returns is critical to building efficient bond portfolios. In fact, even the highest credit quality held-to-maturity portfolios bear risk, and one portfolio can achieve very different long-term returns than another due to different exposures to risk. As with most financial assets, fixed income returns have two components: income and capital appreciation/depreciation. What distinguishes fixed income returns from the other asset classes is that most of the total return comes from the income component rather than the price component. That being said, the price component of the return can distinguish good portfolio performance from bad portfolio performance. Also, an investor can easily increase the income component of the portfolio, but generally it will come at the expense of higher volatility of the price component. So, what drives this price component? First of all, remember that the price change of a bond can be approximated by the formula: Change in price = (Change in yield) X (Duration) X (-1) where the duration of a bond is effectively a weighted average of the time until each cash flow payment where the weights are equal to the present value of each cash flow. So in order to determine what drives the risk and return of the price component of fixed income returns, we must examine the risk exposures that drive changes in fixed income yields. We will now examine the major sources of risk in most fixed income portfolios. Interest Rate Risk Interest rate risk is probably the most widely known and widely discussed risk in the fixed income world. It is the risk that the yield of a bond will change due to changes in the otherwise risk-free bond with the same cash flows. Usually the risk-free yield curve is determined by the yield of credit-risk-free government bonds. However, some market participants (GSAM included) have switched to using the swap yield curve instead of the government yield curve due to significant technical factors that have driven government yields out of line with other high credit quality fixed income instruments. Regardless, the concept of interest rate risk is the same, which is that there is a baseline interest rate for a cash flow at each maturity and if this rate changes in the market, the price of the bond will change with it. There are a number of reasons that credit-risk-free interest rates change, but most changes are due to macroeconomic factors such as current and expected future monetary and fiscal policy, economic growth, level of inflation, and so on. Note also that investors buying fixed income securities in different countries bear different interest rate risks because of the differences in the yield curves and in the macroeconomic and inflationary environments. The measurement that is usually used to quantify a portfolio's exposure to interest rate risk is duration. Duration is effectively the amount in percent that a bond is expected to rise/fall due to a 1 percent decrease/increase in interest rates.