How to think about bond risks

Many factors influence the performance of a bond, and many occur simultaneously

Recently, credit, default, duration and inflation and interest-rate risk have been the focus for most investors, so this article will concentrate on those.

Credit risk

Typically, credit risk is measured by the difference in yield (the spread) between the bond issued and a risk-free investment. 

So, if a yield for a US treasury, as the risk-free investment, is 2 per cent and a corporate bond is yielding 5 per cent, the spread is 3 per cent.

The corporate bond yielding more implies it is seen as riskier. 

A spokesperson for Pimco says: "Every bond carries some risk that the issuer will 'default' or fail to fully repay the loan – this is the greatest risk a bondholder will face.

"Independent credit rating services assess the default risk, or credit risk, of bond issuers and publish credit ratings that not only help investors evaluate that risk, but also help determine the interest rates on individual bonds."

Defaults will rise but not by an unusually high amount.Darius McDermott, FundCalibre

Investors who purchase bonds with low credit ratings can potentially earn higher returns, but know there is an increased chance they will not get paid. 

Bond prices have become so overstretched that they have been vulnerable to rising inflation and interest rates.Colin Leggett, Collidr

A Pimco representative says: "A decline in the financial health of an issuer of a bond can lead to an inability or unwillingness to repay a loan or meet a contractual obligation, therefore investors will demand a higher yield if that risk is higher than other bonds."

FundCalibre managing director Darius McDermott says credit risk will be higher in the high-yield area of the market (BB+ and below) than in investment grade (BBB to AAA rated by agencies).

He says: "Managers are saying that credit spreads on corporate bonds are now looking attractive though – in that you are being compensated quite adequately for the extra risk you are taking, especially in investment grade."

He adds: "They prefer high-quality investment grade over high yield for now and are avoiding deeply cyclical companies or those needing immediate refinancing. Financials are also coming up as ideas."

Default risk

Defaults were historically low prior to the pandemic and, with a swathe of government economic support, default rates remained very low during it.  

But this is changing. In one week of April, nine companies defaulted globally, according to S&P. 

Market participants highlight that investment grade default rates are usually close to zero, while high-yield credit default rates have declined to their lowest levels since 2014.

McDermott adds: "Defaults are normally an issue in the high-yield market rather than investment-grade markets. There is an expectation that defaults will rise if we end up in a long-lasting recession."

"Currently most managers do not think that will be the case though. They believe defaults will rise but not by an unusually high amount."

Artemis fixed income manager Grace Le elaborates, saying, "We expect default rates to rise from their current floor but with companies broadly in better shape than they were two decades ago."

She adds: "Current valuations are reflecting a lot of negativity. We think we are being compensated for the risk."

In the current market, Pimco's spokesperson says it is time to "focus on capital preservation, flexibility and liquidity”.

What is duration risk? 

Duration is a measurement of a bond’s interest rate sensitivity, and considers a bond’s maturity, yield, coupon and call features

Generally, the longer a bond’s duration, the more its value will fall as interest rates rise, because when rates go up, bond values fall and vice versa.

An investor expecting interest rates to fall during the time the bond is held would find bonds with a longer duration appealing because the bond’s value would increase more than comparable bonds with shorter durations.

According to Rathbones' head of fixed income Bryn Jones, it is "purely mathematical". 

He said: "This is because each rise in interest rates leads to a fall in prices. Therefore, quid pro quo, shorter duration assets are less sensitive to such moves."

Muzinich & Co's Michael McEachern, co-head of public markets, explains the pull-to-par effect.

"Short-dated bonds of creditworthy companies tend to display less price volatility than their longer-dated counterparts, as they don’t often trade below par. When they do, they tend to reverse back to their par value quickly.

"They also tend to converge back to par as the bond approaches maturity. This is known as the ‘pull-to-par’ effect. The ‘pull-to-par’ effect also helps short-dated bonds recover from drawdowns."

How can one mitigate duration risk in a portfolio? The shorter a bond’s duration, the less volatile it is likely to be.

For example:

• A bond with a duration of one year would lose 1 per cent if rates were to rise 1 per cent.
• In contrast, a bond with a duration of 10 years would lose 10 per cent if rates were to rise by that same 1 per cent.
• Conversely, if rates fell by 1 per cent, bonds with a longer duration would gain more while those with a shorter duration would gain less.

Those investors concerned about wide fluctuations in the value of their bond holdings should consider a bond strategy with a very short duration.

Investors who are more comfortable with these fluctuations, or who are confident that interest rates will fall, should look for longer duration.

Inflation risks

If duration risk increases because interest rates rise, rates only tend to rise if they are being used to combat inflation. 

Interest rate risk is entangled with inflation expectations. 

According to Fairview Investing's Gavin Haynes, "inflation is the enemy of fixed interest markets and rising inflation expectations lead to price falls for most bonds".

Higher inflation is likely to lead to rising interest rates, which makes the return from fixed interest less attractive in real terms.

Haynes says there are exceptions, such as index-linked bonds, which pay a coupon linked to the rate of inflation, and their prices can increase on expectation of increasing inflation.

He says the key is for a bond fund manager to take a flexible approach to the duration of the bond portfolio right now.

"During times when expectations of inflation are increasing, the bond manager should reduce the duration of the bond portfolio (ie the term to maturity of the underlying bonds) as they will be less impacted by future inflation expectations."