Credit Premium: Fact(or) Fiction

Credit Premium: Fact(or) Fiction

By Jared Kizer The above title may well end up being my most significant marketing achievement. Yet, it is a good descriptor of a research topic I’ve tackled, and I continue to be surprised by how little attention has been paid to whether there’s any historical justification that the credit premium — the difference in return between corporate bonds and comparable maturity government bonds — is additive to portfolios that already own stocks and government bonds. Based upon work I’ve previously done and the working paper I posted in March, I’m convinced that it isn’t, at least in the form it takes in most investment-grade corporate bond indexes and many investment-grade corporate bond funds. Here, in the spirit of AQR’s pieces on various premia, I’ll detail what I believe are some facts and fiction related to the investment-grade credit premium that investors should understand. Fiction: Early 20th century data on the credit premium is reliable and good quality. I’m as much of a fan as anyone of using the longest-run data possible for research purposes. However, a close inspection of the primary series typically used for long-run analysis of the credit premium — Ibbotson and Sinquefield’s default premium series — reveals that its early history is highly suspect. In the piece I first linked to above, I find that the series had a Sharpe Ratio in excess of 1.30 (!?!?!?) during the 1930s and that the credit premium’s annual returns exhibited positive correlation with Moody’s annual measure of corporate bond defaults. This directional correlation relationship, of course, makes no sense since one would expect to see years with larger numbers...