This article first appeared in Yield matters on 02 August 2016
In the last of this series, focusing on how sensitive XTBs are to changes in yield I turn my attention to how each XTB actually performed and what features contributed to that performance. The study of what produces the return is called “attribution”.
In this article we will cover how an XTB produced a one year return of 12.92% and why…
Total returns & attribution
I believe this is important exercise. I believe that investors can earn attractive risk-adjusted returns by holding XTBs. The exercise of attribution lets them know just where the return is generated.
Let’s look at an example:
Back on 30 June 2015, an investor chose to invest for approximately 7 years, selecting the YTMQF3 on the Qantas 7.75% 19 May 2022 corporate bond. They purchased the XTB with a YTM of 5.46%¹ p.a.
On the same date, they could have chosen the Commonwealth Government 5.75% 15th Jul 2022 bond for a YTM of 2.67%¹ p.a.
The XTB investor in YTMQF3 should earn 2.79%¹ p.a. (5.46% – 2.67%) more than they would in the government bond, assuming both borrowers honour their obligation and the securities are held to maturity. I can ‘attribute’ this expected out-performance to be from the ‘credit premium’ earned by having exposure to the underlying Qantas bond rather than the government bond. You take more credit risk with Qantas than the Government.
But how did each investment actually perform after 1 year?
Again, an important question because XTBs are liquid and investors can access their cash if required by selling.
The actual results after a year were:
- The chosen benchmark government bond had a total return of 7.66%
- YTMQF3 had a total return of 12.92%
So where did this extra return come from?
At the start of the period, YTMQF3 had a yield of 2.79% p.a. above the government bond. (2.79% = 5.46% – 2.67%).
After a year, on 30 Jun 2016 YTMQF3 had a yield of 2.25% p.a. above the government bond. We say that the ‘credit spread’ tightened by 0.54% p.a. (0.54% = 2.79% – 2.25%).
I estimate that this change, or tightening in credit spread of 0.54% p.a. contributed 2.91% of the total 5.26% out-performance (12.92% – 7.66%) over the government bond for the year.
The other 2.35% (2.91% + 2.35% = 5.26%) is the approximate extra income earned from the Qantas bond over the Government bond during the period. We call this extra income from a corporate bond over the government bond ‘carry’.
Carry is the benefit from holding a higher yielding XTB.
How did I calculate this?
- I know the total return of the government bond and the Qantas XTB
- I know the difference in their total returns
- I can define the credit spread at the start of the period and at the end of the period
- I can therefore attribute the portion of the total return that comes from the credit spread movement
- The amount left over is therefore the ‘carry’ or the extra amount earned over the year for holding the higher coupon XTB
Mathematically this can be described as:
YTMQF3Total return = Government bondTotal Return + change in credit spread + carry
Or 12.92% = 7.66% + 2.91% + 2.35%
I use this technique to attribute the different elements of performance as I think it helps to understand an XTB’s overall performance a little better.
When an XTB under-performs a government bond
Unlike the Qantas XTB, YTMAWC under-performed the relevant government bond.
The relevant government bond returned 4.34% and YTMAWC returned 1.48%. Our models allocate negative 4.75% to a widening credit spread (not tightening like Qantas, because the Alumina bond price was falling and so its yield increased relative to the government bond). Add 1.89% from positive carry (again, income differential) to give a total return of 1.48%.
Mathematically this can be described as:
YTMAWCTotal return = Government bondTotal Return + change in credit spread + carry
Or 1.48% = 4.34% + (-4.75%) + 1.89%
Please note this is the return if you bought the Alumina Bond XTB on 30 Jun 2015 and then sold it a year later. If you held it to maturity and Alumina meets its obligations then the XTB would produce a total return (YTM) of 4.18%¹ p.a. which is the YTM you purchased it at on 30 Jun 2015, which would be 1.97%¹ p.a. above the relevant government bond.
Know when you’re getting your capital back
One of the core benefits of bonds is that if you hold to maturity, it doesn’t really matter that in the intervening period, the bond price fell (jumped in yield), because it will come back to par value anyway at maturity. This is unlike equities where if the stock falls, you have to wait for it to recover. With a hard maturity date – you know when you’re getting your capital back.
Same thing for the Qantas bond and XTB – if you held to maturity your total return will be the YTM you bought at on 30 June 2015, being 5.92% (assuming Qantas doesn’t default). You’d only get that strong total return of 12.92% if you’d sold it on 30 Jun 2016.
Attributed performance of each fixed rate XTB
Final note on attribution
One of the definitions of attribution is ‘where the return of the security is decomposed into the contributions of common risk factors plus a residual²’ What this means is you try and measure what you want and there is always a little bit left over you are not sure about. In this study I have measured the one year performance of XTBs vs relevant government bonds. Government bonds and government-like bonds make up approximately 87% of the composite index.
XTBs bring transparency and access to the corporate bond market and we believe it is important that investors can choose their own XTBs or a portfolio provided by their advisers.
We can work with you to generate specific analysis and portfolios to meet client requirements.
Contact us on 1800 995 993 or firstname.lastname@example.org to find out more
About Ian Martin
Ian Martin has over 30 years’ experience in fixed income markets globally. Prior to the formation of ACBC, Ian held the position of Head of Rates Australia and New Zealand for Deutsche Bank Australia. He was a member of the Australian Financial Markets Association (AFMA) Market Governance Committee, a board member of Yieldbroker and a member of Deutsche Bank’s Global Rates Executive Committee.
Useful links – Previously in this series
- 1: Understanding the sensitivity of XTBs to rate changes
- 2: Probability based investing
- 3: Understanding index returns
¹This calculation assumes that coupons or interest payments can be reinvested at the same rate as the YTM.
²The Handbook of Fixed Income Securities Eight edition Frank J. Fabozzi page 1642.