An ever-present goal and challenge when constructing a portfolio is finding the right balance of risk and return. Determining the right combination of risk and reward generally provides a guide for suitable investments that will help to meet an investors’ personal goals. In the fixed income world, one reward is yield. Typically, the higher the yield, the higher the risk.
For a buy-and-hold investor, a bond default may be the predominant risk of concern. With that in mind, we wanted to highlight some historical default rates (past performance is not indicative of future results). The chart below highlights the reliability of high quality bonds. For example, Aa-rated municipal bonds have defaulted only 0.01% of the time over a 5-year time horizon. According to Moody’s data, another way to look at this is to say that Aa-rated municipal bonds have made all payments on time and in full 99.99% of the time. Even the “riskiest” investment-grade bucket, Baa-rated corporate bonds, have paid on time and in full 98.45% of the time.
The chart also indicates, as expected, that as default risk rises, so does the yield/reward. To highlight the tradeoffs between risk and reward, A-rated municipal bonds provide an additional 20 basis points in yield versus Aa-rated municipal bonds. This increased reward is countered by an increased default risk going from 0.01% to 0.03%. For some investors, moving from Aa-rated to A-rated municipals maintains a comfortable risk profile. Although the A-rated bonds default at a higher rate versus the Aa-rated bonds, both categories are relatively safe with “non-defaults” being 99.97% (A-rated) and 99.99% (Aa-rated). Receiving additional yield might be viewed as appealing versus the calculated increase in risk.
Baa-rated corporate bonds provide an additional 55 basis points in yield versus A-rated corporate bonds. This increased reward is countered by an increased default risk going from 0.74% to 1.55%. Again, each investor must determine their own risk profile. This reward of an additional 46 bp is offset by a change in rating categories where 98.45% of bonds historically did not default (Baa-rated) from a 99.26% “non-default” rate (A-rated).
One caveat that should be noted when analyzing bonds and looking at ratings and yields is that a bond’s rating tells us the amount of risk that a particular rating agency sees in a bond, whereas a bond’s yield tells us the amount of risk that the market sees in a particular bond. Noting this distinction is important, as ratings are only updated periodically and could be weeks or months “old”, meaning they might not reflect recent events affecting the bond. On the other hand, the yield that a bond is trading at reflects current market sentiment and might be a more up-to-date indicator of the perceived risk in a particular bond. For example, if you come across an A-rated corporate bond yielding 8% and all other bonds that you can find in the A-rated category are in the 3% range, there has likely been a change in the perceived risk of this bond that is not reflected in the bond’s rating. This is a good reminder that there is no “catch-all” that tells us exactly how risky any investment is and analyzing suitability requires leveraging all relevant information in determining if a security is an appropriate investment.
Every investor possesses different goals including: income needs, cash flow requirements and risk tolerances. Asset allocation and investment selection affect these targets. A bond with its risk and corresponding income may be ideal for one investor yet not meet the criteria for another. Evaluating the risk and reward tradeoffs will provide insight into the potential investments that may be suited for an investor’s individual goals.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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