Swedroe: Are Corp Bonds Worth Risk?

November 28, 2018

 

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).

Liquidity Risk

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.

Summary

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.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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