Choosing maturity dates and the credit rating of the notes or bonds in your fixed-income portfolio is not as simple as it may seem at first glance. Risk comes in many forms; in the fixed income market these inter-related risks may be sovereign risk, credit risk, currency risk, basis risk and market risk i.e., where on the yield curve you make your investments.
The simple fact is, not all sovereign risk is created equal. It may be an obligation of a particular country’s treasury but reality is some counties are more credit worthy than others. Sovereign risk typically does not carry a credit rating so the investor has to make a judgment call on the credit worthiness and political stability of a nation.
States, provinces, counties, cities, school districts et al are all political subdivisions of a particular country. These debt obligations may or may not carry a credit rating. Again, the investor has to make a judgment call on whether to assume the political stability and/or sovereign risk of the particular obligation.
When many investors think of credit risk they tend to think about corporate debt , as most corporate debt carries a rating by one, two or perhaps three of the three major credit rating agencies. Investors have to realize that these credit ratings cannot be lumped together. Rather, these ratings are relevant only to the industry group a given company belongs to.
In other words, comparing a AA Utility to a AA Industrial is a false comparison. In similar fashion, so is comparing a Baa captive finance company debenture (unsecured) to the same company’s Baa First Mortgage (secured) bonds. They are not the same risk even when sharing the same name.
When an investor buys a debt obligation in another currency other than their own, the investor is assuming currency risk in addition to everything else. The effect of currency translation can have a particularly meaningful impact.
If Investor A in the US bought a 30-year UK Gilt 15 years ago, that bond in terms of US dollars would be worth a little more than half at present. Conversely, if Investor B in the UK bought a 30-year US Treasury at the same time, those bonds would be worth almost double than when purchased at present.
The “basis” is amount of yield that a note or bond trades over the equivalent maturity sovereign debt. It is quoted or measured in terms of basis points. One basis point is 1/100 of a percent. When a credit rating is downgraded, the basis expands. The opposite is true for an upgrade, the basis contracts. In addition to that, general economic activity and demand for credit also affect the basis.
Market risk is synonymous with “yield curve” and where an investor places money along it. A “normal” yield curve is commonly called “positive” where the further out in maturity one goes the larger the yield. Conversely, if a yield curve is “negative, the opposite is true. Risk is commonly called “duration,” which is a mathematical combination of maturity and cash flow from the coupon payments that measures volatility.
The further out a maturity is the greater amount of money is represented by a basis point. In addition, duration (volatility) is greater the smaller a coupon is. Thus, for an identical maturity a discounted bond has a greater duration and hence volatility than a bond at a substantial premium even if the overall return is the same.
One final caveat: Interest rate is a statement of risk – period.