Why credit risk and liability risk matter to bond investors

By

Updated

What is credit risk?

A bond portfolio must track a benchmark with a similar risk profile to the portfolio. That is, investors should choose to replicate (or buy an ETF that replicates) an index benchmark that has a risk profile similar they can tolerate. If portfolio investors have a high risk appetite, an appropriate benchmark may be an index that tracks returns on high-yield corporate bonds—like the iBoxx $ Liquid High Yield Index (HYG) or the State Street SPDR Barclays Capital High Yield Bond ETF (JNK)). High yield bonds provide higher yields, but they also come with a higher risk of default than investment-grade bonds like those included in the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). The top ten holdings in LQD include S&P 100 Index (OEF) stalwarts like Wal-Mart 6.5% (WMT) and Goldman Sachs 6.75% (GS).

To learn more about credit risk, please read the Market Realist series Credit Ratings: Another bubble in the making?

What is liability framework risk?

Article continues below advertisement

This is a risk that only applies to portfolios whose primary objective is to meet liabilities. Many institutional investors invest in order to finance future liabilities, such as pension funds, insurance companies, and financial institutions. These liabilities can often be long-term in nature and so they need to be serviced by investing in long-term assets to minimize risk. This is because both the investor’s obligation and assets must be equally impacted by changes in interest rates. Otherwise, there will be a funding mismatch. This principal can also apply to retail investors who would like to set up a fixed income portfolio that generates income to finance a future liability stream—like for college tuition payments or mortgage payments on a home.

If long-term liabilities are financed through a short-term bond portfolio and interest rates fall, the increase in the price of the investor’s liabilities will exceed the price increase from the short-term portfolio, as the duration for the former is much higher and therefore the proposition is riskier. This is because long-term fixed-income securities have a longer duration and experience greater price changes due to volatility in interest rates compared to short-term fixed-income securities. Conversely, investors with a shorter timeframe to meet liabilities should invest in shorter-term assets. So, to avoid a mismatch in portfolio values, matching cash flow streams from assets and liabilities is very important for investors.

In the next part of this series, we’ll discuss how to match these risk factors to a benchmark index. Please read on.

Advertisement

More From Market Realist