Bonds: A Tale of Two Markets (one is flashing green, the other red) Published: April 9, 2025
There are two main risk premiums required by bond investors: interest rate risk and credit risk. In an ideal world, both risk premiums would be high. Today one is high, but the other is definitely not.
We can measure the risk premium offered by taking interest rate risk simply by looking at the real yield in Treasury Inflation Protected Securities (TIPS). When real yields are positive and high, it is great to be a bond investor and one is paid to take on duration risk. When real yields are low or negative, if you are a lender, you should take on less than normal duration risk.
We can measure the risk premium offered by taking credit risk by looking at high-yield spreads (the extra yield one gets over Treasuries by lending to risky companies).
The chart below plots 10-year TIPS yields on the X axis and high yield spreads on the Y axis:
TIPS 10-Year vs High Yield Bond Spreads January 2003 to February 2025
Source: Federal Reserve Economic Data. Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity, Quoted on an Investment Basis, Inflation-Indexed, Percent, Monthly, Not Seasonally Adjusted. ICE BofA BBB US Corporate Index Option-Adjusted Spread, Percent, Monthly, Not Seasonally Adjusted. Standard Deviation is a measure of dispersion of portfolio’s return relative to its mean and is calculated as the square root of the variance. The best investment environment is the top right corner (high real yields and high credit spreads). In late 2008 bond investors could make money by taking on duration risk or credit risk or ideally both! The worst place to be is the bottom left corner (negative real yields and low credit spreads). In late 2021, bond investors were faced with the worst prospective bond investment conditions in over two decades! They needed to steer clear of both duration and credit risk rather than reach for yield. More selective investment environments take up the last two quadrants. In the top left, credit is cheap, but interest rate risk isn’t. Early 2020 (COVID) is the most extreme example of that situation. Last, but not least, in the bottom right quadrant is when interest rate risk is attractive, but credit risk isn’t. The months before the financial crisis (2007) is the most extreme example of this but we are not far from those conditions today (similar high yield spreads and slightly lower real yields).
1- and 3-Year Performance Following Extreme Periods of Interest Rate Risk and/or Credit Risk
January 2003 to February 2025
Source: Morningstar. Past performance is no guarantee, nor is it indicative, of future results. We believe fixed investors should embrace duration (flashing green) but be wary of credit risk (flashing red). Though it was our absolute value perspective that led us to that conclusion and resulted in our increasing duration and reducing credit risk in both FPA New Income and FPA Flexible Fixed Income over the past several quarters, as it happens, the historical data above supports our positioning. While this positioning may seem intuitive, it differs significantly from our peers who, on average, are taking on less interest rate risk and considerably more credit risk (using FPA New Income as an example):
Effective Duration: FPA New Income Fund and Morningstar Short-term Bond Portfolio Category Average
Source: Bloomberg. As of December 31, 2024. The Bloomberg Family of Indices ratings rules use the median if more than two ratings are available. Lower of the two is used if only two ratings are available.
To learn more about our differentiated approach to fixed income investing, please see our latest webcasts to delve deeper into the active management process of the FPA New Income Fund and the FPA Flexible Fixed Income Fund.
First Pacific Advisors
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Glossary of Terms
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.
Effective Duration: the duration calculation for bonds with embedded options. Effective duration takes into account that expected cash flows will fluctuate as interest rates change.
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Bloomberg U.S. Aggregate Bond Index provides a measure of the performance of the U.S. investment grade bonds market, which includes investment grade U.S. Government bonds, investment grade corporate bonds, mortgage pass-through securities and asset-backed securities that are publicly offered for sale in the United States. The securities in the Index must have at least 1 year remaining in maturity. In addition, the securities must be denominated in U.S. dollars and must be fixed rate, nonconvertible, and taxable.
Bloomberg U.S. Corporate High Yield Bond Index measures the market of USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds.
Morningstar Short-term Bond portfolios invest primarily in corporate and other investment-grade U.S. fixed-income issues and typically have durations of 1.0 to 3.5 years. These portfolios are attractive to fairly conservative investors, because they are less sensitive to interest rates than portfolios with longer durations. Morningstar calculates monthly breakpoints using the effective duration of the Morningstar Core Bond Index in determining duration assignment. Short-term is defined as 25% to 75% of the three-year average effective duration of the MCBI. As of December 31, 2024, there were 563 funds in this category.
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