Bond Yield and Risks Triangle

There was an article on Washington Post by Robert Pozen and Theresa Hamacher about bonds:

A bond backfire after racing to buy long-term Treasuries and sell tax-exempt funds

Although I don’t agree with everything they said, especially their error about a TIPS fund in taxable accounts, on balance it’s a good article about the yield and risks relationship in bonds. I call it the bond yield and risks triangle.

In this triangle, you can’t have all three: low interest rate risk, low credit risk, and high yield. You can achieve any two but you are going to sacrifice the third. All the energy spent on figuring out what bonds to buy is basically an attempt to find a balance in this triangle.

Yield is the primary driver for bond returns. Over the long term, your investment return from bonds come from interest and interest on interest.

Interest rate risk is the risk that when interest rates go up, bond prices go down. It’s primarily driven by the bond’s remaining term to maturity. Short-term bonds have a lower interest rate risk than long-term bonds.

Credit risk is the risk that the bond issuer will not pay interest or repay the principal as promised. It’s primarily driven by the type of bonds. Treasury bonds have lower credit risk than investment-grade corporate bonds and municipal bonds, which in turn have lower credit risk than junk bonds.

If you want low interest rate risk and low credit risk, buy short-term Treasury bonds. It also means you are going to have a low yield. If interest rate doesn’t go up and corporate bonds default rate is low, you just sacrificed yield for nothing.

If you want low interest rate risk and a little higher yield, buy short-term investment grade bonds. You will have a higher credit risk. If default rate becomes high or there is flight to quality, your credit risk will come bite you.

If you want low credit risk and a slightly higher yield, buy intermediate-term or long-term Treasury bonds. You will have a higher interest rate risk then. If interest rate goes up fast, you will regret that you chased yield.

If you want even higher yield, buy intermediate-term or long-term investment grade bonds or jump into junk bonds. You will have more credit risk and more interest rate risk. If the risks don’t materialize, you win; if they do, you lose.

Pick you poison among low yield, credit risk, and interest rate risk.

My bond money is in short-term CDs, intermediate-term munis, and long-term TIPS. Each of them represents a different tradeoff in the bond yield and risk triangle.

Interest Rate Risk Credit Risk Yield
Short-term CDs Low Low Low, but higher than short-term Treasuries
Intermediate-term munis Some Some Higher (after tax) than other bonds of comparable term and credit risk
Long-term TIPS High Low Higher, with inflation protection

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Comments

  1. DN says

    I like the article. I think it would be helpful if you could explain in layman’s terms what you mean by “interest rate risk” and what is “yield” in the bond context.

    Thanks.

  2. Harry Sit says

    Thank you DN. I added three small paragraphs under the chart explaining what each end the triangle means.

  3. Tom says

    I think the thirdrisk in the following sentance should be rate:

    Interest rate risk is the risk that when interest risk goes up

    should be

    bInterest rate risk is the risk that when interest rates go up

    Tom

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