Legal and General
FAQsThe answer below pertains to a common question asked by advisers or investors.
A. Investors often just think of bonds as a broad asset class, and consider how much they should allocate to bonds, equities, and property. What many investors fail to realise is that the different bond asset classes can behave very differently, and often move in opposite directions - indeed, high yield bonds are actually more closely correlated to equities than to government bonds. It is very important to understand what drives bond markets - it is all about duration (or interest rate risk) and credit risk.
Interest rate risk
Interest rate risk, ie 'duration', measures a bond fund’s sensitivity to interest rates, where the longer a fund’s duration, the more sensitive it is to interest rate movements.
Credit risk
Credit risk is a measure of how certain the payment of the income stream from an asset is. The starting point for investors is to ask do you want interest rate risk, credit risk, both or maybe neither? Starting with the lowest levels of risk, we outline the main asset classes according to their level and type of risk:
• Gilts have no credit risk – they are backed by the UK government and hence effectively have no risk of default. They do, however, present duration risk, the degree depending on the duration of the relevant individual security.
• Investment grade corporate bonds have the same duration characteristics as gilts, but they also have credit risk. The degree of credit risk can vary significantly – an AAA rated corporate bond has virtually none, while a BBB rated bond that is likely to be downgraded to high yield status, for example, carries a much greater risk of default.
• High yield bonds display greater default risk than investment grade bonds. They also tend to have shorter maturities, and hence less duration, than their investment grade counterparts.
• Equities are the riskiest asset class. As undated securities, they have the greatest duration risk. They also have the highest credit risk as, if a company goes bankrupt, other creditors have prior claims on its assets and equity investors can be left with nothing.
Some assets, such as corporate bonds, allow both duration and credit views to be expressed, while others allow only one or other of the two types of views. An investor’s preference for duration and credit risk – and hence for the income streams offered by different assets – will depend on his/her outlook for interest rates and credit conditions.
