A financial security is a contract on future cash flows and an investor takes on the risk of all future uncertainties. An investor also takes a premium against those risks, which is a discount on the present value of the future cash flow stream. If a realized risk factor is more severe than the premium, the investor takes a loss and vice versa.
In the fixed income market, the risk premium is represented by yield, which is a discount rate on the future cash flow that is offered by a bond. A yield in a non-Treasury bond can be deconstructed by the following risk premia:
Yield of a Bond = Inflation + Real Yield + Credit Spread
For example, a Treasury bond has no credit spread and only takes into account inflation and real yield premia. Treasury Inflation-Protected Securities remove the inflation risks by adjusting the principal by an inflation index, hence commanding a lower risk premium. Credit spread is the additional discount to the inflation and real yield on a non-Treasury or on a non-agency-backed bond. It includes the risk premium in the sector of the bond issuer, plus any idiosyncratic risk premium that is specific to the issuer.
The risk of a fixed income security is expressed as duration, which is a sensitivity measure of the bond to change in its benchmark yield. However, duration does not comprise all risks associated with the bond price, due to the fact that it measures sensitivity to the benchmark yield, which is usually pulled either from the Treasury yield curve or from the swap yield curve. Duration, therefore, represents systematic risk, which is in the same vein as beta in the equity market.
Over the last 30 years, there has been a long-standing trend of the Treasury yield curve sloping downward and flattening. Due to recent turmoil caused by the COVID-19 outbreak, the Treasury yield curve flattened even further. By reinstating the Federal Reserve (Fed)’s quantitative easing program, there is a low possibility that inflation or real yield will jump for a while. On the other hand, the remaining risk premium, credit spread, is the main cause of the recent collapse in bond market performance.
So the question becomes, how can we measure the risk/reward tradeoff in credit spreads in the current environment? A good screening tool is Sherman ratio:
Credit Spread / Spread Duration
Spread duration is the sensitivity of a bond price change to changes of its credit spread. The higher this ratio is, the more attractive a security’s carry is compared to its mark-to-market risk. The chart presents a time series of the Sherman ratio on credit spreads of various fixed income sectors.
In the chart, we can see that the Sherman ratios on the high yield and asset-backed security (ABS) sectors are more than or close to 100, whereas all others have barely moved since the market turmoil in March 2020. The Fed’s asset purchase program has taken a crucial role in keeping fixed income functioning and credit spreads low in the investment-grade corporate, mortgage-backed security and commercial mortgage-backed security sectors.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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