Bond Investing 101: Understanding Interest Rate Risk and Credit Risk

This video is one part of BondSavvy's 10-part video "The Crash Course on Corporate Bond Investing" and helps investors weigh interest rate risk and credit risk when investing in individual corporate bonds.  Click here to view the video on YouTube. 

The full Crash Course video is included with a subscription to BondSavvy or can be bought on its own here. This video explains the differences between interest rate risk and credit risk and how you can factor this into your next corporate bond investment. Many investors only invest in investment-grade bonds because they are afraid of the default risk of high-yield (or below investment grade) bonds. The challenge with this thinking is that investment-grade bonds often have longer durations (or time until maturity) and are therefore more sensitive to changes in interest rates. To alleviate these risks, it's important for investors to consider both investment-grade corporate bonds and non-investment-grade corporate bonds.

You will learn the following by watching this video:

  1. Difference between investment-grade corporate bonds and high-yield corporate bonds
  2. Difference in default rates between investment-grade corporate bonds and high-yield corporate bonds
  3. How owning high-yield corporate bonds can help reduce investors' interest rate risk
  4. Why shorter-dated bonds are less sensitive to changes in interest rates
  5. What happens to bond prices when interest rates increase 
  6. How bond prices are quoted
Below is a full transcript of the video:

Most online brokers enable you to search for either investment-grade corporate bonds or high-yield corporate bonds in what is called the “Secondary Market,” which is a term meaning that the bond has already been issued and you are buying from or selling to another investor, as opposed to the primary market where you are purchasing the bonds from the issuing company. The key difference between investment grade and high yield bonds is how their credit quality is rated by Moody’s and S&P, the major credit-rating agencies. You’ll see on this table that the highest-rated bonds are at the top, including Microsoft and Apple, both of which are classified as investment-grade corporate bonds. These bonds are rated as having a low risk of default (or low credit risk) and therefore pay a lower interest rate than high-yield bonds, which are considered to carry a higher risk of default (or higher credit risk). Another general differentiator between investment grade and high-yield bonds is the time until maturity, or the duration of the bond. Since investment grade bonds have a higher credit quality, the companies that issue them are able to secure better terms from bondholders, including much longer durations. You’ll see the Microsoft bonds I listed on the table have a maturity in 2055 compared to the Cablevision high-yield bonds that mature in 2020 and were issued in 2010, giving them a 10-year term. The Microsoft bonds were issued in 2015, so they have a 40-year term.

NOTE: The following bonds were shown in the table just discussed:
Microsoft 4.000% 2/12/55  (CUSIP 594918BE3; also known as Microsoft 4% '55 bonds)
Apple 4.45% 5/6/44 (CUSIP 037833AT7; also known as Apple 4.45% '44 bonds)
Discovery Communications 4.95% 5/15/42 (CUSIP 25470DAG4; also known as Discovery 4.95% '42 bonds)
Cablevision 8.000% 4/15/20 (CUSIP 12686CBA6; also known as Cablevision 8% '20 bonds)
Ruby Tuesday 7.625% 5/15/20 (CUSIP U7498NAA8; also known as Ruby Tuesday 7.625% '20 bonds)

This discussion brings us to a fork in the road as bond investors and will impact how we approach evaluating the two key risks we face: credit risk and interest rate risk.

We just briefly touched on credit risk, but it’s important to understand the interplay between credit risk and interest rate risk. Many bond investors might immediately gravitate toward investment-grade bonds due to their higher perceived credit quality, but it’s important to keep in mind that a longer-dated bond will carry higher interest rate risk than one maturing in the near term.

In this graphic, an investor purchased the green bond one year ago at par, and the coupon was 6%, or 60 dollars per year. Bonds are quoted as a percentage of their par value, which is $1,000. Therefore, a bond quoted “at par” is equivalent to 100% of the $1,000 par value. A bond quoted at 90 is worth 90% of $1,000, or $900.

Let’s suppose interest rates have increased 1 percent over the last year, and the same company issued a new bond with the same maturity but at a 7% coupon, shown in blue. Since the green bond pays a lower coupon than the blue bond, it would make no sense for an investor to pay par for the green bond. The price has to decrease all the way to 85.70 to have the same current yield as the blue bond.

Keep in mind the current yield does not factor in the maturity of the bond.

If this bond was to mature in one year, unless the credit quality took a major turn for the worse, it would be unlikely for the price of the bond to fall near the 85.70 level since the bondholder would receive the face value of the bond in one year. If we calculated the Yield to Maturity as shown in this chart, it would be 23.7 percent for a bond priced at 85.70 with a 6 percent coupon and maturing in one year. Since Yield to Maturity factors in not only the coupon payment but also how much the value of the bond would appreciate between purchase and maturity, the Yield to Maturity in this case is very high since the bond would appreciate over 14 points in one year. If the price did fall to 85.70, and there were no material credit-quality issues, investors would likely heavily buy this bond, which would drive the price back up closer to par. This example helps illustrate why shorter-duration bonds help mitigate interest rate risk, or the risk of the bond’s value rising or falling based on changes in interest rates.

If, however, the bond did not mature for 30 years, we see the Yield to Maturity would be 7.17 percent, as it would take 30 years for the investor to realize the price appreciate from 85.70 to par. This shows it is much easier for a longer-dated bond to fall in price with an increase in interest rates.

This brings me back to the earlier point of investing in long-dated investment-grade bonds.  From this example, we see that a bond with a far-out maturity date can fall much further than a bond that is maturing in the near term.  Therefore, it’s important for investors to not invest blindly in long-dated investment-grade bonds given how sensitive they can be to changes in interest rates.

Since high-yield bonds are typically issued with shorter durations than investment grade bonds, if an investor can get comfortable with the credit risk of a high-yield bond, it could be a potentially better investment opportunity than a long-duration investment grade bond that has significant interest-rate risk.

According to Moody’s, the volume-weighted corporate bond default rates from 1994 to 2016 were 0.18 percent for investment grade corporate bonds and 4.18 percent for high-yield corporate bonds.  When evaluating investments, we therefore need to weigh this 4 percentage-point higher default rate with longer-duration investment-grade bonds being more sensitive to changes in interest rates.

Now that we have all of this context, I will walk you through how I narrow down the corporate bond universe into a small number of bonds I believe present high-quality investment opportunities.

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