Decoding the corporate bond discussion

Corporate bond markets are viewed by many with trepidation due to the illusion of complexity surrounding them. But bonds are by and large based on fairly simple concepts, and key to understanding them is becoming fluent in the specialised terminology used to describe the various attributes of fixed income securities. Let’s take a run through a few of the most important concepts.

Yield

Yield is the most common measure of bond performance. It refers to the annual coupon payout on the security, making it effectively a rate of return that excludes capital gains. Current yield, also known as running yield, refers to the annual payout as a percentage of the current market price. For example, the current yield on a bond with a current market price of $1,000 that pays $80 per year in interest would be 8%. Running yield is a similar concept to the dividend yield for equities.

Yield to maturity, or gross redemption yield, is a yield that represents the total coupon payments for that bond if were it to be held to maturity, plus interest on interest (the reinvestment), and the gain or loss realised from the security at maturity.

A yield curve is a function that traces relative yields on a type of security against a spectrum of maturities ranging from three months to 30 years.

Now we have yield as our metric for the performance of the security, the next consideration is the way in which that yield responds to interest rate movements and credit risk, two of the most important influences on bond pricing.

Interest-rate sensitivity

We use the term duration to broadly refer to the extent to which a bond’s pricing responds to interest rate movements. Technically, it’s a weighted measure of the amount of time until the cashflows of the bond are received (Macaulay duration). As such, it reflects the timing and magnitude of each cash flow, and the extent to which changes in the discount rate for those cash flows (at the prevailing interest rate) will affect the price of the bond.

Modified duration is an extension of the Macaulay duration concept, whereby it directly expresses the percentage change in the price of a bond for a given change in interest rates.

Credit sensitivity

The concept of credit risk will be familiar to most investors, being the expected risk of loss due to the issuer delaying or defaulting on interest or principal payments. Credit risk is assessed by agencies who issue credit ratings on the quality of debt securities.

Bond issuers with lower credit ratings must pay a premium to investors who purchase their bonds. The difference between the yield on a bond and a government bond of the same maturity (effectively a risk-free rate of return) is known as the credit spread, measured in basis points.

Credit spreads are affected by factors such as the financial strength of the issuer, broader macroeconomic conditions and the demand and supply amongst investors for the issuer’s securities. After purchasing a corporate bond, the bondholder may benefit from a narrowing of the credit spread which all else being equal, should drive up the price of the bond, delivering a capital gain.

In a similar fashion to interest-rate sensitivity, the term credit spread duration is used to refer to the sensitivity of a bond’s price to movements in credit spread. Typically, the higher the credit spread duration in a portfolio, the greater the credit risk that investors are exposed to.

Understanding corporate bonds, or fixed income generally, does not need to be complicated. Once the basic principles of the terminology used in the asset class are broken down, such as interest-rate sensitivity and credit exposure, investors can better understand how corporate bonds may perform in a changing interest rate and macroeconomic environment.