The efficient portfolio approach
One way to approach this problem is to think about what a risk efficient portfolio might look like. By risk efficient I mean a portfolio that provides potential income without taking on too much risk to do so. Within the bond market, we find the majority of performance is driven by two separate types of risk: interest rate risk and credit risk. Interest rate risk is the risk that a rise in interest rates will drive down the price of your bond or portfolio. Credit risk is the risk that the bonds that you invest in will default and will fail to make their scheduled coupon or maturity payments. Bonds like US Treasuries have no credit risk but are subject to interest rate risk. Others, like corporate bonds, carry both interest rate risk and credit risk.
Market Realist – Risks involved in bonds
The graph above shows the spread between the yield on US high yield bonds (HYG)–as tracked by the BofA Merrill Lynch US High Yield Master effective yield–and that on the ten-year Treasury (IEF). The difference between the yields on corporate bonds and Treasury bonds of the same maturities is often known as the “credit spread.”
This is because Treasuries do not carry credit risk while corporate bonds do, as we explained above. Investors are rewarded for taking on more credit risk in the form of higher yields. The credit spread usually indicates reward over and above the interest rate risk on the Treasury bond of the same maturity. Two bonds with the same maturities carry equal interest rate risks.
Since Treasuries (TLH) do not have any credit risk, the yield on them is the reward you get for taking on interest rate risks. Typically, the higher the maturity of the Treasury bond, the higher the yield. This is because longer-dated Treasuries contain higher interest rate risk. The long-dated Treasuries have one coupon rate locked up over many years. A hike in interest rates would make the future coupon payments unattractive. Comparatively, short-dated Treasuries (SHY)(NEAR) have fewer coupons until maturity, which makes them less sensitive when interest rates rise.