How to Evaluate Fixed-Income Securities: 5 Key Metrics

Steadfast Equity
May 7
11 min read

Updated: 6 days ago

Fixed-income securities, like bonds and CDs, offer steady income and principal repayment at maturity. To evaluate them effectively, focus on these five key metrics:

Yield to Maturity (YTM): Measures total return if held to maturity, factoring in interest, price changes, and time.
Credit Ratings: Assesses risk of default, with AAA to BBB- as investment-grade and lower ratings as speculative.
Duration: Indicates price sensitivity to interest rate changes; longer durations mean higher risk.
Risk-Adjusted Performance: Metrics like the Sharpe ratio compare returns to the level of risk taken.
Ethical Investment Criteria: Focus on ESG factors, such as sustainability goals, use of proceeds, and transparency.

Quick Comparison of Key Metrics

Metric	What It Measures	Why It Matters
Yield to Maturity (YTM)	Total return if held to maturity	Helps compare returns across securities
Credit Ratings	Default risk and issuer reliability	Gauges financial stability
Duration	Price sensitivity to interest rate changes	Manages interest rate risk
Risk-Adjusted Performance	Returns relative to risk	Identifies efficient investments
Ethical Criteria	ESG alignment and sustainability efforts	Ensures alignment with ethical values

Session 2: Understanding Risk - The Risk in Bonds

1. Yield to Maturity (YTM)

Yield to Maturity (YTM) is a crucial metric for assessing fixed-income investments. It calculates the total return - combining interest and capital gains or losses - if the bond is held until it matures. This provides a more detailed view than just looking at the coupon rate.

How YTM Is Calculated

YTM considers multiple factors to determine a bond's actual return. Here's an example to break it down:

Let’s say you have a bond with the following details:

Face value: $1,000
Current market price: $920
Annual coupon payment: $100 (10% of face value)
Time to maturity: 10 years

Using the approximate YTM formula:

Plugging in these values, the bond’s YTM comes out to roughly 11.25% annually if held to maturity. For a precise calculation, you’d need a financial calculator.

YTM Component	Impact on Return
Coupon Payments	Provides regular interest income
Price Discount/Premium	Reflects potential gains or losses
Time to Maturity	Determines the return period
Reinvestment Rate	Assumes consistent reinvestment

YTM and Ethical Investing

For those focused on ethical investing, YTM can highlight how environmental, social, and governance (ESG) factors may influence long-term returns. Bonds with ESG considerations often have distinct risk-return dynamics.

"Yield to maturity helps investors make comparisons between the types of returns they can expect from different securities. Doing so helps them determine which types of securities to include in their investment portfolio."
InvestingAnswers

Here’s what to keep in mind when evaluating ethical bonds:

Payment Reliability: Assess whether the issuer can meet its payment commitments while adhering to ethical practices.
Reinvestment Choices: Look into the availability of similar ethical options for reinvesting coupon payments.
Market Price Changes: Understand how ESG factors might impact the bond’s market value over time.

It’s important to note that YTM doesn’t account for taxes. This metric provides a solid foundation for understanding yield and risk, which is essential for assessing credit quality in the next step.

2. Credit Ratings Analysis

Credit ratings are essential for assessing the risk of default in fixed-income securities. They help investors gauge an issuer's ability to fulfill financial obligations, including paying interest and repaying principal.

Rating Agency Standards

The major credit rating agencies - Moody's, Standard & Poor's (S&P), and Fitch - use standardized scales to evaluate bonds. Bonds rated AAA to BBB- are considered investment-grade, while those rated below BBB- fall into the speculative or "high-yield" category.

Rating Category	Credit Quality	Characteristics
AAA to AA	Highest Quality	Extremely strong ability to meet obligations
A to BBB+	Strong Quality	Reliable but more sensitive to economic changes
BBB to BBB-	Good Quality	Adequate but requires closer monitoring
BB+ and below	Speculative	Higher risk with greater yield potential

These ratings are increasingly influenced by ESG (Environmental, Social, and Governance) factors, which are explored below.

ESG Impact on Credit Ratings

In ethical investing, ESG factors play a growing role in assessing long-term credit stability. Rating agencies now integrate these considerations into their evaluations, reflecting how they can affect an issuer's financial reliability.

Environmental RisksIn November 2018, PG&E Corporation's credit rating was downgraded from BBB to BBB- due to heightened wildfire risks. This highlights how environmental factors can directly impact creditworthiness.
Climate-Related ChallengesAberdeen Roads (Finance) PLC saw its rating drop from A- to BBB+ in February 2017 after severe weather disrupted construction progress. This demonstrates how climate events can influence credit quality.

"We incorporate ESG factors into our credit ratings when we believe they are material to creditworthiness and sufficiently visible." - S&P Global Ratings

Governance issues have been particularly impactful, with 89% of ESG-related rating actions in Q3 2024 tied to governance factors.

Key Considerations for Credit Ratings Analysis

When analyzing credit ratings, it's important to:

Review ratings from multiple agencies for a broader perspective on risk.
Factor in ESG metrics provided by rating agencies.
Assess the long-term stability of the issuer's business model.
Evaluate exposure to environmental and social risks.
Examine governance practices and risk management strategies.

As ESG considerations become more integrated into credit rating methodologies, they provide investors with deeper insights into the risks and opportunities associated with fixed-income securities. This alignment with ethical investing principles also supports more informed decision-making.

3. Duration and Rate Risk

Duration helps measure how a bond's price reacts to changes in interest rates, making it a key tool for managing risk in ethical fixed-income portfolios.

Understanding Duration

Duration estimates the percentage change in a bond's value for every 1% change in interest rates. When rates rise, bond prices drop; when rates fall, prices climb. Bonds with longer durations are more sensitive to rate changes.

For example, here's how a 1% rate hike affects a $100,000 bond:

Duration	Rate Increase 1%	Value Change	New Value
2 years	+1%	-$2,000	$98,000
5 years	+1%	-$5,000	$95,000
10 years	+1%	-$10,000	$90,000

Factors influencing duration include:

Maturity Length: Longer-term bonds usually have higher durations.
Coupon Rate: Higher coupon rates lower duration.
Yield Level: Bonds with higher yields tend to have lower durations.

"Duration is a measure of a security's price sensitivity to changes in interest rates."

These principles play a critical role in managing risk for ESG bonds.

Rate Risk in ESG Bonds

While ESG bonds follow the same duration principles as traditional bonds, ethical considerations can introduce unique risks.

Key strategies for managing rate risk in ESG bonds include:

Portfolio Duration Strategy: Align the portfolio's average duration with your investment goals and risk tolerance. For instance, a portfolio with a 5-year average duration might lose about 5% of its value if rates rise by 1%.
Market Environment Assessment: In rising rate environments, shorter-duration bonds tend to hold their value better. On the other hand, longer-duration bonds may offer higher returns when rates are expected to drop.

Balancing Risk and Return: Duration impacts both potential returns and rate risk. Here's a breakdown:

Duration Strategy	Potential Return	Interest Rate Risk	Best For
Short (1-3 years)	Lower	Minimal	Conservative investors
Medium (4-7 years)	Moderate	Moderate	Balanced portfolios
Long (8+ years)	Higher	Significant	Aggressive investors

Research underscores the importance of actively managing duration in ESG bond portfolios.

"Duration can be an extremely useful tool for bond managers when building portfolios and managing risk." - PIMCO

For ethical investors, combining duration management with yield and credit analysis helps balance financial goals and social impact. This approach is vital for building diversified portfolios that align with ESG values and desired risk-return outcomes.

4. Risk-Adjusted Performance

Risk-adjusted performance measures whether the returns of an investment justify the risks involved. This is especially important when creating portfolios that aim to balance financial objectives with ethical and sustainability goals.

Sharpe Ratio for Bonds

The Sharpe ratio evaluates how much excess return an investment generates per unit of risk. It is calculated by dividing the excess return (investment return minus the risk-free rate) by the standard deviation of returns. This helps determine whether higher returns are due to smart investment decisions or simply taking on more risk.

Here’s a comparison of two ethical bond funds with different risk-return profiles:

Fund Details	Fund A	Fund B
Return	12%	10%
Standard Deviation	10%	7%
Risk-free Rate	3%	3%
Sharpe Ratio	0.90	1.00

Although Fund A offers higher returns, Fund B has a better risk-adjusted performance, making it more appealing to investors who prioritize managing risk. These calculations highlight the importance of addressing specific challenges and risks associated with ESG bonds.

"The Sharpe ratio is the excess return of an investment divided by the standard deviation of returns, which is a measure of risk. Excess returns are returns in excess of a risk-free investment. T-bills are commonly used to estimate a risk-free return." - Asher Rogovy, chief investment officer at Magnifina

Next, let’s explore how these metrics apply specifically to ESG bonds.

ESG Bond Risk Analysis

ESG bonds come with unique risk factors that go beyond standard financial metrics. These investments often feature uneven return profiles, with fixed returns but significant downside risks.

Some key risks to consider include:

Interest Rate Volatility: Fluctuations in interest rates can erode risk-adjusted returns.
Credit Risk: The likelihood that the bond issuer may default.
Liquidity Risk: How easily the bond can be bought or sold in the market.
Call/Prepayment Risk: The chance that the bond may be redeemed early, affecting expected returns.
Inflation Risk: The impact of inflation on real returns.

As of September 28, 2024, the S&P 500 Portfolio holds a Sharpe ratio of 2.91. This serves as a benchmark for evaluating fixed-income investments. Generally, a Sharpe ratio of 1.0 or higher is considered good, 2.0 or higher is very good, and 3.0 or higher is excellent.

"This measurement can help them determine how efficient an investment is in terms of generating returns considering the level of risk taken." - Stephanie Lo, research vice president at NDVR

When comparing fixed-income investments, it’s crucial to use consistent risk metrics. This ensures investors can identify options that not only deliver strong returns but also align with ethical investing principles.

5. Ethical Investment Criteria

Evaluating fixed-income securities through an ethical lens requires more than just traditional financial metrics. With ESG-labeled bonds seeing issuance of nearly $800 billion in 2021, investors need clear and reliable methods for assessing these investments.

Ethical Evaluation Steps

Evaluation Criteria	Key Focus	Potential Issues
ESG Track Record	Review the company's past performance and controversies	Environmental violations, labor disputes
Use of Proceeds	Ensure funds are allocated to specific sustainable projects	Vague or undefined project goals
KPI Structure	Look for measurable and ambitious sustainability targets	Metrics that are weak or too easily met
Reporting Framework	Consistent and transparent impact reporting	Lack of regular or detailed disclosures

These criteria provide a structured way to evaluate ESG investments. The European Investment Bank's green bond framework, introduced back in 2007, continues to influence the market today.

"It's tricky for investors to select bonds with the right structures and features that will meet their ESG promises as advertised. That's why investors and their bond managers must have a disciplined framework for assessing ESG-labeled bonds."
Patrick O'Connell, Salima Lamdouar, and Tiffanie Wong

Investment Selection Guide

Data reveals that ethical bonds, such as green bonds, tend to attract more dedicated investors. For example, green bonds show a median ownership concentration score of 0.20, compared to just 0.06 for traditional bonds. This indicates stronger investor confidence in sustainable investments.

Here’s how to approach the selection process:

Initial Screening: Investigate the issuer's ESG practices, including any controversies. This step ensures you're not investing in companies with a history of unethical practices.
Structure Analysis: Review the bond's design, including timelines for fund deployment and sustainability targets. Well-structured ESG bonds often carry a slight premium but show better stability during market downturns.
Stakeholder Engagement: Communicate directly with issuers and intermediaries to verify their sustainability commitments. This interaction helps ensure accountability and provides a clearer picture of the bond's ethical impact.

The goal is to focus on bonds that genuinely prioritize sustainability, rather than those using the ESG label as a marketing tool. A disciplined evaluation process not only safeguards market credibility but also promotes meaningful environmental and social progress through fixed-income investments.

Conclusion

Bringing together the key metrics we've covered, it's clear they collectively shape the approach to ethical fixed-income investing. Assessing fixed-income securities involves weighing traditional financial metrics alongside ethical factors, offering steady returns and portfolio stability for more cautious investors.

The five core metrics - yield to maturity, credit ratings, duration, risk-adjusted performance, and ethical investment criteria - serve as the backbone for aligning financial objectives with ethical values. This is especially important for ESG-labeled bonds, which require detailed examination and a structured evaluation process.

"Fixed-income securities represent one type of investment that can play an important role in a portfolio. Compared to stocks, the advantages are safety, diversification, and, in the case of government securities, tax benefits. Their rates of return tend to be lower than riskier forms of investments, but they have the ultimate benefit of predictability - an investor knows how much money he or she will have at the end of a certain period." – William J. Wardrope, Ph.D., Associate Professor of Economics and International Business, University of Central Oklahoma

A thoughtful approach that blends traditional financial analysis with ESG considerations is key. For instance, Treasury securities offer nearly risk-free returns, while corporate bonds provide higher yields but come with increased risk. Both need to be evaluated against an investor's ethical priorities and financial goals. This combined analysis is essential for creating portfolios that meet both financial and ethical benchmarks.

Investment Type	Risk Level	Primary Benefits	ESG Consideration
Treasury Bonds	Minimal	Tax benefits & safety	Government policy impact
Municipal Bonds	Low	Tax-exempt status	Community development
Corporate Bonds	Moderate-High	Higher yields	ESG track record

To achieve the best outcomes, investors should incorporate both fundamental financial research and sustainability-focused insights. Maintaining open dialogue with issuers and stakeholders is also critical. The success of fixed-income investing lies in systematically applying these metrics to build portfolios that deliver reliable returns while promoting positive societal change.

FAQs

How do ESG factors impact the yield to maturity of fixed-income securities?

ESG (Environmental, Social, and Governance) factors can significantly influence the yield to maturity (YTM) of fixed-income securities. Bonds with strong ESG performance often see higher demand, which can lead to lower yields at issuance. This is particularly noticeable in well-regulated financial markets where investors prioritize sustainability and ethical standards.

ESG-labeled bonds, such as green or social bonds, may offer slightly lower yields compared to traditional bonds. This trade-off reflects their appeal to socially conscious investors and the reduced cost of debt for issuers due to high demand. While the yield might be marginally lower, many investors view this as a worthwhile compromise for aligning their portfolios with long-term ethical and sustainable goals.

What happens to my bond investments if the credit rating is downgraded?

When a bond's credit rating is downgraded, it signals that the issuer's financial stability has weakened, making the bond riskier. This typically causes the bond's price to drop and its yield to increase as investors demand higher returns to offset the additional risk.

If the bond is downgraded to junk status (non-investment grade), its price may fall even further due to reduced demand from institutional investors who often avoid lower-rated securities. For bondholders, this can mean a decline in the value of their investment and potential challenges in selling the bond at a favorable price.

How can I manage interest rate risk in an ethical bond portfolio?

Managing interest rate risk in an ethical bond portfolio involves understanding key factors and making strategic adjustments. Start by evaluating the duration of your bonds, which indicates how sensitive they are to interest rate changes - a higher duration means greater price fluctuations. To reduce risk, consider focusing on shorter-term bonds, as they are less affected by rising rates.

Regularly review your portfolio's average duration and make adjustments based on your outlook for interest rates. If your investment horizon is longer than the portfolio's duration, remember that while rising rates may cause short-term price declines, they can lead to long-term gains. Staying proactive and aligned with your ethical investment goals is key to effectively managing interest rate risk.