Bonds refer to long-term fixed-income investments, meaning that you are guaranteed some amount of income. While you may begin with the rudimentary low vs. high-risk understanding, you will encounter interest and credit risk with further fixed-income research. These are the main kinds of risks you incur when investing in bonds.
The risk you expose yourself to differs depending on the asset class you choose in the bond market. However, we must understand the two risk types before getting ahead of ourselves and looking at asset classes.
Interest Rate Risk and Credit Risk – Two Sides of the Same Coin
Interest rate risk refers to how likely your bond is to incur losses if the interest rate changes. For example, if the interest rate in the market rises, the value of your bond declines. It is also important to remember that rate-sensitive securities perform best when interest rates fall due to slower economic growth.
Meanwhile, credit risk refers to the bond’s risk of default. This indicates a scenario where the investors do not receive the principal and interest amounts due to them. The credit risk for high-risk individual bonds depends on the issuers’ financial situations – if strong, the bonds do well, and vice versa. Similarly, high-risk asset classes perform better under a fast-growing and robust economy.
How These Risks Affect Different Asset Classes
Understanding interest and credit risk is just the first step. If you are looking to build a bond portfolio and conduct the necessary fixed-income research, you must also understand which asset classes are sensitive to risk.
The asset types subject to interest rate risk include:
- Treasury Inflation-Protected Securities (TIPS)
- Mortgage-Backed Securities
- Corporate Bonds
- Municipal Bonds
Meanwhile, the investments that incur credit risk are:
- High-Yield Bonds
- Emerging Market Debt
- Floating-Rate Bonds
- Low-Quality Municipal Bonds
When building an investment portfolio, you need to diversify your investments to mitigate risk. Only choosing investments subject to interest risk can compound the losses you incur should the rates significantly fluctuate. Therefore, learning to balance your risks is key to a healthy portfolio.
Balancing Interest Rate and Credit Risk
The barbell approach to risk management involves pairing interest-rate-sensitive bonds with high-yielding credit assets. When you blend asset classes this way, you ensure you earn an income regardless of the economic growth. When growth slows, you gain returns from your interest rate-dependent bonds. Meanwhile, your credit risk reduces when growth speeds up, and your high-yielding credit assets bring you income.
The barbell approach involves ensuring that the assets on one side are strong enough to weather any losses on the other side. Analyzing your portfolio with this in mind also allows you to choose the right moment to sell and buy assets as and when necessary for a healthy balance.
At the end of the day, diversification remains the most important way to mitigate risk. Using the barbell approach helps diversify your portfolio through various fixed-income assets that guarantee income and improve your yield substantially. Thus, understanding the nuances of interest and credit risk is essential to sound investment decisions and better returns.
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