Credit Risk And Rate Risk Do Different Damage

Bonds are often treated as a single category positioned against stocks. They actually carry two separate risks, and the two behave very differently when equity markets fall.

The two risks have different sources

Interest rate risk arises from the comparison between an existing bond's fixed payments and what newly issued debt offers. It affects the price of any fixed payment stream.

Credit risk arises from the possibility that the borrower does not pay as promised, or that the market's assessment of that possibility changes.

A government obligation in its own currency is dominated by the first. A borrower with weaker finances carries both, with the second growing as credit quality declines.

They diverge in a downturn

When economic conditions deteriorate, high-quality government debt often attracts buyers, which supports its price at the moment equity holdings are falling.

Lower-quality corporate debt tends to move the other way. The conditions that hurt company earnings also raise doubts about repayment, so prices fall alongside stocks.

This is why the diversifying property attributed to bonds belongs mainly to the high-quality end. It does not automatically extend across the whole category.

Yield describes what is being taken on

A higher yield on similar maturity debt is compensation for something. Usually it is credit risk, sometimes it is illiquidity or a structural feature.

Reading yield as a simple ranking therefore misstates what is happening. The extra income is payment for a risk that shows up at particular times rather than continuously.

Spread is the term for that additional yield above comparable government debt, and its size moves with market conditions rather than staying fixed.

Funds blend the two and report both

A bond fund's materials generally publish average duration alongside a breakdown of credit quality, which are the two measures needed to see what is inside.

A fund can be short in duration and heavy in credit, or long in duration and entirely government-backed. These are very different holdings with similar labels.

Category names are unreliable here. The published characteristics describe the fund; the name describes the shelf it sits on.

What the distinction changes in an allocation

If the purpose of a bond allocation is to steady a portfolio when equities fall, the relevant risk is credit rather than duration, because credit tends to move with equities.

If the purpose is to match a future obligation, duration is the measure that matters, since the timing of payments determines how well the holding tracks that obligation.

Stating which job the allocation is doing is what makes the choice between the two decidable. The two purposes point at different holdings and cannot both be optimized at once.