By Larry Swedroe
It’s important that investors understand all risky assets can experience long periods of underperformance.
My favorite example that makes this point is that, for the 40-year period from 1969 through 2008, the S&P 500 Index returned 9%, and so did 20-year Treasury bonds. Making matters worse, while producing the same returns as long-term Treasuries, the S&P 500 experienced far greater volatility—its annual standard deviation during the period was 15.4% compared to just 10.6% for Treasuries.
That equities could underperform Treasuries for 40 years surprised many people, but it shouldn’t have. No matter how long the horizon, there must be at least some risk stocks will underperform safer investments.
Another risk premium also failed to appear over this same 40-year period, one that has received far less, if any, attention. Specifically, there was no corporate credit risk premium. From 1969 through 2008, 20-year corporate bonds returned 8.4% a year and underperformed 20-year Treasury bonds. Having no corporate credit risk premium at a time when there also was no equity risk premium shouldn’t have surprised investors, because corporate bonds are really hybrid securities (a mix of the risks of stocks and Treasury bonds) that don’t have much unique risk.
Now consider the following: For the 92-year period 1926 through 2017, the riskier S&P 500 Index provided a significant return premium over safer long-term Treasuries, outperforming them by 4.7% percentge points a year (10.2% versus 5.5%). Over the same period, riskier long-term corporate bonds also outperformed safer long-term Treasuries—6.1% versus 5.5%.
However, that’s before considering their greater implementation costs.
Only Right Way To See Things
Investors should not consider assets in isolation; they should consider how an asset’s addition impacts their portfolio’s risk and return. The following table covers the 92-year period 1926 through 2017, and compares the results of two 60/40 portfolios rebalanced annually. Portfolio A’s allocation is 60% to the S&P 500 Index and 40% to long-term Treasuries. Portfolio B substitutes long-term corporate bonds for the fixed-income allocation.
As you can see, there was just a 0.1 percentage point advantage for a portfolio with corporate bonds. That slightly higher return came with slightly more volatility, resulting in the same risk-adjusted return.
The reason most of the higher returns of corporate bonds did not show up in the portfolio returns was that long-term Treasury bonds mix better with the risks of stocks. Their annual correlation of returns to the S&P 500 was lower than for long-term corporate bonds.
There are some other factors to consider that make the picture less favorable for corporate bonds.
CDs: Higher Yields Without Credit Risk
First, the table understates the case for avoiding corporate credit risk, at least for individual investors who have access to the CD market. FDIC-insured CDs, which also have no credit risk (as long as you remain within the limits of the insurance), typically carry significantly higher yields that likely would more than wipe out the advantage in the yield corporate bonds have over Treasuries.
For example, on Nov. 13, 2018, Bloomberg data show the yield on five-year Treasuries was 3%. CDs of the same maturity were available with a yield of 3.5%. That’s an improvement that wipes out the entire difference in returns earned by corporates over Treasuries.
In addition, CDs don’t come with the call risk that corporate bonds do. (Martin Fridson and Karen Sterling’s 2007 study “Original Issue High-Yield Bonds” found that call risk was a negative contributor to the return on high-yield bonds.) Another benefit of CDs relative to corporate bonds is that CDs often have very low early redemption penalties, allowing investors to benefit from rising rates, which is the opposite of what happens with corporate bonds.
But we are not done yet.
The data we looked at so far are based on indexes, which have no costs. Implementing strategies, however, does.
With that in mind, and using data from Portfolio Visualizer, we’ll now look at more recent data using two Vanguard funds. I’ve substituted intermediate-term funds instead of longer-term funds, because Vanguard’s intermediate funds have far more assets than their long-term funds, and the data is available for a longer period.
- Vanguard Intermediate-Term Treasury Fund Investor Shares (VFITX)
- Vanguard Intermediate-Term Investment-Grade Fund Investor Shares (VFICX)
Because VFICX was launched in December 1993, we’ll look at the evidence for the 24-year period 1994-2017. Over that period, VFITX returned 5.2% per year, underperforming VFICX’s return of 5.8% per year. In addition, the volatility (annual standard deviation of returns) of the two funds was virtually identical, at 4.7%.
However, you should never look at investments in isolation, you should consider how their addition impacts the portfolio. With that in mind, let’s look at the results of portfolios using those two funds in combination with Vanguard’s 500 Index Fund Investor Shares (VFINX).
Portfolio A, with the less risky Treasury bonds, produced the same return, but did so with lower volatility and thus a higher Sharpe ratio. Perhaps most importantly, the maximum drawdown was nearly 7 percentage points higher for the portfolio with corporate bonds. Contributing to the superior performance of Portfolio A was the annual correlation of VFITX to VFINX of -0.3, while the annual correlation of VFICX to VFICX was +0.3. You could have owned CDs instead of Treasuries and earned higher returns without incurring the costs of a mutual fund.
Taxable Accounts & Taxes Matter
Interest on U.S. government obligations is exempt from state and local taxes. Interest on corporate bonds is not. Thus, if investors reside in a place that has a state income tax, a taxable investor would require a higher yield on a corporate bond to compensate for the tax cost.
That’s why part of the higher yield that investors require on corporate bonds over Treasury bonds is related to the difference in tax treatment.
The other reasons for the higher required yield are credit risk, liquidity risk and call risk (many corporate bonds provide the issuer with the ability to redeem the bond prior to maturity).
In 2008, the market taught investors that significant liquidity risk exists, even in investment-grade bonds. Not only did the spread related to credit risk between Treasuries and investment-grade bonds widen, the liquidity premium also widened. And the weaker the credit, the wider the credit and liquidity premiums became.
This is important for investors because it shows that, just as the case with stocks, corporate credit has significant tail risk.
Note that the tail risk of corporate bonds is well-documented in the literature, including in the May 2016 study “Can Higher-Order Risks Explain the Credit Spread Puzzle?” by Cedric Okou, Olfa Maalaoui Chun, Georges Dionne and Jingyuan Li. As one example, the authors cited the fact that bonds rated BBB saw their liquidity premium rise from 5 bps before the financial crisis to 93 bps during the crisis.
I would add that, due to increased capital requirements for the banking industry, which historically supplied most of the liquidity for corporate bonds, corporate bond liquidity has diminished. As a result, liquidity risk is now higher than it was historically.
It must also be observed that the liquidity and credit risks inherent in corporate bonds showed up at a time when stock prices were collapsing, demonstrating that credit/default risk and equity risk are related.
Unfortunately, it looks like investors have not been adequately compensated for taking the various risks involved with corporate bonds over the past 92 years. But the negative news doesn’t end there, because we have not yet considered the costs associated with implementing a strategy of investing in corporate bonds.
Diversification Required With Corporate Bonds
Diversification is the most basic concept of prudent investing. Because Treasury securities entail no credit risk, there is no need for diversification. As a result, investors do not need to employ a mutual fund. Instead, they can buy Treasury securities on their own—saving on mutual fund expenses.
However, corporate bonds entail credit risk; thus, diversification is the prudent strategy. That requires the use of a fund. Even low-cost mutual funds and ETFs can cost 0.10-0.20%, wiping out much of the slim premium corporate bonds have earned.
Because trading costs for corporate bonds are also higher than Treasuries, the realizable premium would be even slimmer, if there were any premium remaining at all.
The historical evidence suggests investors may be best served by excluding corporate bonds from their portfolios, instead using CDs, Treasuries and municipal bonds rated AAA/AA as appropriate.
If you need or desire a higher return from your portfolio, instead of adding credit risk, the evidence suggests you should consider taking that risk with equities—for example, increasing your exposure to small and value stocks, and today, to international developed and emerging markets, with their lower valuations; not with corporate bonds.
Finally, remember the risks inherent in corporate bonds (credit, liquidity and call) tend to show up at exactly the same time as equity risk. While Treasuries tend to serve as a safe harbor during the storms that impact equities, corporate bonds do not.
Thus, if you decide to have an allocation to corporate bonds, some portion of that exposure should be considered equity risk, not bond risk. And the lower the credit rating, the higher that percentage should be.
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