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Difficulty: Moderate
1) “Yield to Maturity” provides a bond’s annualized return assuming that the bond does not default prior to maturity
2) For expected return, you need to account for default risk
3) If it’s a bond fund, you need to account for management fees & expenses
4) If you’re not holding to maturity, then you need to anticipate interest rate & credit spread changes
Expected return =/= Yield to Maturity
What’s the expected return of a bond? If you are in the market to buy a bond or bond fund and happen to ask your sales rep what is the expected return for the investment, chances are they will reply with the yield to maturity (YTM) of the bond or distribution yield of the fund. This answer is only half correct, as it omits a few key points:
- Default risk
- Mutual fund management fees and expenses
- Mark to market price changes due to changes in interest rates and credit spreads
1) Default Risk
The YTM of a bond provides the annualized return assuming that the bond does not default prior to maturity. This is less of a concern for investment-grade bonds (rated BBB- or higher) but as you can see from the chart below, such risk cannot be ignored for Speculative Grade aka Junk aka High Yield bonds. On average, 4% of High Yield bonds default annually and this figures spikes to 10% or higher during recessions.
So ,the expected return of a bond investment should include a deduction for the expected default losses. We can compute this by considering two variables, 1) the probability that a bond will default and 2) what is the recovery rate if it does. Simply put, the recovery rate is the amount that the bond holder receives back after the firm liquidates its assets and uses the proceeds to pay back its creditors.
So what’s the probability a bond will default? For easy reference, I have included the average default rate from 1981-2018 by credit rating in the table below.
And what’s the recovery rate? Assuming a High Yield bond default, the average recovery rate tends to be 25-40% of the bond’s face value, though the actual figure will be very issue specific.
Here’s a working example. Putting the above knowledge into practice: Assuming you purchased a bond with a credit rating of B with yield to maturity of 7%, the annual probability of default for a B rated bond is 3.44% and the recovery rate of a B rated bond is 30%, the expected credit loss would be 2.41% p.a (3.44% * 70%).
The answer. Your expected return should be 4.59% p.a (7% – 2.41%), a far cry from the 7% yield to maturity.
2) Mutual Fund management fees and expenses
What if you’re buying a bond mutual fund, instead of a single-issuer bond? In addition to factoring in the expected losses from bond defaults, you will also have to consider the fund’s management fees and expenses, which will eat into your expected returns. The aggregation of such fees will be disclosed by the mutual fund as its Total Expense Ratio (TER), which consists primarily of management fees, trading fees, legal fees, auditor fees, and other operational expenses.
A fund’s cash distributions could be net of or gross of the TER, depending on the policy of the specific fund. My preference would be the former, since I wouldn’t want the TER to erode the principal of my investment over time.
Typical range of TERs. To give you an idea of how much TERs are on average, I have included what is charged by the larger fixed income mutual funds for their retail share class below:
- Pimco Income Fund: 1.45% p.a
- Pimco Total Return Fund: 0.83% p.a
- Dodge & Cox Income Fund: 0.43% p.a
- Doubleline Total Return Bond Fund: 0.73% p.a
- J.P. Morgan Core Bond Fund: 0.74% p.a
Example of where TER is found on a Bloomberg Mutual Fund Description Page
Continuing from the earlier example, assuming a B credit rated bond fund with portfolio yield to maturity of 7%, expected loss from defaults at 2.41% p.a and fund total expense ratio at 0.75%:
Answer for a mutual fund. Your expected return is now at 3.84% p.a (7% – 2.41% – 0.75%).
3) Changes in interest rates and credit spreads
Corporate bond returns are derived from three main factors:
- Nominal interest rates. When nominal interest rates increase, the market generally expects higher returns from yield-bearing asset classes like bonds. Market participants expect this in the form of higher yield from bonds (or higher dividends from stocks, etc.). Because the market demands a higher yield, bond prices fall.
- Longer-dated bonds‘ prices are more sensitive/volatile to changes in interest rates than those shorter-dated bonds.
- The shape of the yield curve. The yield is interest rate (y-axis) against time (x-axis).
- A (normal) upward-sloping yield curve generally indicates that the market expects the economy to grow. Upward-sloping yield curve means buying a longer dated bond tends to provides higher expected returns.
- If the yield curve becomes steeper, it could mean market expectations have become more buoyant. The effect of the steepening on bond prices depends (on whether the steepening was caused by an increase/decrease in the short/long-end of the curve, and whether credit spreads change).
- Credit risk. You will need to be paid more to invest in a riskier company.
Recall, the YTM assumes that you hold the bond to maturity.
Assuming you are not planning to hold a bond to maturity, there is the opportunity for shorter term gains if you are able to identify in advance when interest rates are going to decline and at which part of the yield curve that would happen at. Alternatively, if you are able to purchase a bond whose credit risk has been mispriced too high, you will likely be able to enjoy price gains on the bond when the market realizes that.
In summary, to avoid disappointment, do not solely rely on YTM to generate return expectations.
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