Bond investments – via yield and spread

Investing in the bond market means

• to invest one’s capital in an issuer and to trust that the promised interest (or “coupon”) payments and repayment (redemption) will be executed timely and in full, and
• to look at the issuer’s rating, i.e. the ability and willingness of the debtor to pay.

The promised interest (coupon) payments should never be the sole reason for an investment. More important than the achievable interest is the certainty of full repayment at the end of maturity. In this article we take a look at the currently achievable yields of different credit rating segments and at the spread, the interest premium that can be achieved with corporate bonds.

Corporate bonds offer a spread on government bonds

For many private investors, corporate bonds are more popular than government bonds because they offer an interest rate premium (spread) compared to government bonds with the same remaining time to maturity. But how high is this spread, and what bonds should be used as a reference?

Before investing in the interest rate market, it is important to know that no issuer voluntarily pays more interest than they have to. A (credit-) safe government bond with a comparable maturity can be used as a point of reference and basis. A higher interest rate than this should cover the risks of the respective issuer. Usually, the risk of default is rated by investors as the risk with the highest priority.

Rating agencies are concerned with assessing this risk. They analyse the issuer and then assign a credit rating to a bond. This rating usually comes in the form of letters, with “AAA” (triple A) being the best possible rating. Lower ratings thus have a higher default risk associated with them, which should be compensated for by a correspondingly higher yield.

The yields of Eurozone companies by rating class

Let us first take a look at the yields of corporate bonds of different credit rating segments. Since there are many different companies, we use indices that represent a wide range of remaining time to maturity for the respective segment.

At first glance, we can see a lot of lines. By looking at the chart from bottom to top, we can see the following:

• The yield of the German Bund (i.e. the German government bond; shown as an area) is the lowest in the comparison, because it represents the best credit rating.
• AAA euro corporate bonds (BOFA index) currently offer approximately 1% more yield than the German Bund
• The further up we go (chart BOFA indices up to “BBB”), the higher the yield.

The chart also shows that yields change over time, but lower credit rating classes usually have to offer higher yields, as investors demand risk compensation.

The spread as compensation for risk

We have seen in the upper chart that nominal yields fluctuate over time. In a second step, we are interested in the risk premium (spread), because this indicates the surplus return we expect from a riskier investment. Here, we have selected the BBB credit rating segment from the example above.

From the chart above we can easily calculate the current spread ourselves (data from indices):

However, bond investors should not only be interested in the current but also the historical spread. After all, how else should one assess whether the time to buy is currently right?

In the chart we can see that the spread is subject to fluctuations over time, but currently tends to be in the upper range. These are the calculations from an index that covers a wide range of different bonds from the same credit segment and provides a rough orientation for investors. The data for individual bonds may accordingly differ due to their structure (e.g. issuer, country, maturity, etc.).

Conclusion: bond investments require more know-how than just knowledge of the coupon payments

In this article we wanted to give some background for the selection of corporate bonds. We have shown that yields and spreads change over time. But credit ratings can change over time as well. Downgrades or upgrades can occur. This in turn has a direct impact on the yield of the corresponding bond. 

For private investors, the selection and assessment of individual bonds is not a simple matter, because:

• The interest rate markets are constantly in motion and yields can change very quickly, for example due to economic influences.
• For all individual bonds, but especially for longer maturities, there are many variables for private investors to consider. This could be one of the reasons why private investors often prefer corporate bond issues with relatively short maturities.
• Those who are not confident in selecting individual bonds can invest in bond funds (also referred to as fixed income funds), where professionals assess the individual securities and combine them in a broadly diversified fund.

For a glossary of technical terms, please visit this link: Fund Glossary | Erste Asset Management

Legal note:

Prognoses are no reliable indicator for future performance.

Please note: an investment in securities also entails risks in addition to the opportunities described.

For further information on “Investing in bonds with short maturitie”, please visit the blog