Post Modern Investment: Facts and Fallacies of Growing Wealth in a Multi-Asset World

Chapter 2

Equity and Fixed Income

The Traditional Pair

For most investment firms, financial products reflect the opportunities of a given time and place. For example, in the 1970s and early 1980s, changes were taking place in how individuals viewed bond ratings and the pricing of fixed-income securities. During this period, Salomon Brothers took a 20-year government bond and split it into 41 individual bonds (i.e., 40 semiannual coupon payments and one principal payment). Salespeople then took each of the individual bonds (zero coupons) with a fixed maturity and sold it at a discount equal to the bonds' then-required return. Suddenly there existed a complete series of zero-coupon yield-to-maturity (YTM) or yield-to-duration (YTD) bonds (note that for zero-coupon bonds, YTM and YTD are the same thing), such that investors had access to a complete term structure for bonds (i.e., spot rates and forward rates). The creation and further development of a series of zero-coupon bonds forced a sea change in how fixed-income securities could be managed. For the first time, investors could easily single out, mix, or match bonds to meet a particular investment need, with little or no default or reinvestment risk.

Correspondingly, other changes were taking place in the fixed-income area. In the 1970s, research increasingly began to address the use of a bond's duration rather than a bond's maturity as the primary means to compare yields on bonds.¹ In addition, with the New York City credit crisis ...