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Not All Bonds are Created Equal

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KATHY JONES: The bond market has been a lot more volatile recently as interest rates have gone up, but not every area of the bond market has performed the same. Hi, I’m Kathy Jones with Bond Market Today. And joining me is my colleague, Collin Martin. Thanks for joining us, Collin.

I wanted to talk to you a little bit about some different areas of the bond market. Last time, I talked about the treasury market, and how the rise in yields, particularly bond yields, I think reflects an increased risk premium to compensate investors for the potential inflation increase down the road. But I’ve noticed that not every area of the bond market has seen an increase in the risk premium, especially corporate bonds. Can you talk about that a little bit?

COLLIN MARTIN: That’s right. We really haven’t seen a rise in the credit-risk premium. And by that, we mean relative yields or a credit spread--is what we call it--for parts of the bond market like corporate bonds or international emerging market bonds, you know, things that have additional risks, like the risk of default, relative to a high-quality treasury security. We really haven’t seen those credit spreads rise much, and, in fact, they’re very low today. They’re pretty close to both post-crisis lows for both the investment-grade market and the high-yield market, and they’re well below their long-term averages.

KATHY: So why do you suppose that is? Why aren’t investors demanding more in the way of a risk premium in those markets?

COLLIN: Well, overall, things are pretty good. Economic growth has started to show signs of life. We saw a couple quarters of 3% growth here in the U.S. We’re seeing falling default rates with the U.S. corporate bond market. The tax bill that was passed last year should generally be a good thing for corporations. It should put more cash on their balance sheets, which means there might be more cash left over to pay bond holders. And we’re starting to see better corporate earnings. So with improving corporate earnings, better cash flows, and that’s a good thing for investors and it should help keep the default rate low going forward. So, overall, we think these are good things that can help support the market, and maybe prevent prices from falling much or that credit risk premium from rising much in the near-term.

KATHY: So it sounds pretty good. What should an investor take away from this?

COLLIN: Well, what we don’t recommend right now is investors really reaching for yields if their risk tolerance can’t handle it. So even though things are pretty good in the corporate bond market, investors just really aren’t being compensated too much with that additional yield. So there’s a slim margin for error in case we do get some sort of risk--off environment, or a pickup in volatility, or steep stock declines--where we can see some underperformance with corporate bonds, especially high-yield bonds. So we wouldn’t be taking on additional risks if you really can’t handle it based on your risk tolerance.

KATHY: Okay, it sounds like diversification is the key and making sure that you know what you own and what the risk is in what you own.

COLLIN: Uh-huh.

KATHY: Thanks for joining me, Collin. And if you would like to hear more from Collin and I, you can find us on Schwab.com on the Insights & Ideas tab, or you can follow us on Twitter @SchwabResearch, or you can follow me on Twitter @KathyJones. I always tweet out links to Collin’s articles. Thanks for joining us.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author’s opinions may change, without notice, in reaction to shifting economic, market, business, and other conditions.

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Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Schwab Center for Financial Research (“SCFR”) is a division of Charles Schwab & Co., Inc.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Investing involves risk including loss of principal.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

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