fixed income
Swiss credit: approximating bond returns
What ingredients go into calculating expected bond returns? Quite a few it turns out. Using a practitioner’s method, we outline one approach to approximating returns for bonds and bond portfolios.
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A practitioner’s approach to estimating bond returns
The expected return of a bond is often estimated using the yield to maturity. However, the yield to maturity always refers to the period up to the maturity date, which can vary considerably. For example, in 2022 some bonds had a positive yield to maturity at the beginning of the year but ended up with a clearly negative return over the whole year.
Using yield to maturity to estimate and compare expected bond returns is of limited use because focusing on the maturity date also leads to the mixing of different time horizons and the relevant market fluctuations for common return periods are not taken into account.
We advocate instead using a more practical method to estimate bond returns. This practitioner’s method – widely used among fixed-income managers – helps to avoid the shortcomings of yield-to-maturity and better estimates expected bond returns, in our view.
Our practitioner's method is based on two steps:
- In the first step, the length of the return period is not taken into account. This approximation only calculates return based on an instantaneous shift in interest rates and credit spreads. It is independent of the current level of interest rates and spreads, or of the length of the return period under consideration
- In the second step, the length of the return period and the level of systematic risk factors are incorporated by approximating the current income over the return period. This second step takes on greater importance for investments with a longer-term horizon
The practitioner’s method can also be applied to an entire bond portfolio and represents a broader and more comprehensive method than a straight yield to maturity approach.
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Using yield to maturity to estimate expected bond returns has its drawbacks. How could our practitioner’s method approach things differently? We use a two-step process to approximate returns in a broader analysis that can be applied to both individual bonds and portfolios.
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