Balancing lacked - Bond investors may need to think harder about the risk-reward equation


Ian Kelly

Ian Kelly

Fund Manager, Equity Value

In recent pieces such as Long-term cares, and Sale of a century, The Value Perspective has raised a metaphorical eyebrow about the way some investors seem to be weighing the balance between risk and reward. This time, however, we will let one picture replace 1,000 words on how the market would appear to have become less discerning than it used to be.

Using data from ratings agency Moody’s that goes back to 1965, the following graph shows the different yields you would have received from investing in two grades of corporate bonds of very long duration. The bottom line (orange) is the yield from those bonds rated ‘AAA’ while the top line (white) is the yield from those bonds Moody’s designates ‘baa’ and everyone else calls ‘BBB’.


Source: Bloomberg finance LP June 2014

If you were after a more precise explanation of “very long duration” in this instance, we would point you towards part of Moody’s own definition of its baa corporate bond index, which says: “the bonds have maturities as close as possible to 30 years; they are dropped from the list if their remaining life falls below 20 years, if they are susceptible to redemption or if their ratings change.”

The difference in yield – or ‘spread’ – between AAA and baa-rated credits has varied dramatically over the last decade, let alone the last 50 years. You will note, however, that the uplift in yield over the highest rated corporate debt investors now receive from holding what are known in the trade as ‘medium-quality’ bonds is just 60 basis points (bps).

The so-called ‘hunt for yield’ has been a defining characteristic of the investment environment for more than five years now so different people may well have different thoughts as to whether 60 basis points represents adequate compensation for owning bonds that, however they may be known in the trade, are still just one notch away from speculative grade.

Here on The Value Perspective, however, we are firmly of the opinion fixed income investors could be displaying a bit more judgement these days. after all, quantitatively speaking, the numbers show the default rate on baa bonds over five years is about one percentage point higher than it is for AAA bonds while you might reasonably expect to recover about half your money if a bond defaults.

Over five years, therefore, that 60bps of extra yield will probably pay for you to reach break-even point on the expected additional defaults. The trouble is this calculation has yet to take into account the fact you have another two and a half decades of owning your long-duration bond issued by a low-quality company with a weak balance sheet and you are receiving no compensation at all for that. As we suggested at the start, that looks to us like a serious imbalance between risk and reward.


Ian Kelly

Ian Kelly

Fund Manager, Equity Value

I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth. 

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