liquid and well insulated from credit loss

Question 18

“Core” vs “Core-Plus”

Answer 18

Most importantly, the “plus” in core-plus can mean higher yields, but also higher risks.

1. Intermediate core bond portfolios invest primarily in investment-grade U.S. fixed-income issues, including government, corporate and securitized debt, and typically hold less than 5% in below-investment-grade exposures. Their durations (a measure of interest-rate sensitivity) typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index.
2. Intermediate core-plus bond portfolios invest primarily in investment-grade U.S. fixed-income issues, including government, corporate and securitized debt, but generally have greater flexibility than core offerings to hold non-core sectors such as c_orporate high yield, bank loans, emerging-markets debt and non-U.S. currency exposures_. Their durations typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index.

Question 19

Trailing 12 Month Speculative-Grade Default Rate

Answer 19

Above 12% between 1990 and 1991

Above 12% between 2008 and 2009

Above 10% between 2001 and 2002

Standard and Poor’s Trailing 12-Month Speculative-Grade Corporate Default Rate, February 2020. S&P conducts its default studies on the basis of groupings called static pools. For the purpose of the study, S&P forms static pools by grouping issuers by rating category at the beginning of each year that the CreditPro database covers. Each static pool is followed from that point forward. All companies included in the study are assigned to one or more static pools. When an issuer defaults, S&P assigns that default all the way back to all of the static pools to which the issuer belonged. S&P calculates annual default rates for each static pool, first in units and later as percentages with respect to the number of issuers in each rating category. Shaded bars represent recessions.

Question 20

Compares the default rate with the average “spread” of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index

Answer 20

A rise in defaults tends to follow a rise in spreads, and the average spread of the index is at its highest level in May 2020 since the 2008-2009 financial crisis.

Source: Bloomberg and Standard & Poor’s. Bloomberg Barclays US Corporate High Yield Average OAS (LF98OAS Index) and Standard & Poor’s Trailing 12-Month Speculative-Grade Default Rate. Monthly data as of 3/31/2020 and 2/29/2020 for the high-yield spread and the default rate, respectively. Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower’s option to prepay a loan. Shaded bars represent recessions.

Question 21

Chapter 11 vs. Chapter 7

Answer 21

It’s not just the value of the proceeds that can vary, but how investors are compensated. It’s usually not as simple as just receiving a cash payment in lieu of the defaulted bonds. Since Chapter 11 results in a newly organized company, holders of the defaulted bonds usually receive some sort of new securities as proceeds. The proceeds may consist of new bonds, an equity stake in the company, equity warrants, or some combination of those options.5 Conversely, in a Chapter 7 bankruptcy, bondholders often receive cash proceeds as the issuer liquidates its assets. The proceeds may come in installments, as various assets are liquidated, and this can take a very long time.

Question 22

U.S. Trailing 12-Month Speculative-Frade Default Rate and December 2020 Forecast

Answer 22

Question 23

History suggests that bond market spreads can be a good indicator of future defaults.

Answer 23

Question 24

Leveraged Loans

Answer 24

S&P’s Leveraged Commentary & Data (LCD), which is a provider of leveraged loan news and analytics, places a loan in its leveraged loan universe if the loan is rated BB- or lower. Alternatively, a loan that is nonrated or BBB- or higher is often classified as a leveraged loan if the spread is LIBOR plus 125 basis points or higher and is secured by a first or second lien.

Question 25

Credit Default Swaps

Answer 25

The performance of CDS, like that of corporate bonds, is closely related to changes in credit spreads.

This makes them an effective tool for hedging risk, and efficiently taking credit exposure.

CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle to transfer the risk of a default or other credit event, from one investor to another.

In a CDS, one party “sells” risk and the counterparty “buys” that risk. The “seller” of credit risk – who also tends to own the underlying credit asset – pays a periodic fee to the risk “buyer.” In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default (technically, a credit event). CDS are designed to cover many risks, including: defaults, bankruptcies and credit rating downgrades. (For a more detailed list of CDS credit events see the Commonly Established CDS Credit Events table below).

The settlement terms of a CDS are determined when the CDS contract is written. The most common type of CDS involves exchanging bonds for their par value, although the settlement can also be in the form of a cash payment equal to the difference between the bonds’ market value and par value.

Question 26

potential benefits of CDS include:

Answer 26

1. Requiring only a limited cash outlay (which is significantly less than for cash bonds)
2. Access to maturity exposures not available in the cash market
3. Access to credit risk with limited interest rate risk
4. Investments in foreign credits without currency risk
5. At times, more liquidity than investing in the underlying cash bonds

The performance of credit default swaps, like that of corporate bonds, is closely related to changes in credit spreads. This sensitivity makes them an effective tool for portfolio managers to hedge or gain exposure to credit. Credit default swaps also allow for arbitrage opportunities.

Question 27

SHORT-TERM VERSUS LONG-TERM RATES

Answer 27

While central banks are responsible for setting a country’s short-term rate, they do not control long-term interest rates.

Instead, it is the market forces of supply and demand that determine long-term bond pricing. In turn, this provides direction for long-term interest rates.

For example, if market participants believe a central bank has set interest rates too low, they may worry about a potential increase in inflation. To compensate for this risk, issuers of long-dated bonds will tend to offer higher interest rates. This may cause the yield curve, which reflects the relationship between long- and short-term bonds, to steepen.

Question 28

Interest Rate Risk

Answer 28

The risk posed by changing interest rates is called interest rate risk.

In the short run, rising interest rates may negatively affect the value of a bond portfolio.

However, over the long run, rising interest rates can actually increase a bond portfolio’s overall return. This is because money from maturing bonds can be reinvested into new bonds with higher yields.

Question 29

Senior Note Structures vs. Junior Subordinated Debentures and Perpetual Preferreds

Answer 29

Question 30

Preferred Stock

Answer 30

Preferred securities usually have long maturities—often 30 years or longer—or even no maturity date at all, meaning they can remain outstanding in perpetuity. They generally are “callable,” meaning they can be retired prior to maturity at a specified price after a specified date. But the option of the issuer to call is just that—an option. Given the option of the issuer to call these securities, pay attention to the price paid for the preferred. If a preferred security is bought at a price above its par value, but then the issuer calls the issue at par, the return, or yield-to-call, may be lower than originally anticipated.

If rates do rise, the price of preferred securities may fall, and fall further than the prices of shorter-term bonds, all else being equal.

Question 31

Fixed to-floating rate perpetual preferreds

Answer 31

These hybrid securities carry a fixed coupon for a specified period of time which then begins floating at a spread, determined at issuance, over a specified benchmark — typically three-month LIBOR. These “reset spreads” have most commonly ranged from 3% to 4.5% and the dividend adjustments can be either quarterly or semiannually depending on the specific issue. Currently dominated by financial issuers, these fixed-to-float securities are issued in initial increments of $25 par or $1,000 par

With the passage and implementation of the Dodd-Frank Wall Street and Consumer Protection Act, fixed-to-float dividends paid by banks are noncumulative in order for the securities to qualify as Tier 1 capital and the issuer is not obligated to make up any missed payments, should that occur.

As illustrated in Exhibit 2, the potential exists for the coupon rate to reset lower in a declining rate environment. However, one potential benefit of this structure is that in a rising rate environment, fixedto-float perpetuals can provide for higher dividend payments and greater price stability as the coupon will periodically reset and reflect those higher rates.

Question 32

Interest Rates During Expansion

1. Spreads
2. Interest Rates

What to do at the end of an Expansion and flattened curve?

Answer 32

1. Spreads
   
   1. economic expansion spreads tighten to the point of being compressed and generally unattractive by the end
2. Interest Rates
   
   1. Interest rates rise during the expansion as the Fed tightens causing the curve to flatten, so that by the end the curve is inverted or nearly so

Expansion and Flattened Curve

1. Counter to the “received wisdom” of staying short duration when the curve is flat or inverted, the way to take advantage of the coming cycle change is to go long duration while shedding credit risk

Question 33

Signal from Inverted Curve

Action from Inverted Curve

Answer 33

The signal from an inverted curve is that the cycle has run its course and that sooner or later the Fed will be forced to cut rates as the expansion ends and a recession begins.

Action:

1. The way to take advantage of the coming cycle change is to go LONG DURATION WHILE SHEDDING CREDIT RISK
2. Thus:
   
   1. Go Longer Duration Triple AAA at the sign of inverted curve

Question 34

During the beginning of a Recession

Answer 34

Once the cycle turns, and a recession is underway the Fed is already cutting rates, the curve is steepening and the credit spreads are widening.

Smart Investors sell their long duration positions taken on at the end of the expansion and plow the proceeds into shurt duration credit product.

Benefit is twofold:

1. investors benefit from narrowing credit spreads in on the curve while waiting for long-term rates to rise, AND
2. the curve to steepen as the Fed keeps the front-end anchored.

Question 35

So, in a nutshell, the credit and duration question should be timed as…

Answer 35

the time to sell credit and extend duration is at the end of an economic expansion, BEFORE the recession begins and the Fed starts cutting, and the time to increase credit risk and unwind long duration trades is AFTER, when credit spreads have spiked and interest rates have collapsed

Many investors do the exact opposite: they pile into credit product chasing yield at the end of the expansion, get burned by the subsequent spike in risk premiums, and then wait for the economy to improve before diving back in, missing a goodly part of the spread tightening

In rates, it’s a similar phenomenon, as many investors shun the long-end because they think that yields will “only go higher” as the economy continues to run, using the argument as to why they should not be taking duration risk when money market paper offers them approximately the same yield, not realizing that when the Fed cuts rates (which is precisely what an inverted curve is signaling) they will have missed the chance to lock-in attractive yields and instead will be forced to invest at much lower yield levels

Question 36

Inflation Breakeven Rate

Answer 36

The market-based measure of inflation expectations is widely known as the breakeven rate of inflation. There are several methods to calculate the yield curve and, thus, capture the breakeven rate.

1. 10-year breakeven inflation rate = (10-year nominal Treasury yield) - (10-year TIPS yield).
2. Treasury Breakeven Inflation (TBI) curve, which is based on the nominal and real yield curves calculated by the U.S. Treasury Department.

For example, the Fed H.15 data for the end of April had the 10-year nominal Treasury at a yield of 2.71%, and the 10-year TIPS yield at 0.53%. The difference between those values was 2.18%, the 10-year breakeven inflation rate. Therefore, you would be indifferent between owning TIPS and Treasurys if you expect CPI inflation to average 2.18% over the next 10 years. If you think inflation will be higher, you would prefer TIPS, and nominal Treasurys otherwise.

During 2008, the TIPS market broke down. I would argue that although the 10-year breakeven inflation rate dropped to about 0% at the end of 2008, no major market participants expected no inflation over the following 10 years. Rather the situation was that very few investors had the capacity to buy them, and everybody knew that there was a lot of forced selling to come. Therefore, there is no point trying to line up the breakeven inflation rate with inflation surveys at that point in time.

Question 37

Market Linked Notes

Answer 37

1. All cases they forgoe dividends and interest payments
   
   1. This is due to the structure of a zero coupon bond and the purchase of call options
2. All subject to credit risk of issuer
3. Many held in tax-deferred accounts
4. Typically mature between 1-10 years
   
   1. Maturities shorter than 3 years typically have a cap or max return
5. Market Linked Investment
   
   1. issuer invests in both a zero coupon bond and equity call options
6. Suitable for
   
   1. risk averse investors who want a guarantee of principle with exposure to the updside of an underlying asset

Question 38

Buffer Return Enhanced Notes (BREN)

Answer 38

1. Often issued as senior unsecured debt obligations
2. Typically mature with 1-3 years
3. Frequently use leverage to provide investors:
   
   1. a return of as much as 150% and 200% of positive performance of the underlying index, up to a specified cap, and
   2. frequently provide a 10%-15% buffer from loss in the case of negative performance of the underlying index

Question 39

Early-cycle phase

Answer 39

1. Generally, a sharp recovery from recession, marked by an inflection from negative to positive growth in economic activity (e.g., gross domestic product, industrial production), then an accelerating growth rate.
   
   1. activity rebounds (GDP, IP, Employment Incomes)
2. Credit conditions stop tightening amid easy monetary policy, creating a healthy environment for rapid margin expansion and profit growth.
3. Business inventories are low, while sales growth improves significantly.

Question 40

Mid-cycle phase:

Answer 40

1. Typically the longest phase of the business cycle.
2. The mid cycle is characterized by a positive but more moderate rate of growth than that experienced during the early-cycle phase.
3. Economic activity gathers momentum, credit growth becomes strong, and profitability is healthy against an accommodative—though increasingly neutral—monetary policy backdrop.
4. Inventories and sales grow, reaching equilibrium relative to each other.

Question 41

Late-cycle phase:

Answer 41

1. Often coincides with peak economic activity, implying that the rate of growth remains positive but slows.
2. Credit tightens and Earnings under pressure
3. A typical late-cycle phase may be characterized as an overheating stage for the economy when capacity becomes constrained, which leads to rising inflationary pressures.
4. While rates of inflation are not always high, rising inflationary pressures and a tight labor market tend to crimp profit margins and lead to tighter monetary policy.

Question 42

Recession phase:

Answer 42

1. Features a contraction in economic activity.
2. Corporate profits decline and credit is scarce for all economic actors.
3. Monetary policy becomes more accommodative and inventories gradually fall despite low sales levels, setting up for the next recovery.

Question 43

Equity Returns during Business Cycle

Answer 43

The performance of economically sensitive assets such as stocks tends to be the strongest during the early phase of the business cycle, when growth rises at an accelerating rate, then moderates through the other phases until returns generally decline during the recession.

Question 44

Treasury Bonds During Recession

Answer 44

Enjoying their highest returns relative to stocks during a recession, and their worst performance during the early cycle (see Fidelity article “The Business Cycle Approach to Asset Allocation”)

Question 45

Interest Rate-Sensitive Sectors

Answer 45

On a relative basis, sectors that typically benefit most from a backdrop of low interest rates and the first signs of economic improvement have tended to lead the broader market’s advance.

Financials

1. The financial sector has historically been among the most sensitive to changes in interest rates.
2. With profit margins that actually expand as rates climb, entities like banks, insurance companies, brokerage firms, and money managers generally benefit from higher interest rates

Question 46

Financials Sector

Answer 46

Subcategories

1. Banks
2. Capital Markets
3. Consumer Finance
4. Diversified Financial Services
5. Insurance
6. Mortgage REITs
7. Thirfts and Mortgage Finance

Top Ten S&P 500

1. Berkshire Hathaway = Wide Moat
   
   1. The company remains a broadly diversified conglomerate, with a collection of moaty businesses operating in industries ranging from property-casualty insurance to railroads, utilities and pipelines, and manufacturing, service, and retailing. Aside from having economic moats built on cost advantage, efficient scale, and intangible assets, most of these businesses have operated essentially as private companies under the Berkshire umbrella–while still taking advantage of the parent company’s strong balance sheet, diverse income statement, and larger consolidated tax return
   2. Geico, Berkshire Hathaway Reinsurance Group, or BHRG, and Berkshire Hathaway Primary Group, or BHPG–remain important contributors to the overall business. Not only do they account for 25%-35% of Berkshire’s pretax earnings (and close to 40% of our current valuation of the firm owing to the firm being overcapitalized and maintaining a larger than normal equity investment portfolio for a property and casualty insurer), but they also generate low-cost float.
2. JPMorgan = Wide Moat
   
   1. JPMorgan Chase is arguably the most dominant bank in the United States. With leading investment bank, commercial bank, credit card, retail bank, and asset and wealth management franchises, JPMorgan is truly a force to be reckoned with. The bank’s combination of scale, diversification, and sound risk management seems like a simple path to competitive advantage, but few other firms have been able to execute a similar strategy.
   2. Within payments, depending on the metric, JPMorgan is generally the largest credit card issuer in the U.S. and the second-largest U.S. acquirer by purchase volume.
   3. The company’s investment bank is the leading global generator of fees, and JPMorgan’s FICC trading desk remains one of the top global players. The bank is expanding upon its already large and comprehensive commercial banking operations and locations, and is even opening new retail branches in expansion markets.
3. Bank of America = Wide Moat
   
   1. Bank of America now has one of the best retail branch networks and overall retail franchises in the United States, is still a Tier 1 investment bank, is a top four U.S. credit card issuer, is a top three U.S. acquirer, has a solid commercial banking franchise, and owns the Merrill Lynch franchise, which has turned into one of the leading U.S. brokerage and advisor firms.
4. Citigroup = Narrow Moat
   
   1. In our view, Citigroup’s truly global presence differentiates the bank from all of its U.S.-based peers. With significant revenue coming from Latin America and Asia, the bank is poised to ride the growth of these economies through the coming decade. Because of its wide geographical footprint, Citigroup should remain a bank of choice for global corporations, thanks to its ability to provide a variety of services across borders. Developing economies should offer an attractive combination of high margins and rapid credit growth over time, especially in comparison with the low rates and declining leverage that we expect to persist in the United States and other Western economies for the next few years.
   2. On the downside, it’s still difficult to see how some of Citigroup’s lines of businesses fit together. We don’t see material value creation by having multiple retail franchises in different countries, which is the case for Citi, with material operations in the U.S., Latin America, and Asia. Unsurprisingly, the bank’s global consumer franchise has underperformed peers. Citigroup also arguably remains the most complex of the Big Four. Overall, the bank continues to be on a path to improved returns and efficiencies, but we don’t expect it to match the operating performance of its money center peers.
5. Wells Fargo = Wide Moat
   
   1. Unlike its major competitors, Wells is not a top player in the capital markets. Its business model is more akin to a regional bank than a money center institution. Wells is also almost entirely U.S. focused. These factors can make the business simpler and results less volatile. For these reasons, we believe Wells deserves a lower cost of capital than its money center peers.
6. Blackrock = Wide Moat
   
   1. BlackRock closed out the June quarter with a near-record $7.318 trillion in managed assets, up 13.2% (6.9%) sequentially (year over year), with organic growth, market gains and advantageous currency exchange all adding to the improvement in overall AUM
   2. BlackRock is at its core a passive investor. Through its iShares exchange-traded fund platform and institutional index fund offerings, the wide-moat firm sources two thirds of its managed assets (and close to half of annual revenue) from passive products. In an environment where retail-advised and institutional clients are expected to seek out providers of passive products, as well as active asset managers that have greater scale, established brands, solid long-term performance, and reasonable fees, we believe that BlackRock is well-positioned. The biggest differentiators for the firm are its scale, ability to offer both passive and active products, greater focus on institutional investors, strong brands, and reasonable fees. We believe that the iShares ETF platform as well as technology that provides risk management and product/portfolio construction tools directly to end users, which makes them stickier in the long run, should allow BlackRock to generate higher and more stable levels of organic growth than its publicly traded peers the next five years.
7. S&P Global = Wide Moat
   
   1. S&P Ratings was the star of the quarter with revenue growth of 26% and adjusted operating margins of 69.1%, up significantly from 58.9% in the year-ago period. Non-transaction revenue was roughly flat while the surge in investment-grade and high-yield issuance drove transaction revenue 48% higher. Non-financial corporate revenue increased 38% as corporations rushed to issue bonds to ensure extra liquidity. While management anticipates slowing growth in the second half of the year, it doesn’t believe that the bulk of the second-quarter growth was pulled forward. The firm noted that the traditional link between GDP growth and issuance growth has been weakened by central bank bond purchase programs, which have rendered the fixed-income market a liquid and attractive source of financing. Financial services and government-related ratings business also posted strong growth. Structured finance revenue declined 21% during the quarter, and the outlook for structured finance issuance continues to be weak.
   2. While revenue growth will slow in 2020, we expect S&P Global will fare relatively well through the coronavirus-related downturn. The biggest wild card is bond issuance volumes, which can be volatile. Bond issuance volumes are a key revenue driver for its ratings business, which makes up 51% of the firm’s adjusted operating income. Over the long term, we believe mid-single-digit revenue growth, driven by GDP growth and pricing, is a reasonable expectation for S&P Ratings. Regulatory issues are part of the backdrop of the firm’s ratings business, but regulations can often benefit established players. Prior to 2008, S&P spent about $35 million on compliance and now spends over $100 million, thus increasing barriers to entry.
8. American Express = Wide Moat
   
   1. ​Investors should expect a difficult year for American Express, or Amex, as the company battles the coronavirus pandemic. We expect payments volumes will decrease, revenue will decline, and credit costs will rise. A material portion of Amex’s billings (roughly 30%) are related to the travel and entertainment industry, further exposing the company to some of the most affected industries. These trends will eventually reverse as the economy recovers, but Amex will indeed be dependent on that recovery to return to pre-COVID-19 profitability levels.
9. Goldman = Narrow-Moat
   
   1. Investment banking moats are primarily built upon the network effect and intangibles. A large securities distribution platform and extensive web of relationships allow an investment bank to more properly price and place securities. A strong reputation makes it more likely that an investment bank will be selected as a book runner, capturing more of the profits from an underwriting deal, and gives the firm an early opportunity to hire top revenue-generating talent
10. CME Group = Wide-Moat
    
    1. ​

Financial exchanges primarily construct moats derived from network effects, intangible assets, and cost advantages. For exchanges, volume and liquidity are of significant importance to customers. As a result, moats are frequently created through the network effect. As more investors use an exchange, volume increases and the bid-ask spreads on securities narrow, which lowers investors’ overall costs while increasing their ability to buy and sell a security with minimal market impact. Increasingly, exchanges are relying on intangible assets to increase their competitive advantage. Once an exchange becomes the leading or sole venue to trade a security or derivative, the exchange can use this intangible asset to develop additional products. In many cases, this means an exchange can create ancillary products to capitalize on strength within a particular asset class. For example, CME Group now offers futures on Nasdaq indexes, which are complementary to its exclusive S&P futures contract. In addition, increasingly, exchanges are selling data licenses derived from its securities and order flow. Here, exchanges have a strong competitive advantage resulting from a proprietary data set derived from its order flow.

CME Group has achieved a wide moat resulting from its position as the dominant venue for trading multiple asset classes, but specifically, the exchange’s role as an integrated clearinghouse, which greatly enhances the benefits from a network effect. Unlike with individual equities, which can be bought and then sold on different exchanges, futures must be bought and sold on the same exchange, giving CME Group substantial pricing power. Unlike with individual equities, futures are customized contracts with higher risk of settlement. If one of CME’s customer’s fails to settle a contract, the exchange will step in and close out the transaction after seizing the collateral of the defaulted counterparty. This substantially reduces the systemic risk for investors and helps attract additional trading volume to exchanges while greatly reducing the amount of competition for CME Group.

Question 47

The Fama French 3-factor model

Answer 47

The Fama French 3-factor model is an asset pricing model that expands on the capital asset pricing model by adding size risk and value risk factors to the market risk factors.

1. Size of Firms
2. Book-to-Market Values
3. Excess Return on the Market

Question 48

Morningstar = Size

Answer 48

Stocks’ risk and return profile varies across the market-cap spectrum. We use the raw size score from the Morningstar Style Box as the input for calculating stocks’ size exposure. This ensures that the size ranking of the Factor Profile is consistent with that of the style box.

Question 49

Morningstar = Style

Answer 49

Similarly, to be consistent with the ranking from the Morningstar Style Box, we use the raw style scores from the style box as the input for calculating stocks’ value-growth exposure

Value

1. Prospective earnings
2. Book to Value
3. Revenue
4. Cash Flow
5. Dividend

Growth Score

1. growth in the company’s earnings
2. book value
3. revenue
4. cash flow

Question 50

Morningstar = Momentum

Answer 50

The momentum effect has been well documented. This describes the tendency for stocks that have recently performed well to continue to do so and for those that have performed poorly to continue to fall.

It has been well documented that there is a momentum effect in stock markets, where stocks that have performed well recently tend to outperform in the future (Jegadeesh and Titman, 1993; Carhart, 1997). We calculate the momentum factor exposure as the log trailing 12-month return minus trailing onemonth return. Higher values indicate larger, positive momentum exposure:

Question 51

Morningstar = Liquidity

Answer 51

It has been shown both theoretically and empirically that the liquidity of stocks affects their expected returns (Amihud and Mendelson, 1986; Amihud and Mendelson, 1989; Amihud, 2002). Effectively, there exists an illiquidity premium to compensate investors for holding illiquid assets. In Factor Profile, we define the liquidity score of a stock as its average daily trading volume scaled by the number of shares outstanding over a month, assuming 21 trading days

Question 52

Morningstar = Quality

Answer 52

Research has also shown that stocks of high quality tend to outperform those of low quality (Sloan, 1996; Asness, Frazzini, and Pedersen, 2019). We define a quality score of a stock as the equally weighted z-score of a company’s profitability (trailing 12-month return on equity) and the z-score of its financial leverage (trailing 12-month debt/capital). The z-score is with respect to all the stocks in the global universe. Higher values indicate higher quality

Question 53

Morningstar = Yield

Question 54

Morningstar = Volatility

Answer 54

The volatility of stock returns is a widely used measure of risk. Although theoretically stocks with higher risk should earn higher expected return, some research has shown that stocks with low volatility outperform stocks with high volatility (Ang, Hodrick, Xing, and Zhang, 2006). As low- and minimum volatility investment strategies have become more popular in recent years, we include a volatility score in Factor Profile. The volatility score is defined as the trailing 12-month volatility of daily returns of a stock, where higher values indicate higher volatility