Investment bonds are often put into classes as either “low risk” or “high risk," but this covers only half of the story. When you choose to invest in bonds you're up against two kinds of risk: interest rate risk and credit risk.
These two factors can have very distinct impacts on each of the asset classes within the bond market.
- Investing in bonds comes with two types of risk: credit risk and interest rate risk.
- Bonds with heavy interest rate risk are subject to changes in interest rates, and they tend to do poorly when rates begin to rise.
- Credit risk refers to the chance that investors won’t be repaid for the amount they paid in, or at least a portion of interest and principal.
- Both risks must be addressed in order to properly diversify your portfolio for the best results.
Interest rate risk refers to the vulnerability of a bond to changes in current interest rates. Bonds with more interest rate risk tend to perform well as rates fall, but they will perform poorly or below par as rates begin to rise.
Keep in mind: Bond prices and yields move in opposite directions. One result is when the economy slows down, the slower growth leads to falling interest rates; in times like this, securities that are rate-sensitive tend to do their best.
Credit risk, on the other hand, stands for a bond’s risk of default. It is 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 when their issuer is financially strong, but if the issuer begins to suffer, bonds with high credit risk will weaken. Entire asset classes can also have high credit risk—these do better when the economy is getting stronger and they perform poorly when it slows down.
Risk Potential by Bond Asset Class
Certain types of assets are more sensitive to interest rate risks than others. These include 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 subject to credit risk.
This is difference becomes critical if you are building a bond portfolio and want to achieve effective diversification in your bond portfolio. You'll want to include a range of bonds with varied risks so that they balance each other out.
U.S. Treasuries and TIPS
Government bonds are thought to be nearly free of credit risk since the U.S. government remains the safest borrower on the planet. To date, they have never defaulted on a bond loan.
As a result, a sharp slowdown in growth will do almost no harm to the way these bonds perform. In fact, an economic crisis might help, as market uncertainty drives bond investors to put their money into more stable assets like high 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 rise as their prices start falling. In this instance, long-term bonds will perform much worse than short-term bonds.
On the other hand, signs of slowing growth or falling inflation all have a positive effect on rate-sensitive government bonds—this is most true for the more volatile, long-term bonds.
Mortgage-backed securities (MBS) also tend to have low credit risk. The driving reason behind this is that most are backed by government agencies or sold in pools or funds with other assets. In a pool if one asset defaults it won't have a major impact on the whole pool or fund of securities. But MBS do 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; and second, by a sharp decline in interest rates. This sets off a chain reaction in the housing market, starting with owners who want to refinance their mortgages.
When loans are refinanced, the principal is returned, which then needs to be reinvested at lower rates and a lower payout than investors were planning for. They earn zero interest on the retired principal. For this reason, MBS tend to perform best in a market where rates are mostly stable.
Not all municipal bonds are created alike. The asset class includes both higher quality, safe issuers, as well as lower quality, higher-risk issuers.
Municipal bonds on the higher quality end of the spectrum are not very likely to default; as a result, interest rate risk is by far the largest factor in how well they perform.
As you move toward the higher-risk end of the spectrum, credit risk becomes the main issue with municipal bonds, and interest rate risk has less of an impact.
The financial crisis of 2008 brought with it actual defaults, but it also brought fears of rising defaults for lower quality bonds of all types. This caused lower-rated, high-yielding munis to perform very poorly. During this time, many bond mutual funds lost more than 20% 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 bonds, wrapped up the year in the green with a high return of 1.16%.
In contrast, many lower quality funds produced returns in the 25% to 30% range in the next year, which far outpaced the 6.4% return of MUB.
What does this mean for you as an investor? The type of muni 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 changing market conditions.
Corporate bonds present a hybrid of interest rate and credit risk. Corporate bonds are priced on their “yield spread” compared to Treasuries. In other words, the higher yields they provide over government bonds. The effect is that 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 for a couple of reasons: First, because their yields are closer to Treasury yields, and second, because investors see them as being less likely to default.
Lower-rated, higher-yielding corporate bonds tend to be less rate-sensitive and more sensitive to credit risk because their yields are higher than Treasury yields, and because they have more risk of default.
By far the biggest concern with high-yield bonds, often referred to as "junk bonds," is the credit risk. The types of companies that issue high-yield bonds may be smaller, new to the market, and yet to prove themselves. Or they may be larger companies that are dealing with a spell of financial distress. Neither are in a strong position to weather a span of slower economic growth, so high-yield bonds tend to lag when investors grow wary about the growth outlook.
On the other hand, changes in interest rates have less of an impact on how well high-yield bonds perform. The reason for this is simple: a bond that pays 3% is more sensitive to a change in the 10-year U.S. Treasury yield of .3% than a bond that pays 9%.
High-yield bonds, while risky, can provide a tool for diversification when paired with government bonds. On the flip side, they do not offer a great deal of diversification when paired with 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 stable market economies have very little impact on the emerging markets, concerns about slowing growth or other upsets in the global economy can have a major impact on emerging market debt.
The Bottom Line
To diversify properly, you must weigh the risks of the types of bonds you hold or plan to purchase. While emerging market and high-yield bonds can be used to diversify a bond portfolio (which tends to be on the risk averse side), they do not have as great an effect when used to balance a portfolio that invests heavily in stocks (which tends to have more risk).
To diversify stock market risk, you may find help in holdings that are more sensitive to interest rates. But keep in mind these will saddle you with losses when rates go up.
Be sure you're aware of the types of risks at play and what factors drive each market segment before building your bond portfolio.