When it comes to bonds, the old rule of thumb states: prices rise when interest rates fall. However, in reality it’s not quite that simple.
This is because an investment in bonds carries two distinct types of risk:
- Interest rate risk: the vulnerability of a bond to changes in interest
- Credit risk: a bond’s sensitivity to its issuer defaulting. That is, the probability of the borrower not being able to pay the principal and interest
Depending on the type of bond, these risks can have a unique impact on performance.
Risk-freeBonds issued by the U.S. government are considered the star of this category, in line with its reputation as a “safe borrower.” While there is no associated credit risk, performance of these bonds are heavily influenced by changes in interest rates. As a result, these bonds often perform their best during periods of slowing economic growth (declining rates and/or inflation). They tend to underperform during periods of rapid economic growth (rising rates and/or inflation).
Investment grade (corporate)These bonds bring a combination of interest rate and credit risk. Within this category, high-quality bonds, issued by companies with strong balance sheets, tend to be more influenced by changes in interest rates. The market views them as less likely to default .The market views these companies as less likely to default than those in a weaker financial position.
High yieldBonds in this category are less sensitive to changes in interest rates. They are also more sensitive to changes in the issuer’s perceived creditworthiness. Companies issuing these bonds may not be in a strong financial position, making it more challenging for them to repay their obligations during an economic downturn. As a result, high yield bonds tend to lag during periods of slowing economic growth (rising default risk). Likewise, they tend to lead during periods of improving economic conditions (declining default risk).
When interest rates are low, taking on some level of credit risk is required to achieve the return objectives from your fixed income investments. As you move along the continuum from risk-free to high yield bonds, you unlock the potential for higher returns. You also assume more risk. This risk/reward equation is reflected in the spread – the difference between the yield on a risk-free bond and a comparable investment grade or high yield alternative with more risk.
Economic disruptions and market shifts can be a good opportunity for you to look to different corners of the market to construct a strong fixed income portfolio that delivers in helping you reach your goals. Here are some examples:
- Income: when government yields are low, look to take on more credit risk to generate income. Diversification is a must for this corner of your portfolio.
- Liquidity: look for short-term bonds from high-quality issuers as holdings you can readily turn to cash.
- Stability: look for exposure to high-quality holdings on the long end of the curve to provide stability in your fixed income portfolio.
In times of economic uncertainty, investing in fixed income markets is a good way to ensure your portfolio remains resilient and on track to achieve your goals.
To learn more about opportunities through fixed income investing, talk to your financial advisor.