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Gauging returns and risk in the bond market

The term premium, risk premium, and yield curve

Investors in the corporate bond market routinely make decisions about which bonds to purchase; and they look at, among other things, the rates of return of those bonds. One way of computing a bond’s rate of return is to take into account all future streams of payments (interest coupons) as well as the difference between the price and the principal if the bond is held to maturity. This rate of return is known as the yield of the bond.

The yield on a security allows investors to decide whether to accept the riskiness and the cost of holding that security for an extended period or to invest in a safer, shorter-term bond. In other words, yields capture both a risk premium (the compensation for uncertainty in the streams of payments) and a term premium (the compensation for a longer delay in receiving payments). We can use FRED’s data and graphing tools to produce measures of both the risk premium and the term premium and see how these measures have evolved over time.

The first graph shows three interest rates: the 5-year yield on investment-grade corporate bonds, the 5-year Treasury rate, and the federal funds rate. These three interest rates provide us with information on the returns to a 5-year corporate bond, a 5-year Treasury bond, and an overnight bond. The graph shows that the federal funds rate is typically lower than the other two rates: Lenders require additional compensation to lend for longer periods (5 years in this case). Since both Treasury bonds and federal funds are extremely safe assets, the risk premium is negligible and any difference between the two arises from the term premium.

Mathematically, the term premium is the difference between the Treasury rate for a given maturity and the federal funds rate. The second graph plots the term premium since 1984. This indicator seems to be countercyclical—that is, it falls during expansions and rises during recessions. More interestingly, it tends to go negative right before a recession, and this is what people refer to when talking about a “yield curve inversion.”

As the first graph shows, the yield on 5-year corporate bonds exceeds the yield on 5-year Treasury bonds. Since these two groups of bonds have the same maturity, this difference cannot be explained by the term premium. Rather, it’s explained by the risk premium: the compensation lenders require to invest in a riskier asset (such as a corporate bond) as opposed to investing in a safer asset of equivalent maturity (such as a Treasury bond).

Mathematically, the risk premium is the difference between the yield on a risky bond and the yield on a Treasury bond of equivalent maturity. The third graph plots this difference. Again, this measure is countercyclical. See the prominent spike in 2008-09? The risk premium rose way above its historical average during the Great Recession following the Financial Crisis. If market participants anticipate an increase in risk, as they did in 2008, then the risk premium rises in response. Since the risk premium measures expectations of credit risk and default in the economy, it’s an important way to monitor markets to ascertain whether a downturn is expected in the near future.

How these graphs were created: For the first graph, search for and select the series “5-Year High Quality Market (HQM) Corporate Bond Spot Rate.” Use the “Add Line” option in the “Edit Graph” menu to search for and add the other two series: “5-Year Treasury Constant Maturity Rate” and “Effective Federal Funds Rate.” For the second graph, search for and select the series “5-Year Treasury Constant Maturity Rate.” Then use the “Edit Line 1” tab in the “Edit Graph” menu to add the series “Effective Federal Funds Rate” in the “Customize data” field. In the “Formula” box, type a-b. Repeat these steps for the third graph by searching for and selecting the series “5-Year HQM Corporate Bond Spot Rate” and the series “5-year Treasury Constant Maturity Rate.”

Suggested by Asha Bharadwaj and Miguel Faria-e-Castro.

View on FRED, series used in this post: FEDFUNDS, GS5, HQMCB5YR

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