What does the excess return on a bond measure?

The excess return on a bond measures the additional yield that investors require in order to compensate for the credit-related risks associated with that bond above what they would receive from a risk-free asset, such as government securities. This return reflects the idea that investors need to be incentivized to take on the additional risk of potential default or credit downgrading when they choose to invest in a bond that carries credit risk.

The concept captures how much more yield an investor expects to earn as a reward for assuming the additional risk inherent in bonds that are not considered risk-free. This is especially relevant in the evaluation of corporate bonds or bonds from issuers with lower credit ratings compared to highly-rated government bonds. It highlights the trade-off between risk and return that is fundamental to fixed-income investing.

In contrast, other options consider different aspects of bonds. Market volatility does not directly correlate with excess return; total return encompasses both interest income and any capital appreciation, whereas excess return specifically focuses on the yield earned above the risk-free rate relative to credit risk. Additionally, interest income alone does not capture the measure of excess return, which also considers factors such as potential price changes in the bond due to credit risk adjustments.