How to Assess Risk and Return in Fixed Income

Michael Helmuth is chief portfolio manager of fixed income at Northwestern Mutual Wealth Management Company.

Investors should be compensated for taking on risk. That is a fundamental tenet of investing—and it means that evaluating any investment involves assessing its balance of risk and potential return.

In fixed income, a security’s yield (its annual interest payment as a percentage of its price) provides a useful approximation of its potential return. Investors need to assess whether a fixed income investment’s yield adequately compensates for the risk the investment represents.

Types of risk in fixed income

Fixed income investors may be compensated for taking on four types of risk:

1. Interest rate risk: How much changes in the general level of interest rates are likely to affect bond values. The higher a bond’s duration, the greater its sensitivity to interest rate risk. When interest rates rise 1 percent, a bond’s price is expected to fall 1 percent for each year of duration. The reverse is also true: A 1 percent decline in rates is expected to boost a bond’s price 1 percent for each year of duration.
2. Credit risk: The likelihood a security’s issuer will fail to make its full payments on time (default). Ratings issued by the major credit bureaus are the most common way to gauge credit risk.
3. Liquidity risk: The possibility that an investor will not be able to sell an investment in a timely manner. Liquidity risk is lowest for U.S. Treasury securities and highest for deals in the private credit markets.
4. Implied volatility risk: The degree of expected price fluctuation as reflected in options pricing. (We will address implied volatility in future issues.)

These risks affect different fixed income segments to varying degrees. Most of the yield paid by high-quality fixed income compensates for interest rate risk, with modest additional yield coming from credit risk.

The lower a security’s credit rating, the more its yield compensates investors for credit and liquidity risk. This dynamic means that when securities pay especially high yields, it usually means they have large credit and/or liquidity risks.

Evaluating risk versus yield

To judge whether a security’s yield adequately compensates for its level of risk, investors need to understand the risks it presents and how much additional yield is appropriate for them.

Securities with greater time to maturity present higher risk, all else being equal. For higher-quality securities, longer time periods amplify interest rate risk. For lower-quality securities, longer time periods increase the possibility of a default during the bond’s term. As a result, longer-term assets generally pay higher yields than shorter-term securities.

Investors can judge how much a security compensates for credit risk using spreads to Treasurys. U.S. Treasurys are assumed to be risk-free from a credit perspective, so they make a useful point of comparison: The spread between a security’s yield and the yield on a Treasury with comparable maturity should be appropriate for the investment’s overall credit risk.

Consider the table below, which shows recent credit spreads for securities in a range of maturity buckets.

Note that yields rise steadily as maturities increase and gain rapidly as credit ratings decrease. For example:

• The spread on a AAA-rated two- to three-year bond was 29 basis points on November 5. The spread on a bond rated CCC+ in the same maturity bucket was 697 basis points.
• In the five- to seven-year bucket, the spread on AAA-rated bonds was 50 basis points, compared to 606 for bonds rated CCC+.

The higher compensation provided by lower-quality debt reflects its higher risk of default. About a decade ago, Moody’s published a 50-year study of default rates over rolling 10-year periods. An average of 2.81 percent of investment-grade corporate bonds defaulted over 10-year time horizons, compared to 32.41 percent of speculative-grade bonds (those rated BB+ or lower) and an eye-popping 63 percent of bonds rated CCC and below. When bonds defaulted, investors on average recovered between 40 and 60 cents on the dollar. Given the far greater credit risk in lower-rated bonds, it stands to reason that investors should expect them to pay much higher yields than Treasurys.

Investors can extend this line of thinking to private credit. Private, “senior unsecured” loans may offer investors yields of between 10 percent and 13 percent. Investors should ask themselves why these yields are so high when companies can finance in the capital markets at much lower rates. The most logical explanation is that these borrowers are less creditworthy than even the lowest rung of investment-grade fixed income. While there is nothing inherently wrong with these markets, investors should be clear about the reasons they offer higher yields than public fixed income markets. The upshot: Investments that pay yields comparable to expected returns in the equity market probably carry equity-like risks.

Risk and yield in the municipal bond market

Investors can look at municipal bonds in much the same way, adjusting for the securities’ distinctive tax advantage. Municipal bond payments are exempt from taxable income. This quality may make a dollar of municipal bond income more valuable than a dollar of income from taxable bonds such as Treasurys. How much more valuable depends on the investor’s effective tax bracket.

Thanks to this tax advantage, the yields on AAA-rated munis typically are lower than yields on Treasurys with comparable maturities. Rather than using spreads to Treasurys, municipal bond investors typically gauge the spread between the yield on a given security and the yield on a AAA-rated muni with similar maturity, as shown in the table below.

Compared with corporate bonds, municipal bonds’ yields do not increase as much as they go down in credit quality. The difference reflects the fact that munis historically have been less likely to default than corporate bonds with comparable credit ratings. Moody’s study found that investment-grade municipal bonds defaulted just 0.08 percent of the time over 10-year time horizons, while sub-investment-grade munis defaulted 7.52 percent of the time over 10-year periods.

Higher yield, higher risk

The moral of this story is simple: Nothing in the markets is free. If securities pay yields similar to the expected return offered by equities, they carry risk similar to that of equities–including substantially higher default risk than lower-yielding, higher-quality bonds.

When contemplating fixed income investments, investors should be mindful of the role their fixed income allocation plays in their portfolio. Investors generally need those assets to provide capital preservation and diversification away from risk assets. For that role, there is no alternative to safe assets that offer predictable interest payments and return of principal.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. No investment strategy can guarantee a profit or protect against loss. Past performance is no guarantee of future results. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and nonproprietary sources. To learn more, click here.

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