Credit risk vs. interest rate risk gas out game commercial

This leads to the return of principal, which then needs to be reinvested at lower rates and a lower yield than investors were anticipating since they earn no interest on the retired principal. MBS, therefore, tend to perform best in an environment of relatively stable interest rates. Municipal Bonds

Not all municipal bonds are created alike. The asset class includes both higher-quality, safe issuers and lower-quality, higher-risk issuers. Municipal bonds on the higher-quality end of the spectrum have the probability of being very unlikely to default; therefore, interest rate risk is by far the largest factor in their performance.

For instance, the financial crisis of 2008, which brought with it actual defaults and fears of rising defaults for lower-quality bonds of all types, led to an extremely poor performance for lower-rated, high-yielding munis, with many bond mutual funds losing over 20 percent of their value.

At the same time, the exchange-traded fund iShares S&P National AMT-Free Muni Bond Fund (ticker: MUB), which invests in higher-quality securities, finished the year with a positive return of 1.16 percent. In contrast, many lower-quality funds produced returns in the 25-30 percent range in the recovery that occurred in the subsequent year, far outpacing the 6.4 percent return of MUB.

Corporate bonds present a hybrid of interest rate and credit risk. Since corporate bonds are priced on their “ yield spread” versus Treasuries, or in other words, the higher yields they provide over government bonds, the changes in government bond yields have a direct impact on the yields of corporate bond issues. At the same time, corporations are seen as less financially stable than the U.S. government, so they also carry credit risk.

Higher-rated, lower-yielding corporate bonds tend to be more rate-sensitive because their yields are closer to Treasury yields and also because investors see them as being less likely to default. Lower-rated, higher-yielding corporates tend to be less rate-sensitive and more sensitive to credit risk because their yields are higher than Treasury yields and also because they have more likelihood of default. High Yield Bonds

The largest concern with individual high yield bonds often referred to as "junk bonds," is the credit risk. The types of companies that issue high-yield bonds are either smaller, unproven corporations or larger companies that have experienced financial distress. Neither are in a particularly strong position to weather a period of slower economic growth, so high yield bonds tend to lag when investors grow less confident about the growth outlook.

On the other hand, changes in interest rates have less of an impact on high yield bonds’ performance. The reason for this is straightforward: a bond yielding 3 percent is more sensitive to a change in the 10-year U.S. Treasury yield of .3 percent than a bond that pays 9 percent.

Like high-yield bonds, emerging market bonds are much more sensitive to credit risk than interest rate risk. While rising rates in the United States or developing economies will typically have little impact on the emerging markets, concerns about slowing growth or other disruptions in the global economy can have a major impact on emerging market debt. The Bottom Line

To diversify properly, you must understand the risks of the types of bonds you hold or plan to purchase. While emerging market and high yield bonds can diversify a conservative bond portfolio, they are much less effective when used to diversify a portfolio with substantial investments in stocks.