Risk and Return (Part 4)

Credit risk counts.

Corporate bonds are not Treasury bonds. That seemingly trivial observation explains not just credit losses, but a lot of price action. Corporate bonds carry interest rate risk and default risk. When an issuer’s chance of default is trivially low—like the recent Apple deal—almost all the price changes will come from movements in Treasury rates. But when an issuer is less creditworthy—like JC Penny, or Cooper Tire—then some of the price movement is attributable to credit changes.

Ironically, this source of risk can reduce bond price volatility. That’s because if rates rise while corporate health improves, credit spreads will narrow. That means that Corporate bonds prices will fall less than Treasury bond prices. Conversely, if the economy weakens and rates fall, spreads on lower-rated Corporates will widen, and their prices won’t rise as much.

So while Corporate bonds unquestionably bear credit risk, their spread activity—as a group—usually will reduce how much their prices vary. By some measures, practically, that means they’re less risky. Less risk with more return—this is a winning combination.

Douglas R. Tengdin, CFA

Chief Investment Officer

If you have questions, please write us at questions.

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