Superiority and stability of returns from credit risk vs interest rate risk

Because of their income characteristics, it is possible to anticipate the future return profile of global credit securities with a reasonable degree of confidence. Doing so is certainly less complicated than predicting movements in interest rates in an effort to earn capital gains.

• For credit investments, if the bond’s coupon at the time of issuance meets your return target, you will achieve that return target as long as the bond does not default. We feel the probability of default for investment grade bonds is quite limited, resulting in a high probability of return outcomes.
  
• Alternatively, if you invest in a bond at time of issuance with a coupon below your target return, you need capital appreciation to help achieve your return target.

Credit risk and interest rate risk are the two most significant risk premiums in fixed income markets, which drive returns. Investors can dial these risks up or down to alter the potential return profile. For example, if an investor is comfortable taking credit risk, they can choose to buy a corporate bond with a higher return expectation than a comparable government bond. Alternatively, investors can increase their exposure to interest rate risk by buying a ten-year fixed rate bond, instead of a one-year term deposit.

When investing in a credit security, investors earn the cash or government bond yield plus a credit risk premium. The credit risk premium ranges in size, depending on the level of perceived credit risk.

For example, let’s say an investor is targeting a 6% annualised return over four years. If they invest in an investment grade corporate bond with a four-year maturity profile and a credit risk premium (also known as a credit spread) of 2% above a government yield of 4%, they will successfully generate the desired return of 6% assuming the bond does not default.

Using historical default rates as a guide to default expectations, investment grade corporate bonds have a 0.7% likelihood of defaulting over a four-year period¹. More importantly, these corporate bonds therefore have a 99.3% likelihood of paying regular interest and principal upon maturity to generate the desired return target.

That’s pretty compelling and provides scope for investors to generate returns over and above cash and comparable government bonds through allocations to credit.

Let’s continue with the same example, whereby a fixed income investor is targeting a 6% annualised return target over four years. As before, let’s assume the current government bond yield is 4%, but in this case the investor is unwilling to take credit risk. Accordingly, they are only able to invest in government bonds. To earn the 6% annualised return over four years would require government bonds to increase in price, generating capital gains to augment the income stream from regular coupon payments. This is possible, but requires investors to get the timing, size and direction of the market move right.

The simplest scenario to achieve the desired return objective would be something like this:

Step One: Buy a government bond, let’s say also earning a 4% coupon and yield. For ease of calculation, let’s assume it has a 10-year duration.

Step Two: The yield for the 10-year government bond would need to immediately decline to 2.6% from 4%, increasing the price of the bond by 14% (a 1.4% drop in yield, multiplied by the 10 years of duration).

Step Three: The investor sells the 10-year government bond, crystallising the 14% capital gain, and then buys a 4-year government bond at the new market price of around 2.6% coupon and yield. 

Without a drop in yield and an associated capital gain from the bonds, it’s simply not possible to achieve the desired 6% annualised return target.

Moreover, it’s important to remember that interest rate risk works both ways. If bond yields had increased rather than fallen, the bonds would have generated a capital loss up front, making it even more challenging to recoup this loss and generate the desired return in the subsequent four years.

We therefore believe the risk/return trade off of an allocation to credit may appeal to fixed income investors seeking returns over and above those currently available from cash and government bonds. As a reminder, our flagship First Sentier Global Credit Income Fund aims to generate returns 1.5% p.a. over and above the Bloomberg AusBond Bank Bill Index (after fees) and has a favourable performance track record² over more than 20 years and across a broad range of market conditions during that period.