Bonds: Giving Credit

Written by: Global Thought Leadership | January 26, 2018

Source: Bloomberg and Legg Mason, Jan 25, 2018. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The Bottom Line

  • There’s no free lunch in the bond market: the question for investors is whether the tradeoff is worth the trade.
  • Example: the potential for higher return by shifting a portfolio toward lower-quality credit.
  • In 2017, investors in U.S. Treasuries, considered to have no credit risk, would have earned an average total return of about 2.3 percent – a rock-bottom level.1
  • How much could those investors have gained in 2017 from riskier bond sectors? Non-Treasury bonds issued by U.S. government agencies – with very slightly more credit risk – would have boosted total return somewhat, from 2.3% to 2.98%.
  • Corporate bonds would have provided a larger pickup. Moving from Aaa-rated to Aa-rated corporates would have boosted total return from 2.41% to 4.23%; to A-rated, 5.98%; to Baa – still investment-grade territory but clearly higher risk – to 7.45% -- a fairly large return pick-up. But also a fairly large pickup in risk.
  • It’s hard for a typical investor to determine if they’re being paid enough to take on the levels of risk that go with these yields on a sector level — and virtually impossible on a security level. 
  • What’s more, passive investments driven by broad indexes may involve more risk than is immediately apparent — which begs the question of whether the return they offer is sufficient compensation.
  • Active bond managers, on the other hand, can vet risks at the market, sector and security level and evaluate the tradeoffs with a critical eye — valuable flexibility at a time when the overall interest rate environment is changing.

1 Source: Bloomberg, Jan 24, 2018. All figures for total return, yield and duration are for the Bloomberg Barclays Indexes representing their respective fixed income categories or subcategories.

Duration is a measure of the price sensitivity of a fixed-income security to an interest rate change. It is calculated as the weighted average of the present values for all cash flows, and is measured in years. Modified duration incorporates the fact that bond prices and yields move in opposite directions.

The yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

The Bloomberg Barclays U.S. Aggregate Aaa Total Return Index covers the universe of Aaa-rated, fixed-rate taxable bonds.

The Bloomberg Barclays U.S. Aggregate Aa Total Return Index covers the universe of Aa-rated, fixed-rate taxable bonds.

The Bloomberg Barclays U.S. Aggregate A Total Return Index covers the universe of A-rated, fixed-rate taxable bonds.

The Bloomberg Barclays U.S. Aggregate Baa Total Return Index covers the universe of Baa-rated, fixed-rate taxable bonds.

The Bloomberg Barclays US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury, excluding Treasyr bills due to maturity constraints.

The Bloomberg Barclays US Agencies Total Return Total Return Index covers U.S. government debt issued by federal agencies.

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An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Diversification does not guarantee a profit or protect against loss.

Outperformance does not imply positive results.

A credit rating is a measure of an issuer’s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor’s, Moody’s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see www.standardandpoors.com, www.moodys.com, or www.fitchratings.com for details.

Active management does not ensure gains or protect against market declines.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

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