Hi all! Please help me understand one thing about bonds.
Treasuries have no credit risk. Any other issuer's bonds will have some amount of that risk. For corporate bonds of different quality that risk has been mostly explained by Fama-French 3-factor model. We can say then, that corporate bonds = treasuries + equity-like risk, making them not a good portfolio diversifier.
Now there are other issuers, like munies, agencies, foreign USD-nominated debt, all with some credit risk. Does this risk also has something to do with equites or has it some other nature? In the latter case, should it work beneficially inside one's portfolio?
Bond risk nature
Re: Bond risk nature
My take is that high quality munis have slightly higher economic risk than Treasuries and they can have liquidity risk as well. That said, I hold a ton in MFs in my taxable account. I view the risk vs. treasuries as only mild.
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Re: Bond risk nature
Credit risk is not equity risk. There is some correlation between equity risk and credit risk for publicly-traded companies because when they get into trouble, both credit and equity prices take a hit. Bonds issued by foreign governments and municipal entities also have credit risk but the issuers are often not public traded companies.
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Re: Bond risk nature
Bonds (other than Treasuries) also often have a prepayment risk, that if you're earning a higher rate on the bond and rates go down, the issuer might call the bond earlier than its maturity and pay it off (often selling new bonds at the now lower rates.)
Many U.S. Gov "Agency" bonds also don't have credit risk, or at least they may enjoy the same "Full Faith and Credit of U.S. Government" as Treasuries, or even if the cases where they don't explicitly, there is a reasonable presumption that the agency and it's bonds are too big to fail, e.g. if Fannie/Freddie MBS were allowed to default, despite being required to explicitly state their bonds do not have "full faith and credit of Gov" it would cascade into such chaos in the mortgage market those agencies would fail and they would not be able achieve the goal Congress chartered those agencies to do, further those bond pools are so large and deep it would cause massive impacts to the Fed's monetary goals and ability to implement monetary policy.
... but that said, the Treasury can't spend money that isn't appropriated by Congress, so there is always some possibility of political risks that despite prior statements and actions of Congress, they get deadlocked into a stalemate of not being able to spend. It's generally assumed Congress wouldn't let that happen though, as a default would be a death-knell, and even outside of Congress, the Fed has some interesting tools and abilities to act in certain ways outside of political actions to come to the aid of the dollar.
Despite many "Agency" bonds having the lack for credit risk that is similar to Treasuries, their interest is often taxed at the state level whereas treasuries are state income tax free.
Many U.S. Gov "Agency" bonds also don't have credit risk, or at least they may enjoy the same "Full Faith and Credit of U.S. Government" as Treasuries, or even if the cases where they don't explicitly, there is a reasonable presumption that the agency and it's bonds are too big to fail, e.g. if Fannie/Freddie MBS were allowed to default, despite being required to explicitly state their bonds do not have "full faith and credit of Gov" it would cascade into such chaos in the mortgage market those agencies would fail and they would not be able achieve the goal Congress chartered those agencies to do, further those bond pools are so large and deep it would cause massive impacts to the Fed's monetary goals and ability to implement monetary policy.
... but that said, the Treasury can't spend money that isn't appropriated by Congress, so there is always some possibility of political risks that despite prior statements and actions of Congress, they get deadlocked into a stalemate of not being able to spend. It's generally assumed Congress wouldn't let that happen though, as a default would be a death-knell, and even outside of Congress, the Fed has some interesting tools and abilities to act in certain ways outside of political actions to come to the aid of the dollar.
Despite many "Agency" bonds having the lack for credit risk that is similar to Treasuries, their interest is often taxed at the state level whereas treasuries are state income tax free.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
Re: Bond risk nature
Annette Thau in her Bond Book goes into the nature of different kinds of bonds and their risks and I recommend it if you really want to understand them.
As others have said, credit risk is not exactly the same as equity risk.
As others have said, credit risk is not exactly the same as equity risk.
Re: Bond risk nature
Glancing at the low, flat treasury yield curve and historical low credit spreads I really don’t think that is a risk in today’s market.
Still, it is a good question to ask.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.