Bond Fund Credit RiskJuly 23rd, 2012 by David Waring
Credit risk is the risk that the issuer of the bond will not be able to pay the interest or principal payments and you will lose some, or all of the money you have invested. Just as with interest rate risk the more credit risk you are willing to take the higher your potential returns can be, and the more volatile you can expect those returns to be. Bond funds with the least credit risk are those that invest only in US Treasuries and other debt which is backed by the US Government. In fact, US Government bonds are free of default risk all together.
What you trade for the safety of US Government bond funds is a lower yield than other types of investment grade bond funds, like a fund that invests in Investment Grade Corporate bonds. To help demonstrate this point have a look at the chart below which shows the performance of Vanguard Intermediate Treasury Fund (Ticker: VFIUX) which invests only in US Government Debt to Vanguard’s Investment Grade Intermediate Bond Fund (Ticker: VFIDX) which invests in a wide variety of Investment Grade bonds. As you can see the performance of the Treasury Fund is significantly less volatile, especially during times of economic uncertainty, like during the recent financial crisis.
The below example is true even though the Vanguard Intermediate Treasury Fund and the Vanguard Investment Grade Intermediate Bond Fund are both investment grade bond funds. This is true because within the investment grade and non investment grade bond universes, there are multiple levels of ratings and credit risk. For a full list of the various credit ratings see our table here.