Bond Market Math (Part 3)

Where do bond returns come from?

With rates rising, it’s important to keep bond maturities short. That way their price declines won’t hurt the portfolio too much, and investors can reinvest the principle sooner when the bonds mature. But longer bonds pay more to compensate investors for interest rate risk. Short Treasury bonds pay less than inflation now, so those investments have negative real returns.

Bonds carry three major risks: interest rate risk, credit risk, and structural risk. Credit risk is the risk of not being paid—that the issuer defaults. With Treasuries, the credit risk is virtually zero, so they pay almost no credit premium. Most other US Dollar bonds, however, can be quoted in relation to Treasuries. The difference between their yield and that of a comparable Treasury Note is called the “spread,” that can widen or narrow.

Bonds with greater credit risk have a larger spread. As the spread narrows, the bonds go up in price. A key strategy, therefore, is to find bonds of improving credits—issuers whose spreads overstate the possibility of loss, and have potential to improve. Sometimes these will be pristine credits caught up in market turmoil; sometimes solid companies are in risky—but improving–industries; or a troubled issuer might be in a sound industry and change its managemement. In any case, it’s the direction of the credit risk—rather than its absolute level—that matters.

This kind of approach is dynamic, but can provide some of the return bond investors need to outpace inflation. Finding returns from credit is hard—but the gain to a portfolio is worth the sweat that buyers need to put in.

Douglas R. Tengdin, CFA

Chief Investment Officer

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