Scientific Investing III: Peanut Butter Spread or Term and Credit Spread?
So, you’ve realized that equities are risky investments and are looking towards bonds to serve as a “safety net” for your portfolio; however, there are some things you first must know before entering the world of fixed income, i.e. the world of bonds. The previous two blog posts regarding the academic way of investing have exclusively discussed the equity portion of your portfolio, so this blog post will shed some light on the world of bonds and show you how to control the term spread (duration) and the credit spread of your bond investments.
In order to understand bonds, also called “fixed income”, we will first break down what term spread and credit spread actually mean. Bond prices are determined by calculating the term risk and the default risk—basically, how long the bond’s duration is, and how likely the bond is to default. The longer the bond maturity and the higher the likelihood of default, the higher the expected returns should be for the investor due to the increased risk of the investment. Term risk, or the risk found in the length of the bond’s lifespan, is primarily effected by interest rates and how they may change in the future which in itself is impossible to accurately predict. If an investor invests in a longer-term bond, it is riskier because of this unpredictability. In basic terms, if you were to lend a friend five dollars to be paid back tomorrow there would be little risk because the likelihood of repayment is high. On the other hand, if you were to lend a friend five dollars to be paid back in thirty years, the likelihood of repayment is significantly smaller since a lot can happen in the time span of thirty years. The majority of benefit from taking on manageable term risk can be found in the 1 to 5 years maturity bracket, a concept that was supported by Nobel Laureate Eugene Fama, the co-founder of the 3-factor model. In his publication “Term-Structure Forecasts of Interest Rates, Inflation, and Real Returns”, Fama notes that 1 to 5-year bonds capture the ideal benefits of term risk, and anything past 5 years increases term risk without increasing returns adequately due to diminishing marginal returns of the yield curve.
When trying to capture the term spread without taking on too much risk, an essential component is the yield curve. The yield curve is a plotted curve of interest rates at a set point in time that show different maturity dates all the way up to 30 years, while keeping credit quality constant. Essentially, it is showing different costs to a bond issuer of borrowing money through a given bond at a set time over a certain period. The shape of the yield curve is determined by interest rates and monetary policy; thus, it can change to be inverted, normal, or flat depending on the monetary environment of the country. Such shifts in the yield curve are unpredictable, nevertheless the current yield and the roll down yield for holding the bond for 1 year are determined. The best investment is a bond with an upward sloping “normal” curve which is normally steepest in the first 5 years of the bond’s duration. A working paper from Harvard University, “Yield Spreads and Interest Rate Movements: A Bird’s Eye View”, reiterates Fama’s ideas that the longer the bond’s term is, the more expected returns fall compared to shorter term bonds. The paper explains, “In plain English, when the spread is high the long rate tends to fall and the short rate tends to rise”, meaning that the shorter the duration of the bond, the better an investment it will be on a risk-adjusted basis.
When investing in bonds, there are different types of return possible. There is another type of return called “roll-down return”. Roll-down return is the form of return that emerges in an upward sloping yield curve when the bond is held for 1 year. Roll-down returns correlate with the steepness of the upward sloping yield curve (you darkly remember the first derivative from your high school mathematics class, don’t you?), hence they are smaller for longer term bonds. In addition, if a particular bond on the yield curve is trading at a discount, the roll down effect will be positively magnified, meaning that the price will trend towards par upon bond maturity (or the original price of the bond), causing higher returns for the bondholder.
While the return on bonds is generally not as high as equities since bonds are generally safer investments compared to equities, this by no means implies that high-yield bonds are the answer to find more returns. As previously evaluated in another blog post, high-yield bonds, aka junk-bonds, are often times deceptively risky investments. Even though one of the advantages to investing in bonds is that they are generally less risky than equities, if a bond is not investment-grade it loses the security you are looking for in the first place compared to investments in equities. Junk bonds are high-risk high-reward situations that are consistently unpredictable and unstable. Bonds are meant to be the safety parachute of your portfolio—why poke giant holes in it with junk bonds? In order to have the safest support possible, the key to investing in bonds is to choose exclusively short-term investment-grade bonds in order to maximize the benefits of term spread on a risk-adjusted basis and in order to protect against the volatility of high-risk high-yield bonds.
Positioning your bond portfolio at the steepest part of the upward sloping yield curve between 1 and 5 year duration will help to protect and support your portfolios. Additionally, that way your portfolio will always stay academically clean and you will never run the risk of taking on undue risk in the bond portion of your portfolio.