Bond Performance

I understand that the performance of a bond is driven by several variables which includes the coupon that it earns, the reinvestment rate of those coupon payments, and capital gains/losses from the bond price moving up and down.

This can change based on underlying risk free rates, credit risk, etc.

What I am confused about is when I read that the return is attributable to spread compression or spread widening?

If the risk free rate is constant and the bonds spread widens, I can understand how this degrades bond return. The same thing for when the spread narrows with the risk free rate staying constant. Basically the bonds yield moves up and down which compresses/widens the spread.

However, what happens if the bonds yields stays the same and the risk free rate is the only leg that moves? If the bonds yield stays the same, there is no bond return performance however the spread can still narrow/widen. Does this spread performance contribute to the bond return?

Fixed that for you.

If the yield stays the same while the risk-free rate moves, then the spread is changing opposite the risk-free rate; i.e., if the risk-free rate increases, the spread narrows (by the same amount) and if the risk-free rate falls, the spread widens (by the same amount). These effects offset each other: you get a change in value from the change in the risk-free rate (modified or effective duration), and an equal and opposite change in value from the change in the spread (spread duration, a Level II concept).

Bond yields are usually the end product of many different variables put on top of the base rate (risk-free rate).

Holding all other premium spreads constant, a bond’s yield should increase or decrease by the same magnitude as the risk-free rate. If the risk free rate increases, while a bond trades at the same price (or yield) before and after the event, then there was an offsetting factor, of which it may or may not be tied to the RFR, that held the yield constant. Be it that credit rating, borrower performance, volatility, option cost, taxability, bond market liquitidy…etc