Credit Risk vs. Interest Rate Risk
Learn about the two types of risks affecting your bond investments
Investment bonds often fall into either the “low risk” or “high risk” classification, but this covers only half of the story. Making an investment in bonds carries two kinds of risk: interest rate risk and credit risk. These two influences can have very distinct impacts on the different asset classes within the bond market.
Interest rate risk represents the vulnerability of a bond to movements in prevailing interest rates. Bonds with more interest-rate risk tend to perform well as interest rates fall, but they start to underperform as interest rates begin rising.
Keep in mind, bond prices and yields move in opposite directions. As a result, rate-sensitive securities tend to do their best when the economy starts slowing down since slower growth likely leads to falling interest rates.
Credit risk, on the other hand, signifies a bond’s sensitivity to default, or the chance that a portion of the principal and interest will not be paid back to investors. Individual bonds with high credit risk do well as their underlying financial strength improves, but weaken when their finances deteriorate. Entire asset classes can also have high credit risk; these do better when the economy is strengthening and underperform when it slows down.
Risk Potential by Bond Asset Class
While some types of assets have more sensitivity to interest rate risks, such as U.S. Treasuries, Treasury Inflation-Protected Securities (TIPS), mortgage-backed securities and high-quality corporate and municipal bonds, others, such as high yield bonds, emerging market debt, floating rate bonds, and lower-quality municipal bonds, are more vulnerable to credit risk. Understanding this difference becomes critical if you want to achieve effective diversification in your bond portfolio.
U.S. Treasuries and TIPS
Government bonds are considered to be nearly free of credit risk since the U.S. government remains the safest borrower on the planet. As a result, a sharp slowdown in growth or an economic crisis won’t hurt their performance. In fact, an economic crisis might help as market uncertainty drives bond investors to put their money into more quality bonds.
On the other hand, Treasuries and TIPS are highly sensitive to rising interest rates, or interest rate risk. When the market expects the Fed to raise interest rates, or when investors become concerned about inflation, the yields on Treasuries and TIPS will likely rise as their prices start falling. In this scenario, long-term bonds will perform much worse than their short-term counterparts.
On the other hand, signs of slowing growth or falling inflation all have a positive effect on rate-sensitive government bonds, especially the more volatile, longer-term bonds.
Mortgage-backed securities (MBS) also tend to have low credit risk, since most are backed by government agencies or sold in pools where individual defaults don’t have a significant impact on the overall pool of securities. However, these investments have a high sensitivity to interest rates.
The MBS asset class can be hurt in two ways, first by a sharp increase in interest rates, which causes prices to fall. The second way involves a sharp decline in interest rates, which starts off a chain reaction beginning with homeowners who refinance their mortgages.
This leads to the return of principal, which then needs to be reinvested at lower rates and a lower yield than investors were anticipating since they earn no interest on the retired principal. MBS, therefore, tend to perform best in an environment of relatively stable interest rates.
Not all municipal bonds are created alike. The asset class includes both higher-quality, safe issuers and lower-quality, higher-risk issuers. Municipal bonds on the higher-quality end of the spectrum have the probability of being very unlikely to default; therefore, interest rate risk is by far the largest factor in their performance.
As you move toward the higher-risk end of the spectrum, credit risk becomes the primary issue with municipal bonds, and interest rate risk has less of an impact.
For instance, the financial crisis of 2008, which brought with it actual defaults and fears of rising defaults for lower-quality bonds of all types, led to an extremely poor performance for lower-rated, high-yielding munis, with many bond mutual funds losing over 20 percent of their value.
At the same time, the exchange-traded fund iShares S&P National AMT-Free Muni Bond Fund (ticker: MUB), which invests in higher-quality securities, finished the year with a positive return of 1.16 percent. In contrast, many lower-quality funds produced returns in the 25-30 percent range in the recovery that occurred in the subsequent year, far outpacing the 6.4 percent return of MUB.
The takeaway? The type of municipal bond or fund you choose can have a huge impact on the type of risk you’re taking on, whether credit or interest risk and the returns that you can expect under different circumstances.
Corporate bonds present a hybrid of interest rate and credit risk. Since corporate bonds are priced on their “yield spread” versus Treasuries, or in other words, the higher yields they provide over government bonds, the changes in government bond yields have a direct impact on the yields of corporate bond issues. At the same time, corporations are seen as less financially stable than the U.S. government, so they also carry credit risk.
Higher-rated, lower-yielding corporate bonds tend to be more rate-sensitive because their yields are closer to Treasury yields and also because investors see them as being less likely to default. Lower-rated, higher-yielding corporates tend to be less rate-sensitive and more sensitive to credit risk because their yields are higher than Treasury yields and also because they have more likelihood of default.
High Yield Bonds
The largest concern with individual high yield bonds often referred to as "junk bonds," is the credit risk. The types of companies that issue high-yield bonds are either smaller, unproven corporations or larger companies that have experienced financial distress. Neither are in a particularly strong position to weather a period of slower economic growth, so high yield bonds tend to lag when investors grow less confident about the growth outlook.
On the other hand, changes in interest rates have less of an impact on high yield bonds’ performance. The reason for this is straightforward: a bond yielding 3 percent is more sensitive to a change in the 10-year U.S. Treasury yield of .3 percent than a bond that pays 9 percent.
In this way, high yield bonds, while risky, can provide an element of diversification when paired with government bonds. Conversely, they do not provide a great deal of diversification relative to stocks.
Emerging Market Bonds
Like high-yield bonds, emerging market bonds are much more sensitive to credit risk than interest rate risk. While rising rates in the United States or developing economies will typically have little impact on the emerging markets, concerns about slowing growth or other disruptions in the global economy can have a major impact on emerging market debt.
The Bottom Line
To diversify properly, you must understand the risks of the types of bonds you hold or plan to purchase. While emerging market and high yield bonds can diversify a conservative bond portfolio, they are much less effective when used to diversify a portfolio with substantial investments in stocks.
Interest rate-sensitive holdings can help you with diversifying stock market risk, but they will saddle you with losses when rates go up.
Be sure to understand the specific risks and performance drivers. of each market segment before constructing your bond investment portfolio.