Greater price risk now exists
Price is an important risk that most corporate bond investors, in my opinion, are overlooking. Bond investors typically measure price sensitivity by duration – that is, the percentage price change for a given change in rates.
All else being equal, a bond with a higher coupon has a lower duration than a similar bond with a lower coupon. The reason for this relationship is straightforward: a bond with a higher coupon receives a greater cash flow in interim periods, whereas a bond with a lower coupon receives a greater percentage of cash flows at maturity. Why are these details important for investors? As interest rates and spreads have fallen, the coupons on investment-grade (IG) and HY bonds have also fallen. As shown in the following charts, the average coupon on IG and HY bonds fell from 6.31% and 8.30%, respectively, three years ago to 5.02% and 7.86% today. To the investor, this means greater duration (price sensitivity) per unit of maturity.
Do investors realize that duration has drifted and they now hold bonds that have greater price sensitivity than they did a few years ago? The duration/maturity ratio (adjusted for calls), which is meant to show the amount of price volatility per year of maturity, shows a steady increase, reflecting greater inherent price sensitivity over time. Professional investors recognize this change, but market participants who are chasing yield and have adopted HY as their new favorite asset class may not realize what’s at play.
I am not calling for a top in HY or saying that it can’t have a place in an investor’s portfolio today, but the characteristics of these assets have changed. Investors who are not aware of these changes are likely to meet a reality that differs greatly from their expectations.
Copyright 2012, CFA Institute, Reproduced from the Inside Investing Blog with permission from the CFA Institute. All rights reserved.
David Schawel, CFA, is based in Raleigh Durham NC and works as a fixed-income portfolio manager. His blog is Economic Musings and you can follow him on twitter at @davidschawel.