factors affecting corporate and government bonds

Question

If we assume that FED hikes the interest rates next time, then we will expect bond prices in general to fall, but what types of bond do you expect to be affected the most? Corporate bonds or government bonds?

Is it wrong to assume, that when the economy is going well (high PMI, high GDP growth rates and so on), then the prices/returns from High Yield bonds will be higher than investment grade bonds? and in general corporate bond return will be higher than government bonds?

Am I totally wrong? I will say that riskier bonds will perform better, when economy goes well, but worst when economy goes bad?

I hope these are not silly questions

Thanks!

Answer 1

In an improving economic environment the spread between junk and prime will tend decrease (i.e. the price difference between the two will narrow).

Intuition is a rising tide lifts all boats -- i.e. you're not so worried about that slightly spooky company anymore if there is ample economic demand.

The inverse is also true. In a deteriorating economic environment, the spread between junk and prime will generally increase (i.e. a flight to quality -- the rotation out of riskier assets). You can apply the same logic to a single sector or even bond issue.

The first part of your questions tend to relate more to bond duration.

Let's say you have two bonds and the coupon on both issues is 5%. And, conveniently, interest rates are 5%.

The first bond is has residual life of 10 years. The second, one year. All of a sudden, interest rates change to 6%.

In this case, the 10 year bond will be expected to fall more than the one year bond. Basically, you're stuck with a below market coupon for 9 extra years.

Issues tend be rather cookie cutter these days (i.e. bullets), however, there are a number of bond features (such as a put or call element) that will significantly change the performance of a bond.

You can read more about bond duration here: https://en.wikipedia.org/wiki/Bond_duration