Money market instruments, which have a maturity below one year, have very low risk but a relatively low return. Short-term bond products, with a maturity of up to five years, offer a higher return over time but are more volatile and therefore riskier. A broad-based bond fund, with scope to invest in maturities beyond 5 years, offers a still higher return over time but with yet more risk.
A bond investor has to deal with three main types of risk: (1) interest rate risk which can be indicated by duration or, more simply, by the term to maturity, (2) credit quality, which may be assessed with reference to an agency rating or subjectively by the investor using his own judgment and (3) the risks inherent in bond-type investments which are not just “plain vanilla” bonds. Let us consider these categories of risk in turn.
A typical short-term bond fund invests in fixed income instruments with a maturity not longer than five years and has an overall duration in the area of 2.5 to 3 years. These two guiding principles keep the interest rate risk moderate. Typically, the price sensitivity of fixed rate instruments increases with the term to maturity. Therefore shorter maturities are not as price sensitive over time as longer-term instruments.
Historically money market rates tend to fluctuate much more than 5-year bond yields. Nevertheless, the price impact of money market rate fluctuations tends to be relatively moderate. In turn, 5-year bond yields fluctuate somewhat more than 10-year yields. However, the price impact for 10-year bonds for a given movement in yields is likely to be twice as large as for 5-year bonds.
This means that an investor is very well rewarded if he correctly anticipates that yields will fall and holds long-term bonds. On the other hand, the return impact of long-dated issues in a rising yield environment can be very harmful.
In the past few years, the impact of “credit events” on all kinds of bond portfolios has been a focus of market attention. “Credit events” refer mainly to corporate bonds but also to other types of debt — for example emerging market sovereign paper. Specifically, markets have become more concerned about default risk — either of default itself or of a “ratings downgrade”, which would indicate an increased risk of default and might force institutional investors to sell.
This shift in focus not only reflects the collapse of some very high profile companies – e.g. Enron, Global Crossing or Swissair. Also, for reasons discussed below, bond portfolios have become more sensitive to corporate developments.
How does credit risk add to the risk profile in short-term bond portfolios? Using the “Sharpe Ratio” which is a measure of the “efficiency” of an investment, one can compare efficiency between any types of investment, e.g. stocks relative to bonds. The ratio relates the incremental return on an investment over the “risk free” return (or money market rate) relative to the riskiness of that investment as measured by the standard deviation. The higher the Sharpe ratio, the more “efficient” it is. Consequently, by analyzing the period 1985 to 2002, we found that 1-3 year investment grade corporate bonds have been relatively efficient, in terms of the Sharpe Ratio, with respect to both similar maturity government bonds and also longer-dated (7-10 year) investment grade corporate bonds. It reflects the facts that short-dated corporate bonds have offered a somewhat better return than short-dated government paper with slightly less risk and that they have been much less risky than longer-dated corporate bonds, although admittedly delivering a lower return (7.9% pa. versus 9.6% pa.)
The development of new bond structures, and the importance of bonds outside the “plain vanilla” area, is one aspect of the increased importance of non-government debt markets as opposed to those for government paper. In part, this reflects a long-run trend, which has recently reversed, to reduced government deficits or, in some countries, a shift toward public sector surpluses.
Also, there has been a trend disinter mediation of the banking system. Many banks are no longer able or willing to lend as much to their corporate customers as they did. As a result an increasing number of companies have been forced to enter the capital markets in order to get financing for their businesses. Along the same lines, one can see a growing volume of asset-backed securities. This represents nothing else than a risk transfer from banks or other finance companies to the capital markets.
What does all this mean for an investor? First, it adds to the diversification potential of bond portfolios. Asset backed securities have, in most cases, a very high rating and offer a good yield pick up over similar rated bonds. Sometimes innovations in the fixed income area offer a substantial premium, which over time erodes as investors become familiar with the new product and a new sub-asset class is established as an integrated part of the bond market. One example in this area is the funding agreements issued by insurance companies. The short-term (1 to 3 year) area of the bond market has access to most of these innovations and is therefore well placed to benefit from the incremental returns, which often derive from new fixed income products.
What returns can an investor expect over time? Performance data for US dollar and euro denominated 1-5 year bonds over the last few years indicate a 1%-1.5% pa. yield pick up over 3-month money market rates in the euro-denominated paper and a nearer 2.5% pa incremental return in the dollars. This experience could be a good guide to the future.
(This article is contributed by Clariden Bank, London, which is a wholly-owned subsidiary of Credit Suisse, Zurich, specializing in asset and client relationship management)