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).