In this case, junk bond volatility is higher than investment-grade volatility above, as we would expect. So, now we have decent estimates of both returns and risks for corporate bonds across the full range of quality ratings. But how do those data compare to the balance of returns and risks available from other asset classes? The graph shows results from to , which is the same period used in Bekaert and De Santis research. The best-fit line for the theoretical relationship between these asset classes differs substantially from the best-fit line for the actual data for the 21 years from to , particularly at the high-risk right side of the graph.
Put another way, the actual returns in this period for emerging market stocks, developed market stocks, and U. Conversely, the returns for BBB corporate bonds were notably higher than generic expectations. All this suggests that the data from to could be a poor illustration of the typical long-term relationship between these assets.
Portfolio Visualizer contains corporate bond data with no differentiation of AAA, BBB, or other types of investment-grade bonds extending back to So, I built a similar graph covering the almost year period from the start of through to May Although this period starts only five years after the previous graph, the relationship based on actual data is much more closely aligned with generic expectations for these assets.
Further, the unusual performance of investment-grade corporate bonds particularly BBB over the two decades starting in disappears if we start the calculation just a few years later. So, armed with the detailed data and associated caveats we can make some broad generalizations about the risks and returns of corporate bonds as compared to other asset classes.
In general, we can rank the asset classes in terms of long-term risks and returns in increasing order:. More interestingly, corporate bonds, even junk bonds, tend to have about half the volatility of stocks. Put more simply, corporate bonds tend to have a better return to risk ratio than stocks.
However, the last graph shows that corporate bond volatility can abruptly increase when the markets are in turmoil. The history of corporate bond returns and risks suggests two potential perspectives. If you are risk-averse and are starting with a portfolio that contains mostly government bonds, adding some corporate bonds even junk bonds may be a prudent way to moderately boost your long-term returns without adding huge risks. Corporate bond funds, sometimes, do take small exposures to government securities as well.
But they do so only when no suitable opportunities in the credit space are available. On average, corporate bond funds will have approximately 5. This default risk is higher for low-rated securities and goes up exponentially with increasing maturities.
Here, the risk is also minimal. On the other hand, if you invest in a slightly low-rated but a well-managed fund, then it can be rewarding.
For instance, companies tend to give somewhat higher coupon rates to attract investors. Hence, if a company defaults on interest payments or principal repayment or the company gets downgraded further, then it is a setback for investors. There is a debt market where several bonds are traded.
In this market, the prices of different bonds can rise or fall, as they do on the stock markets. For instance, a mutual fund buys a bond, and its price subsequently rises. Then, it can make additional money over and above what it would have made out of the interest income alone. However, it could also go the other way. Start investing now or. Download link sent. Start Investing Now. FDs Are you a value investor or growth investor? Tax Saving Made Simple.
Start Tax Saving. Was this article helpful? It is key that you be compensated for the call provision with a higher yield. Event risk is the risk that a corporate transaction, natural disaster or regulatory change will cause an abrupt downgrade in a corporate bond.
Event risk tends to vary by industry sector. For example, if the telecom industry happens to be consolidating, then event risk may run high for all bonds in this sector. The risk is that the bondholder's company may purchase another telecom company and possibly increase its debt burden financial leverage in the process.
The payoff for assuming all these extra risks is a higher yield. The difference between the yield on a corporate bond and a government bond is called the credit spread sometimes just called the yield spread. As the illustrated yield curves demonstrate, the credit spread is the difference in yield between a corporate bond and a government bond at each point of maturity.
As such, the credit spread reflects the extra compensation investors receive for bearing credit risk.
Therefore, the total yield on a corporate bond is a function of both the Treasury yield and the credit spread, which is greater for lower-rated bonds.
If the bond is callable by the issuing corporation, the credit spread increases more, reflecting the added risk that the bond may be called. Predicting changes in a credit spread is difficult because it depends on both the specific corporate issuer and overall bond market conditions.
If interest rates are unchanged, the total yield on this "upgraded" bond will go down in an amount equal to the narrowing spread, and the price will increase accordingly. After purchasing a corporate bond, the bondholder will benefit from declining interest rates and from a narrowing of the credit spread, which contributes to a lessening yield to maturity of newly issued bonds.
This, in turn, drives up the price of the bondholder's corporate bond. On the other hand, rising interest rates and a widening of the credit spread work against the bondholder by causing a higher yield to maturity and a lower bond price.
Therefore, because narrowing spreads offer less ongoing yield and because any widening of the spread will hurt the price of the bond, investors should be wary of bonds with abnormally narrow credit spreads. Conversely, if the risk is acceptable, corporate bonds with high credit spreads offer the prospect of a narrowing spread, which in turn will create price appreciation.
However, interest rates and credit spreads can move independently. In terms of business cycles, a slowing economy tends to widen credit spreads as companies are more likely to default, and an economy emerging from a recession tends to narrow the spread, as companies are theoretically less likely to default in a growing economy.
In an economy that is growing out of a recession, there is also a possibility for higher interest rates, which would cause Treasury yields to increase.
This factor offsets the narrowing credit spread, so the effects of a growing economy could produce either higher or lower total yields on corporate bonds. If the extra yield is affordable from a risk perspective, the corporate bond investor is concerned with future interest rates and the credit spread. Like other bondholders, they are generally hoping that interest rates hold steady or, even better, decline.
Additionally, they generally hope that the credit spread either remains constant or narrows, but does not widen too much. Because the width of the credit spread is a major contributor to your bond's price, make sure you evaluate whether the spread is too narrow—but also make sure you evaluate the credit risk of companies with wide credit spreads. Board of Governors of the Federal Reserve System. Corporate Bonds.
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