Swedroe: Fixed Income’s Low Risk Anomaly

April 23, 2014

As you can see, despite its 0.47 percent return advantage (5.95 versus 4.48) adding default risk resulted in only a very small improvement in the portfolio’s return (just 0.10 percent). And the higher return was offset by higher portfolio volatility. The result was no improvement in risk-adjusted returns (the Sharpe ratio). It’s important to understand that the above results are the returns of indexes, not live portfolios.

With Treasury bonds, the most liquid investment in the world, trading costs are extremely low. And since there is no credit risk, you don’t need to use a mutual fund to implement the plan. Instead, you can buy individual Treasurys on your own, directly from the Treasury, saving the expense ratio of a mutual fund.

If you’re going to own corporate bonds, you should use a mutual fund to diversify the credit risks. Thus, not only will you incur the fund’s expenses, trading costs in corporate bonds are higher than for Treasurys. The bottom line is that after considering implementation costs, the returns of the portfolio with corporate bonds would have been lower than the portfolio with Treasurys, despite the higher risk.

The following example, using high-yield (junk) bonds makes an even more compelling case. For the 30-year period of 1984-2013, the Barclays U.S. High Yield Index returned 9.5 percent, outperforming five-year Treasurys’ return of 7.4 percent by 2.1 percent. The table below shows the returns and Sharpe ratio for two 60/40 portfolios.

1984-2013
Portfolio Annualized Return Annual Standard Deviation Sharpe Ratio*
Portfolio A:
60%S&P 500/40%
5-year Treasury
10.1 10.7 0.61
Portfolio B:
60%S&P 500/40%
Barclays U.S. High
Yield Bond Index
10.7 15.3 0.51

 

While the addition of high-yield bonds added to returns, the volatility of the portfolio increased far more than did the returns, resulting in a much less efficient portfolio—the Sharpe ratio of the portfolio with Treasurys is 20 percent higher than it is for the portfolio using high-yield bonds.

Over this period, the annual correlation of returns of the high-yield index to the S&P 500 was +0.6. On the other hand, the annual correlation of five-year Treasurys to the S&P 500 was -0.1. This demonstrates that not only are Treasurys better diversifiers of the risks of stocks, high-yield bonds are really hybrid securities, containing equitylike risks.

Another way to look at the issue is to consider that if you wanted to have a portfolio with higher expected returns than a 60/40 portfolio using Treasurys, the more efficient way to increase expected returns would have been to increase the equity allocation (not substitute high-yield bonds), as the table below demonstrates.

1984-2013
Portfolio Annualized Return
(%)
Annual Standard
Deviation
Sharpe Ratio*
Portfiolio A:
80%S&P 500/20%
5-year Treasury
10.7 14.0 0.54
Portfolio B:
60%S&P 500/40%
Barclays U.S. High
Yield Bond Index
10.7 15.3 0.51

*measure of risk - adjusted returns

International Evidence

The authors of the paper “Low-Risk Anomalies in Global Fixed Income: Evidence from Major Broad Markets,” examined global data to see if the same phenomena existed outside the U.S. The study covered the 16-year period 1997-2012. They found that the same low-volatility (risk) anomaly that exists in the stock market existed in the bond market. Following is a summary of their findings:

  • Portfolios with the lowest term and default risk would have delivered the largest positive alpha and highest Sharpe ratios.
  • Portfolios invested in riskier (longer-term and lower credit quality) bonds would have delivered the most negative alpha and lowest Sharpe ratios.
  • The results were extremely robust and confirmed for government bonds, quasi-government and foreign government bonds, securitized and collateralized bonds, corporate investment-grade bonds, corporate high-yield bonds, emerging market bonds and aggregates of some of these universes.
  • The robustness of the results was confirmed by using different measures of risk.

While the above study covers a relatively short period, it does provide out-of-sample evidence that the same low-risk anomaly that is well documented in stocks exists in bonds as well. This has implications for investors considering taking credit risk and/or term risk (beyond the intermediate term) in a search for yield in the low-rate regime we have been living with since 2008.


Larry Swedroe is director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.

 

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