As investors search for yield, low risk doesn’t necessarily mean lower returns.
Modern financial theory now includes the existence of many anomalies that shouldn’t exist if investors were perfectly rational and markets were perfectly efficient.
Perhaps the most important anomaly is the persistent and pervasive momentum premium. Among the others are the low-volatility anomaly (low-volatility stocks have outperformed high-volatility stocks) and the poor performance of extreme small growth stocks, IPOs, penny stocks and stocks in bankruptcy. And while there is no debate about the equity or the small-cap premium being anomalies, there are many behavioral finance people who believe the value premium is an anomaly.
Interestingly, there hasn’t been much debate about the default and term premiums in bonds. Yet investors have historically received very little in the way of compensation for taking default risk, and not much of a premium for taking term risk once you get beyond the intermediate term.
The default premium from 1927 through 2013 has been just 0.3 percent. And while 20-year Treasurys produced higher returns than did five-year Treasurys (5.48 percent versus 5.29 percent), the longer bonds had much higher volatility (9.85 percent annual standard deviation versus 5.66).
The result is that the Sharpe ratio on five-year Treasurys was 0.33, while the Sharpe ratio on 20-year Treasurys was 0.24. It appears that just as with stocks, there is a low-volatility anomaly in bonds.
Historical Risk Premiums
From 1927 through 2013, the annual average risk premiums and annual standard deviations of those premiums have been:
- Equity Premium: 8.2 percent/20.3 percent
- Size Premium: 3.1 percent/12.7 percent
- Value Premium: 4.9 percent/12.8 percent
- Term Premium: 2.5 percent/9.4 percent
- Default Premium: 0.3 percent/4.2 percent
Not only has the default premium been negligible, its volatility has been 13 times the premium itself. In the cases of the other premiums, the ratio is in the range of about 2.5 to 4 times. In addition, while the term premium is uncorrelated with the equity premium, the default premium is correlated, with an annual correlation of 0.3 percent.
While investors have been well rewarded for taking the risks of investing in stocks in general, and specifically small stocks and value stocks, as well as for taking term risk, they have received almost no reward for accepting corporate credit risks.
While corporate bonds yields have been much higher than the 0.30 percent premium, the realized return has been very small because of defaults and the risks of bonds being called prior to maturity.
We’ll take a look at more of the historical evidence, evidence that’s likely to surprise most investors as well as provide a warning to those investors who are now stretching for yield by taking more credit or term risk.
Over the 88-year period of 1926-2013, the annualized return on long-term (20-year) Treasury bonds was 5.48 percent, and the return on long-term corporate bonds was 5.95 percent.
However, since assets shouldn’t be viewed in isolation (but in how their addition impacts the risk and return of the portfolio), we’ll see how the two investments performed within the context of a typical 60 percent stock/40 percent bond portfolio. Portfolio A holds long-term Treasury bonds and Portfolio B holds long-term corporate bonds.
60% S&P 500/ 40%