The Sharpe ratio measures the excess return of an investment per unit of risk (volatility). It is the most widely used risk-adjusted performance metric in portfolio management.
Sharpe Ratio = (Return - Risk-Free Rate) / Standard Deviation of Return
A Sharpe ratio of 1.0 means the investment earned 1 unit of excess return for each unit of volatility. Higher is better.
In fixed-income contexts, Sharpe ratios are used to:
Compare maturities: which sector of the curve delivers the best return per unit of interest rate risk
Evaluate strategies: the Salomon Brothers yield curve primer (Part 3) shows that the Sharpe ratio of rolling 1-month strategies varies significantly across the maturity spectrum
Assess regime performance: the blog post "Asset Returns During Various Yield Curve Regimes" computes Sharpe ratios for bond ETFs across bull/bear steep/flat regimes
Typical Sharpe ratios for Treasury sectors:
Short-term bills: high Sharpe (low vol, modest return)
Intermediate notes (2-5Y): often the best Sharpe on the curve due to favorable carry-to-risk tradeoff
Long bonds (20-30Y): lower Sharpe due to high duration volatility
The Sharpe ratio has limitations — it penalizes upside volatility equally with downside, doesn't account for non-normal return distributions, and depends heavily on the measurement period. The Sortino ratio (which only penalizes downside deviation) is sometimes preferred.
Yield Volatility— The standard deviation of yield changes, measuring how much interest rates fluctuate over a given period.
Carry— The income earned from holding a bond, equal to the coupon income minus the cost of financing the position.
Duration— A measure of a bond's price sensitivity to interest rate changes, expressed in years. The primary risk metric for fixed-income portfolio construction and hedging.