Credit risk and interest risk
Other things being equal, bondholders in the fixed income market are essentially exposed to two significant risks: credit risk and interest risk. Except for U.S. Treasury bonds (TLT), which are considered the safest asset class, all other fixed income assets are prone to credit risk. Credit risk varies with corporate credit ratings. Another major risk that impacts almost the entire financial market is interest rates.
Investment-grade bonds pay floating interest rates also known as floating rate notes or FRNs. FRNs are a debt security that reference a benchmark such as LIBOR. LIBOR stands for the “London Interbank Offered Rate,” and it’s the benchmark interest rate for many adjustable-rate mortgages, business loans, and financial instruments traded in the global financial market. Currently, the three-month LIBOR rate is 0.24%.
Generally, the interest rate in the case of investment-grade bonds is less than or equal to LIBOR plus 150 basis points, while high yield bonds pay a fixed interest rate. When one-month or three-month LIBOR changes, the coupon rate on investment-grade corporate bonds tends to increase. The coupon rate is the interest rate expressed as a percentage of a bond’s face value.
Compared to high yield bonds (HYG), which pay a fixed interest rate, investment-grade bonds are more protective towards fluctuation in interest rates. When interest rates rise, bond prices fall due to the inverse relationship between the two. Conversely, when interest rates fall, bond prices tend to rise. Rises and falls in bond prices are a function of demand and supply in the market. So, when interest rates decline, investors try to grab bonds that pay higher interest than the prevailing market rate. This, in turn, creates demand for existing and new bonds issued at higher interest rates and increases bond prices. On the other hand, if prevailing market interest rates rise, investors naturally abandon bonds that pay lower interest rates. This, in turn, forces bond prices to go down.
A basic understanding of credit risk and interest rate risk allows investors to carefully choose their options. However, some other important differences that could add to a sound investment decision include default risk, maturity, yield, and volatility. Read on to the next part of this series to learn more.