The must-know risk-return trade-off in fixed income investing

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As we know from the risk-return trade-off, the higher the level of credit risk an issue has the higher the yield will likely be. Credit risk is often measured with a metric called Option Adjusted Spread or OAS, which considers the additional yield an investor is paid over and above the yield on a similar Treasury security. If we compare the credit spreads of different corporate ETFs (AGG) to their fund ratings we find a typical upward sloping curve that reflects the fact that investors will require more yield to compensate for higher levels of credit risk.

Here is an illustration of this relationship using ETFs with a range of levels of credit risk:
Blackrock graph 1

Source: BlackRock as of 5/9/2014

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At the far left of the graph is the iShares Aaa-A Rated Corporate Bond ETF, QLTA. This fund primarily provides exposures to securities with ratings of A or higher. At the far right of the graph is the iShares B-Ca Rated Corporate Bond ETF, (QLTC). This fund provides exposure to the lower credit quality segments of the high yield market, and because of the level of credit risk in the fund, it offers the highest yields of the group.

So where does EM debt fit into the risk versus return landscape? Typically EM lies somewhere in the middle, as the EM bond universe contains a combination of investment grade (Chile, Malaysia, Mexico and others) and high yield (Ukraine, Argentina, Venezuela) issuers.

Market Realist – Emerging market bonds are usually considered riskier than bonds issued by developed countries. So they provide a higher yield to compensate for the risk.

According to Bloomberg estimates, emerging market corporate bonds have given 9% returns in 2013. Local currency debt showed 5.0% returns, whereas dollar-denominated government securities gave returns of 11.2%.

According to statistics compiled by JP Morgan and Chase, emerging market corporate bonds have a spread of 2.8% over U.S. Treasuries (IEF) and of 0.22% over dollar-denominated sovereign bonds.

Read on to the next part of this series to learn more about emerging market spreads and whether now is the right time to invest in EM bonds.

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