Corporate bond prices are driven by many factors but two of the more important factors are changes in overall interest rates and the market’s view on an issuer’s creditworthiness. Bond portfolio managers try to manage these two factors in seeking to outperform the index their performance is being compared against.
The price of a corporate bond is calculated as the sum of the present value of all the cash flows the bond gives off from both its interest payments and principal repayment.
Central to this calculation is the interest rate used to discount the bond’s cash flows. Now, the higher the interest rate used to discount those cash flows, the lower the price of the bond will be as the present value of the future cash flows is discounted by a larger number.
What this means is that as overall interest rates rise, bond prices bonds fall. Conversely, as interest rates falls, bond prices rise as the discount factor used to calculate the present value of the bond’s cash flows is smaller. The graphic below depicts this inverse relationship.
Figure 1: Changes in Interest Rates Driven Bond Prices
For illustration purposes only
The second important factor that impacts corporate bond prices is the market’s view on how likely it is to be repaid. In general, if the market views one company as riskier than another, it will charge a higher interest rate to the riskier company as it requires a higher return.
A way to evaluate the riskiness of company is by comparing its corporate bond yield to the yield of a government bond with a similar maturity - known as a credit spread. Essentially, the credit spread measures how much more it costs a company to borrow than it costs the government.
Figure 2: Credit spreads are equal to the difference between corporate and government bond yields
Source: MacKay Shields, Bloomberg, For illustration purposes only.
We can plot the yields of government bonds across different maturities to chart the yield curve. We can do the same for corporate bonds to show a corporate yield curve. Figure 2 shows the difference between these two curves at any given maturity is equal to the credit spread.
Typically, the wider the credit spread, the more the market wants to be compensated for lending to that company. Lower risk companies are usually associated with higher credit ratings and tighter credit spreads. Conversely, companies that are viewed as having more risk - the market is less certain principal and coupon payments will be made - have higher credit spreads.
Figure 3 is a representation of credit curves for different credit ratings. Credit curves are upward sloping as investors demand higher returns (or greater credit spreads) for lending money to for longer time periods. This reflects the greater degree of uncertainty over longer time periods. When viewing an individual company’s credit curve, a more stable company is likely to have a gently sloped credit curve whereas a company with a more uncertain future typically has a steeper credit curve.
Figure 3: Credit spread curves are upward sloping
Source: MacKay Shields, Bloomberg, For illustration purposes only. Treasury Securities are backed by the full faith and credit of the United States government as to payment of principal and interest if held to maturity. Credit ratings are evaluations of the ability of an organization to meet is debt obligations.
As active bond managers we compare companies’ credit spreads to gauge both the relative attractiveness and riskiness of different bonds with similar maturities. By combining active portfolio management and bond selection, we look to own those companies whose credit spreads we believe will compress as companies’ financial prospects strengthen. Conversely, we seek to avoid owning companies whose fundamentals we believe will weaken and credit spreads widen.
In fact, active bond portfolio management allows us to go even further than simply picking the right company. We can intentionally choose how long we want to lend to a company by selecting bonds with specific maturities. For example, we may not want to own a 50 year bond of a traditional clothing manufacturer as we believe clothing fashions will radically change in the next 50 years. However, we may own a 5-year bond of that same manufacturer if we do not expect drastic fashion changes over those 5 years and believe the company will remain solvent.
Putting this all together, by combining informed views of how well we believe corporations will perform and an understanding of available investment opportunities has the potential to lead to strong (competitive)performance by active bond managers. Passive investments that consist of simply owning an index which ignores the benefits of having informed views of underlying company financial trends, relative attractiveness of credit spreads along different maturities and how changing industry trends can adversely impact returns.
About Risk
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.
This material represents an assessment of the market environment as of a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular. This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
Definitions
Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. Duration is a measure of sensitivity of a bond's or fixed income portfolio's price to changes in interest rates.
“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. Securities are distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.
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