Credit Risk Funds reward the investors for the extra risk they take by investing in lower-rated bonds. Because credit risk mutual funds invest in lower-rated bonds, the bond issuer pays more interest to the investor.
Understanding Credit Risk Fund
Bonds are given ratings based on the credit quality, the issuing company's financial strength, and the company's ability to pay interest and repay the principal amount. These ratings are denoted as AAA, which is the highest, then AA, A, BBB, BB, B and so forth.
Assessing Credit Risk
Credit ratings published by agencies such as Moody's, Standard and Poor's, and Fitch are meant to capture and categorize credit risk.
However, institutional investors in corporate bonds often supplement these agency ratings with their own credit analysis.
Many tools can be used to analyze and assess credit risk, but two traditional metrics are inte.
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Credit Spread: The Payoff For Assuming Credit Risk in Corporate Bonds
The payoff for assuming all these extra risks is a higher yield.
The difference between the yield on a corporate bond and a government bond is called the credit spread (sometimes just called the yield spread).
As the illustrated yield curves demonstrate, the credit spread is the difference in yield between a corporate bond and a government bond at .
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How Changes in The Credit Spread Affect The Corporate Bondholder
Predicting changes in a credit spread is difficult because it depends on both the specific corporate issuer and overall bond market conditions.
For example, a credit upgrade on a specific corporate bond, say from an S&P rating of BBB to A, will narrow the credit spread for that particular bond because the risk of default lessens.
If interest rates .
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How does credit rating affect a bond fund's volatility?
Although most bond funds diversify credit risk well enough, the weighted average credit rating of a bond fund will influence its volatility.
While lower-credit-quality bonds bring higher yields, they also bring higher volatility .
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Other Corporate Bond Risks
Investors should be aware of some other risk factors affecting corporate bonds.
Two of the most important factors are call riskand event risk.
If a corporate bond is callable, then the issuing company has the right to purchase (or pay off) the bond after a minimum time period.
If you hold a high-yielding bond and prevailing interest rates decline, .
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Review of Corporate Bond Market Yield
By yield, we mean yield to maturity, which is the total yield resulting from all coupon payments and any gains from a "built-in" price appreciation.
The current yield is the portion generated by coupon payments, which are usually paid twice a year, and it accounts for most of the yield generated by corporate bonds.
For example, if you pay $95 for a.
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Should you invest in a bond fund?
Interest rates, credit events, geopolitical risk, and liquidity issues are all of interest to investors of bond funds.
Investors should also be cognizant of the fees and potential taxable events generated by owning an actively managed bond portfolio.
Understanding the risk of a bond fund should, of course, be a high priority in your analysis.
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What are the riskiest bonds?
The riskiest bonds are known as "high yield" or "junk" bonds and have a greater probability of default.
For exposure to high-yield bonds, investors can buy FDHY, which primarily invests in non-investment grade debt.
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What is a flexible-bond fund?
Like domestic taxable-bond funds, flexible-bond funds can invest across a mix of bond types.
Unlike domestic taxable-bond funds, flexible-bond funds invest more aggressively in lower-quality bonds and/or international debt.
And nontraditional bond funds, in particular, enjoy a high degree of interest-rate flexibility and may employ shorting.
Setting aside revenue for capital expense or long-term debt
A sinking fund is a fund established by an economic entity by setting aside revenue over a period of time to fund a future capital expense, or repayment of a long-term debt.
