Understanding fixed income investing

Deep dive: Yield curve explained

What is the yield curve?

The interest rate that lenders require of any borrower will depend on the term of the borrowing. The yield curve depicts the various rates at which the same borrower can borrow for different periods of time. The most closely watched yield curve in any country is that of the national government, which is the closest approximation to a risk-free yield. Other yield curves, such as the one for corporate borrowers, are best understood in comparison with the risk-free yield.

When applied to a government bond, it shows the yield for all government bonds at each term to maturity remaining. For example, to calculate the yield curve on a government bond, the yield on all such government bonds with 1 year remaining to maturity is calculated and plotted graphically against the 1-year term. Similarly, the yield on all such government bonds with 5 years remaining until maturity is calculated and plotted graphically against the 5-year term, and so on for all times to maturity, until the yield curve is formed. This concept is illustrated below. Note that this is an illustration only and not representative of an actual yield curve. Yield curves can and do vary.

The yield curve is drawn against two axes, the vertical showing yield and the horizontal giving the term in years. Most of the time the yield curve is positively sloped, going from the lower left corner of the chart to the upper right. In this case, very short-term borrowings would have the lowest yield, with the yield increasing as the term lengthens. The reasons for this shape are readily understandable, as lenders and investors wish to be compensated for the greater risk that inflation will erode the value of their asset over the longer period. 

How to interpret the yield curve?

The level of the yield curve can be used as a measure of the level of interest rates in the economy. The cash rate forms the beginning of the government yield curve given it is the interest rate with the shortest term (overnight). The expected level of the cash rate in the future typically influences the yield from fixed income securities. As such, higher interest rates would be expected to shift the yield curve up and vice versa. The impact of an increase in real interest rates on the yield curve is illustrated below. Note that this is an illustration only and not representative of an actual yield curve. Yield curves can and do vary.

Another important aspect of the yield curve is the slope. The slope of the yield curve reflects the difference between short- and long-term bonds and the cash rate investors can expect at these time periods. The precise shape of the yield curve varies slightly from day to day and can change significantly from one month to the next. If long-term interest rates rise relative to short-term interest rates, the curve is said to steepen; if short-term interest rates rise relative to long-term interest rates, the curve is said to flatten.

One way to think about this is to regard the yield curve as a forecast for future short-term interest rates. Bond issuers and investors always have the option of repeatedly purchasing money-market instruments rather than making long-term commitments, so a steeper yield curve implies that they expect money-market yields to be higher in future than they are now.

The yield curve is said to be ‘normal’ where short-term yields are lower than long-term yields. This curve is typically (although not always) observed in times of economic expansion where there is a greater likelihood that future interest rates will be higher than current interest rates because investors expect central banks to raise rates in response to higher inflation. Bonds with a longer term can be more exposed to the uncertainty that interest rates or inflation may rise in the future, and if this were to occur, the price of a long-term bond would be expected to fall, and therefore investors typically demand a higher yield to own longer-term bonds.

The yield curve is said to be ‘inverted’ if short-term interest rates are higher than long-term interest rates. An inverted yield curve is usually a sign that the central bank is constricting the flow of credit to slow the economy, a step often associated with a lessening of inflation expectations This curve is typically (although not always) an indicator of a recession. This can make investors in longer-term instruments willing to accept lower nominal interest rates than are available on shorter-term instruments, giving the curve an inverted shape.

The yield curve is said to be ‘flat’ where short-term yields are similar to long-term yields, typically observed in times of transition between normal to inverted.

This is illustrated below. Note that this is an illustration only and not representative of an actual yield curve. Yield curves can and do vary.

Deep dive: Duration explained

What is duration?

Duration is a number expressing how quickly the investor will receive half of the total payment due over the bond’s remaining life, with an adjustment for the fact that payments in the distant future are worth less than payments due soon. If two bonds have identical terms, the one with the higher yield will have the shorter duration, because the holder is receiving more money sooner.

The duration of any bond changes from one day to the next. Duration is measured in years. 

Why is duration important? 

Traders and investors pay close attention to duration, as it is the most basic measure of a bond’s riskiness. Duration can be used as a measure of the sensitivity of the price of a bond to changes in interest rates in the economy. This can help investors understand and manage the risks associated with their fixed income investments.

The longer the duration of a bond, the more the price of the bond is likely to fluctuate before maturity. In other words, the longer the duration, the more sensitive the bond’s price can be to rising and falling interest rates and therefore generally, the higher the interest rate risk. Interest rates in the economy and the price of a bond are typically inversely related, and therefore a fall in interest rates is likely to have a greater positive impact on the value of a bond if it has a higher interest rate duration.

What impacts a bond’s duration? 

Many factors impact a bond’s duration. The main factors are outlined below.

• A bond’s maturity. As a bond approaches its maturity date, the interest rate duration of a bond generally declines. Therefore, generally, the greater the maturity of a bond the greater the duration.
• A bond’s coupon. Generally, if a bond’s coupon is less than its yield to maturity, it is more sensitive to interest rate changes. Therefore, generally, the lower the coupon the greater the duration.
• A bond’s yield. Generally, the higher the yield of a bond the greater the duration.

Duration in practice

Consider a hypothetical scenario where interest rates or bond yields were to fall in the economy by 1%. The indicative impact on return for a bond or portfolio of bonds with an interest rate duration of 1 year is a 1% gain (all else remaining the same). The indicative impact on return for a bond or portfolio of bonds with an interest rate duration of 5 years is a 5% gain (all else remaining the same), and so on, for all years of duration. Note that interest rates and bond yields in the economy are just one factor affecting a bond’s future return and the indicative results set out below are not guaranteed to occur. This concept is summarised below: 

How can investors apply ‘duration’ to a diversified or balanced portfolio in different scenarios?

Duration is a commonly used metric for measuring and managing risk in fixed income investing. Investors can view ‘duration’ as a counterbalance to risk assets. To manage interest rate sensitivity risk, if an investor believes interest rates or bond yields are likely to decrease in the future or if the perceived risk of an economic and/or risk market downturn is greater, they may shift to a higher duration strategy.

Deep dive: Spreads explained

What are spreads?

A spread is the difference between the current yields of two bonds with similar and comparable maturities, but different credit quality. It is usually expressed in basis points, with each basis point equal to one-hundredth of a percentage point. Traders in most countries have adopted a benchmark, usually a particular government bond, against which all other bonds are measured. If two bonds have identical ratings but different spreads to the benchmark, investors may conclude that the bond with the wider spread offers better relative value, because its price will rise relative to the other bond if the spread narrows.

It therefore can be a measure of the risk premium that an investor may demand for holding a fixed income security with lower credit quality compared to a fixed income security with a higher credit quality. However, it is important to note that other factors can affect the difference in yield between fixed income securities with similar maturities such as an illiquidity premium. An illiquidity premium can be explained as the difference in yield between two types of securities with all the same qualities except that one type of fixed income security is perceived to be less liquid than the other.

Credit spreads are influenced by various factors. Some of the most common factors include:

• the creditworthiness of the issuer,
• market conditions,
• economic indicators, and
• investor sentiment.

Corporate bond spreads can widen or narrow if investors sense a change in the issuer’s creditworthiness. If a firm’s sales have been weak, investors may think there is a greater likelihood that the firm will be unable to service its debt and will therefore demand wider spread before purchasing the bond. Conversely, investors frequently purchase bonds when they expect that the issuer’s rating will be upgraded by one of the major credit agencies, as the upgrade will cause the bond’s price to rise as its yield moves closer to the benchmark interest rate.

Spreads in practice

Spreads are usually expressed in basis points, with each basis point equal to one-hundredth of a percentage point.  Using a simplistic example, if the yield on a government bond is 2.00% and the yield on a corporate bond is 3.50%, the credit spread would be 150 basis points (3.50% - 2.00% = 1.50% or 150 bps), noting this difference in yield can also include factors such as illiquidity premium as explained above. If the yield on a high yield bond is 5.50%, the credit spread would be 350 basis points. This concept is summarised below. Note that this is an illustration only and not representative of an actual yield curve. Yield curves can and do vary.

What do credit spreads indicate? 

As illustrated in the above diagram, generally the higher the risk, the larger the credit spread. In general, bonds issued by highly rated corporations tend to have lower credit spreads than lower rated corporations, reflecting the view of investors that those corporations have a lower risk of default (i.e. higher credit quality). Bonds issued by lower-rated corporates or those in sectors sensitive to economic conditions typically (although not always) have higher credit spreads to compensate investors for the perceived higher risk of default.

As an example, tightening credit spreads generally indicate:

• that economic conditions are improving. Credit spreads are often a good barometer of economic health — widening (can indicate a ‘bad’ outlook for economic conditions) and tightening (a ‘good’ outlook). The same way that interest rates move depending on market conditions, credit spreads also typically move with market conditions. Spread is a measure of risk and the risk in the market changes depending on prevailing conditions.
• improvements in company profitability and lower default rates of the issuers of fixed income securities in the market.

What is credit spread duration?

Credit spread duration measures the sensitivity of returns for a bond or portfolio of bonds to changes in credit spreads. It can be used to manage and monitor the level of credit risk in a portfolio.

Consider a hypothetical scenario where credit spreads in the economy were to tighten by 1%. The indicative impact on returns for a bond or portfolio of bonds with credit duration of 1 year is a 1% gain (all else remaining the same). The indicative impact on return for a bond or portfolio of bonds with credit duration of 5 years is a 5% gain (all else remaining the same), and so on, for all years of credit duration. Note that credit spreads in the economy are just one factor affecting a bond or portfolio’s future return and the indicative results set out below are not guaranteed to occur.

This concept is summarised below:

Deep dive: Ratings of risk; what do they tell us?

What is a credit rating?

Before issuing bonds in the public markets, an issuer will often seek a rating from one or more private rating agencies. The selected agencies investigate the issuer’s ability to service the bonds, including such matters as financial strength, the intended use of the funds, the political and regulatory environment, and potential economic changes. After completing its investigation, an agency will issue a rating that represents its estimate of the default risk, the likelihood that the issuer will fail to service the bonds as required.

Three well-known companies, Moody’s Investors Service, Standard & Poor’s, and Fitch dominate the ratings industry. All the ratings agencies emphasise that they rate only the probability of default, not the probability that the issuer will experience financial distress or that the price of its bonds will fall. Nonetheless, ratings are important in setting bond prices. Bonds with lower ratings almost always have a greater yield than bonds with higher ratings. If an agency lowers its rating on a bond that has already been issued, the bond’s price will fall. 

Ratings in practice

Ratings agencies typically assign these ratings at both the issuer level (the issuer of the fixed income security) and at the security level.

The higher the rating, the greater the rating agency’s view of the ability of the issuer to meet its financial obligations. These issuers would generally be classified as investment grade, and typically imply lower default risk (although not always). Investment grade captures securities with a credit rating between AAA+ and BBB-. As credit risk increases, these issuers would generally be classified as non-investment grade or high yield, with a rating from BB to C. A rating of D would indicate the fixed income security is in default. This is illustrated below. 

What do credit ratings indicate? 

As a credit rating is a rating agency’s evaluation of the credit worthiness of a potential borrower, it can provide an investor with a way to measure the credit risk of fixed income assets. It is however important to note that looking at the security rating in isolation is not enough to determine the credit risk of the investment. Credit ratings are a rating agency’s evaluation of the credit risk of a security, and it is possible for the rating agency to be wrong. 

Deep dive: Credit seniority; why does it matter?

Understanding bonds: knowing the capital structure

Capital structure refers to the mix of financing used by businesses, consisting generally of various levels of debt and equity. When investing in any security, it is important to understand where the security sits within the issuer’s capital structure, as a way to determine the potential risk or return of the investment. All securities have different risk and reward characteristics and therefore can be placed on a spectrum of credit risk and level of protection, as illustrated below. Generally, the higher up the capital structure spectrum (with senior debt at the top) the lower the credit risk and the higher the protection. For example, bonds rank higher in the capital structure, with a lower level of risk and offering higher protection against losses, when compared to equities. This means that investors in bonds typically can get priority claim to equity investors over cash flows and assets where the issuer of the security were to liquidate. 

In summary, the capital structure spectrum can provide insight into the credit risk and level of protection when investing in any security.