The yield of a fixed rate corporate bond is made up of two components, a base interest rate and a credit spread. Higher yield is generally commensurate with high risk. We explore the components of yield.
Yield of a bond
Yield is a primary consideration for fixed income investors as it is the expected return of a bond at a given price. The yield to maturity (YTM) is the annualised return an investor can expect to receive based on the current price and the coupon of a bond. Yield to worst (YTW), is the lowest yield achievable for a bond based on any call options. For a bullet bond, i.e. a bond without any calls, the YTW equals YTM.
Generally speaking, bonds with longer tenor, lower rating or complex structure have higher yields than shorter dated, simple bonds with higher ratings.
Yield and price
As is well known, there is an inverse relationship between the yield and the price of a bond. The chart below illustrates this relationship. For the purpose of this illustration, we have used two bonds, both paying 5% coupons, semi-annually, but with differing maturity dates.
The chart also shows that bonds with longer tenor or maturity are more sensitive to movement in interest rates (yield) than shorter dated bonds. The line depicting the 10 year bond price is steeper than the 5 year bond price, because the price of the 10 year bond moves by a larger amount for a given change in yield when compared to the 5 year bond.
This inverse relationship applies to fixed coupon bonds only. Floating rate notes (FRNs) do not have this interest rate sensitivity as the coupon on these securities resets on a regular basis (usually quarterly), eliminating much of the interest rate risk.
Yield of a corporate bond
The yield of a fixed rate corporate bond is made up of two components – a base interest rate and credit spread. The interest rate is equal to the yield of a government bond with a similar maturity, which is considered to be a risk free rate. The credit spread reflects the credit worthiness of the issuer of the bond. As such, issuers that are unrated or rated sub-investment grade will have higher credit spreads than their investment grade counterparts.
The chart below shows how these components contribute to the total yield of a security at various maturities. The light blue shaded area is the interest rate component, whilst the dark blue shaded area represents the credit spread for a generic USD B-rated bond. For example, at the 10 year maturity the total yield of the B-rated bond is 7.00%, broken down into 2.94% interest rate and 4.06% credit spread.
For illustration purposes, we have also included the credit spread for a generic USD AA-rated bond, which carries less credit risk than the B-rated corporate bond. At the same 10 year maturity, this bond has a yield of 3.76%, with interest rate still contributing 2.94%, but at 0.82% the credit spread is lower. Since the AA-rating is closer in credit quality to the government bond, the green line tracks the light blue shaded data point closely.
Investment Strategy – yield and diversification
Investors in corporate bonds can achieve their targeted yield by including bonds of varying characteristics in their portfolios. Bonds that are longer dated and/or lower rated offer higher yield (than bonds that are higher rated and/or shorter dated), but they also carry higher interest rate and/or credit risk.
Having a diversified corporate bond portfolio helps reduce credit risk by reducing single-name exposure. Furthermore, diversification by maturities and bond type (fixed coupon/FRN) helps reduce interest rate sensitivity.
Yield is a primary consideration for fixed income investors as it is the expected return of a bond at a given price. The yield of a fixed rate corporate bond is made up of two components – a base interest rate and credit spread. For higher yielding corporate bonds, investors should ensure they have conviction in the credit quality of the issuer as the risk is higher.
To further understand how portfolios with varying risk characteristics can result in differing yields, please refer to our recently published model portfolios.
Please contact your relationship manager or the Investment Strategy Group (ISG@fiig.com.au) to discuss any queries related to this article or other investment opportunities.