Duration and credit risk are two major risks and drivers of returns of the fixed income asset class.
So how do investors manage this balancing act?
Credit risk is the risk that a company’s creditworthiness may deteriorate, increasing the likelihood that they will either default or be downgraded to reflect a higher likelihood of default.
Investors get compensated for credit risk in the form of a ‘credit spread’, an additional payment above that of the credit risk-free government bond.
The higher the risk of default, the higher spread is demanded.
When credit spreads rise, provided that the credit risk-free component remains unchanged, the total yield of a bond will rise, and the price will fall: yield of corporate bond = yield of risk-free + credit spread.
Duration measures the sensitivity of a bond’s price to a change in interest rates.
Therefore, duration risk is the risk that a bond’s price will fall as rates rise.
Bonds with a longer maturity and lower coupon will be more sensitive to interest rate changes and have higher duration risk.
Oliver Faizallah, head of fixed income research at Charles Stanley, says investors can balance these risks by holding credit risk and duration together.
As an example, an investor may choose to hold short-duration credit risk, with most of the risk associated with the credit default or downgrade.
Faizallah adds: “In a positive economic environment, credit spreads may fall, increasing yields and producing positive returns. In a negative economic environment, such as a recession, credit spreads may widen and more companies may default, causing corporate bond yields to rise and prices to fall.
“This could be paired with longer-duration government bonds. In a negative environment, such as a recession, where you may lose money on credit risk, we may see interest rates being cut, benefiting our long-duration bonds.
“In a positive economic environment, which may see positive returns from credit-risky assets, we may experience demand-led inflation and interest rate hikes, causing duration assets to fall in price.”
Charles Tan, co-chief investment officer of global fixed income at American Century, says that short-duration income-oriented portfolios can outperform in a volatile interest rate market.
This is because these strategies would provide more attractive yields without as much interest rate risk as intermediate core bonds.
However, given tight credit spreads, he would allocate more towards investment-grade credit compared to high yield at this time.
Tan adds: “We favour shorter duration bonds right now as the interest rate environment is volatile.
