Let's explore the basics of corporate bonds and how they introduce an extra type of risk beyond that faced by government bond investors, credit risk.

Corporate bonds are debt obligations issued by private corporations, meaning that when investors buy them, they are essentially lending money to a company.

Unlike government bonds where the risk of default is usually minimal, corporate bonds come with a unique factor.

Credit risk. This is the risk that the corporation may fail to make the required payments, which could lead to losses for investors.

As a result, corporate bonds fall under what's known as credit investments, but why would an investor choose a corporate bond knowing there's added risk? It's because of the compensation offered for taking on that risk.

The credit spread.

The credit spread is the additional yield that investors receive above the yield on any equivalent government bond.

In other words, the yield on a corporate bond has two components.

The credit risk free yield usually benchmarked against government bonds and the credit spread, which compensates investors for the added credit risk of a corporate issuer.

To illustrate this, let's break down the yield of a typical 10 year corporate bond.

Imagine the yield of a comparable 10 year government bond is 5%, which represents the credit risk free rate.

On top of this, a credit spread is added to account for the credit risk of the corporate issuer.

If the credit spread is 1%, the total yield for this corporate bond would then be 6%.

But here's where it gets interesting.

Both of these parts, the risk-free yield and the credit spread can fluctuate over time.

The credit risk-free rate may change based on shifts in economic expectations such as central bank rate adjustments or economic growth forecasts.

The credit spread can also increase or decrease, referred to as the spread widening or narrowing, depending on the perceived credit worthiness of the corporation issuing the bond.

If the market expects the company's credit risk to increase, the spread might widen to compensate for that heightened risk, which raises the bond's yield.

This brings us to the main risks that corporate bond investors face. Since Yields and bond prices move inversely, a change in yield due to either component affects the bond's price.

If the credit risk-free rate increases, the bonds yield goes up and its price goes down.

This is known as interest rate risk measured by rates duration.

If the credit spread widens because the issuer's credit risk is perceived to have increased, the bonds yield also goes up and its price declines.

This is known as credit risk with its impact quantified through credit duration.

So corporate bond investors are not only exposed to the general level of interest rates, but also to the credit quality of the specific issuer.

Together these factors make corporate bonds a unique and sometimes more volatile investment compared to government bonds rewarding investors with higher yields as compensation for these additional risks.

But why choose corporate bonds over equity if both involve taking on corporate risk? While it's true that investing in corporate bonds involves taking on credit risk, corporate bonds are generally less volatile than equities and offer a more stable income stream.

Unlike equity holders, bond holders have a fixed claim on the company's cash flows, receiving regular interest payments referred to as coupons, and they are paid before equity holders in the event of liquidation.

This higher priority in the capital structure known as seniority means bond holders are more likely to recover a portion of their investment if the company goes into liquidation, whereas equity investors may get nothing back.

Additionally, while equities offer potential for higher returns, they also come with greater risk as their value is directly tied to the company's performance and market conditions.

In contrast, corporate bonds provide a more predictable return profile, making them a more conservative choice for investors seeking income with a level of risk lower than equity investments.