Forecasting Fixed-income Returns

To inform the asset allocation process and adequately set client expectations, analysts must be able to create realistic and defensible forecasts for all asset classes, including fixed income. The main ways to approach forecasting fixed-income returns include:

1. Discounted cash flow: This is the most precise method. It involves mapping out the future inflows and outflows of cash associated with the investment and discounting them back to a present value.
2. The risk premium approach: This approach is often applied to fixed income, partly because fixed-income premiums are among the building blocks for estimating expected returns on riskier asset classes, such as equities.
3. Using equilibrium models: This approach provides consistency across asset classes by setting expectations relative to other asset class performances.

Applying DCF to Fixed Income

Fixed income valuation is based on discounted cash flow models. This arises because almost all fixed-income securities have finite maturities, and the stated cash flows are known, governed by explicit rules, or can be modeled with a reasonably high degree of accuracy (e.g., mortgage-backed security prepayments).

Modern arbitrage-free models can value virtually any fixed-income instrument. There is a tight connection between discount rates, valuations, and returns. DCF models incorporate projections of how cash flows and rates will evolve over the investment horizon. Doing so helps derive short-term forecasts.

The Building Block Approach to Fixed-income Returns

The building block approach estimates expected return in terms of required compensation for specific types of risk. The approach is additive and considers each risk independently. The required return for fixed-income asset classes is comprised of:

The one-period default-free rate.

+ A term premium.

+ A credit premium.

+ A liquidity premium.

As the names suggest, the premiums reflect compensation for interest rate risk, duration risk, credit risk, and illiquidity in that order.

The Short-term Default-free Rate

The short-term default-free rate is on a frequently issued zero-coupon government bond. This bond is of the highest quality, is the most liquid security, and has a maturity equal to the investment horizon.

The Term Premium

The default-free spot rate curve reflects the expected path of short-term rates and the required term premiums for each maturity. Premiums are typically favorable, increase with maturity, are roughly proportional to duration, and vary over time.

Inflation is likely the primary catalyst for long-run variation in nominal yields and the term premium. Higher levels of inflation usually coincide with more significant inflation uncertainty. Therefore, nominal yields rise with inflation because of changes in expected inflation and the inflation risk component of the term premium.

The main drivers of the term premiums of nominal bonds include:

• Level-dependent inflation uncertainty: Inflation is the primary factor that causes long-term fluctuations in both nominal yields and the term premium. When inflation levels are high, there is usually more uncertainty about inflation; when inflation levels are low, there is usually less uncertainty. As a result, nominal yields increase or decrease with inflation due to changes in expected inflation and the inflation risk component of the term premium.
• Risk-hedging ability during recessions: Assets that perform well during economic downturns tend to have low or negative risk premiums. When growth and inflation are driven by aggregate demand, nominal bond returns are usually negatively correlated with growth, justifying a low-term premium. On the other hand, when aggregate supply, nominal bond returns drive growth, and inflation is usually positively correlated with growth, necessitating a higher term premium.
• Supply and demand: The relative supply of short- and long-term default-free bonds affects the yield curve’s slope. This is mainly due to the term premium, as the maturity structure of debt has little effect on expected short-term rates. In other words, the availability of short and long-term bonds influences the yield curve primarily because of the term premium. The maturity structure of debt doesn’t impact expected short-term rates.
• Cyclical effects: The yield curve slope changes significantly during the business cycle, being steep at the bottom and flat or inverted at the top. This is due to changes in short-term rate expectations and countercyclical changes in the term premium.

The Credit Premium

The credit premium is the compensation for the risk of default losses and the expected level of losses. Both expected default losses and the credit premium are embedded in credit spreads. High-yield spreads/premiums serve as an economic barometer and tend to rise ahead of realized default rates.

The Liquidity Premium

Few bond issues trade actively for more than a few weeks after issuance. Secondary market trading occurs primarily for the most recently issued sovereign bonds, current coupon mortgage-backed securities, and a few of the most significant high-quality corporate bonds. The liquidity of other bonds largely depends on the willingness of dealers to hold them in inventory long enough to find a buyer. Each step lower in credit quality will likely impact liquidity more than the preceding step. As expected, bonds with lower liquidity necessitate a higher premium or reward for holding onto riskier investments.

Question

Which of the following is least likely a part of the building block approach to setting fixed income returns?

1. Term premium.
2. Default-free premium.
3. Exchange-rate premium.

Solution

The correct answer is C.

The default-free premium is the first block, which adds a return to fixed income for delayed consumption. The term premium incorporates views of future interest rate movements. The exchange-rate premium is not a part of the building approach.

A is incorrect. It is one of the components of the building block approach to setting fixed income returns. The term premium reflects compensation for interest rate risk and duration risk.

B is incorrect. It is not a component of the building block approach to setting fixed income returns. However, the one-period default-free rate is a component of the building block approach. The one-period default-free rate is on a frequently issued zero-coupon government bond. This bond is of the highest quality, is the most liquid security, and has a maturity equal to the investment horizon.

Reading 2: Capital Market Expectations – Part 2 (Forecasting Asset Class Returns)

Los 2 (a) Discuss approaches to setting expectations for fixed-income returns