Bond Education – Rates, Spreads, and Duration
As investors seek bonds that deliver the most attractive returns, it’s essential to understand three key concepts that shape informed investment decisions: interest rates, spreads, and duration.
How interest rates influence bond decisions
Interest rates are set by central banks based on their view of a country’s economic health. The market’s response to these decisions is reflected in bond prices.
For instance, if investors believe central bank borrowing costs are too low, they may worry that excessive spending among the population will push inflation higher. To compensate, they will demand higher yields on longer-dated bonds. This will typically result in wider spreads.
Using spreads to measure risk and opportunity
A spread is the difference in yield between two bonds, typically across factors such as maturity, rating, issuer, or country.
Calculating a spread enables an investor to gauge a bond’s relative cost, risk, and return. This is typically measured against government bonds or top-rated corporate bonds of similar maturity, since these are considered to have the lowest risk of default.
For example, if the yield on a 10-year corporate bond is 6%, and the yield on a 10-year U.S. Treasury is 4.5%, then the spread is 1.5 percentage points, or 150 basis points. Monitoring this spread and how it changes can provide investors with valuable information:
- Wider spreads: If the corporate bond yield rises to 6.5% while the U.S. Treasury yield stays at 4.5%, it indicates investors have lost some confidence in the corporate bond issuer. This means the corporate bond price has dropped, the yield has risen, and risk has potentially increased.
- Narrower spreads: A narrowing in spread indicates improved confidence in the investment quality of the higher yielding bond, pushing its price up and its yield down.
Movements in spreads can also reflect broader changes in an underlying economy. During periods of economic uncertainty, investors typically retreat to safer assets such as U.S. Treasuries, other developed-market government securities, or AAA rated bonds of large corporations. Spread levels help investors understand sentiment: widening spreads signal caution, while narrowing spreads indicate a greater appetite for risk.
Comparing spreads: What is a yield curve?
Investors also compare yields of different maturities from the same issuer to assess the market’s mood. Plotting the yields of different bonds produces a graph called a yield curve, which shows the relationship between short- and long-term bonds of the same asset class and credit quality.
What does the shape of the yield curve tell us?
The shape of the yield curve tells us whether interest rates are expected to rise or fall in the future:
- Normal: Upward sloping from left to right. This curve shows yields are higher on longer maturity bonds, which is typically seen when the economy is growing, and investors demand higher yields on longer-term bonds as compensation for inflation, future rate rises, and economic uncertainty over the life of the bond.
- Flat: Longer- and shorter-term yields are the same, or moving closer together. Flat yield curves are seen when the economy is transitioning from expansion to slowdown, and vice versa. Most often, this happens when central banks increase interest rates to rein in periods of swift growth.
- Inverted: Yields on longer-maturity bonds are lower than shorter-term bonds. This is uncommon and typically occurs during periods of recession when interest rates and inflation are low or declining. Historically, the yield curve inverts about 12 to 18 months before a recession starts and is seen as a key warning sign of an economic downturn.
The yield curve represents the relationship between interest rates and maturity for similar-quality bonds.
Interpreting duration
Duration measures how sensitive a bond is to interest rate changes. It is calculated using a bond’s maturity, yield, coupon, and call features (the option for the issuer to redeem the bond early). In general, bonds with longer maturities have higher duration than bonds with shorter maturities.
- When interest rates rise, newly issued bonds offer higher coupons, making older bonds with lower coupons less attractive – so their prices fall.
- When rates fall, older bonds with higher coupons become more valuable.
If a bond has a higher duration, it means it has a greater sensitivity to interest rate changes. For instance, if an investor expects interest rates to decline, longer-duration bonds may be more attractive, as their prices could rise more than those of shorter-duration bonds.
Gauging interest rate sensitivity
Source: PIMCO. Indicative example for illustrative purposes only.
The table above shows that if interest rates fall by 1%, a bond with one-year of duration will increase in value by 1%, while a bond with 10 years of duration will rise by 10%. If interest rates rise, the impact is reversed.
Therefore, an investor can use duration to adjust their fixed income strategy depending on their outlook, which can be determined by their knowledge of how rates affect bonds and how spreads signal the likely direction of the market.
If the investor expects rates to fall, they could lengthen the average duration of their bond portfolio to maximise the benefits, and if they expect rates to rise they could shorten the average duration to reduce risk.
