Swedroe: Bonds And Premiums

Two risk premiums—term and credit—help explain the performance of bond portfolios.

Earlier this week, we examined the size and the volatility of the three equity premiums: beta, size and value. Today we’ll turn our attention to the two risk premiums that help explain the performance of bond portfolios—term and credit. Unlike with the value premium, there’s no debate about whether these two factors earn premiums based on risk. They are not anomalies created by behavioral errors.

The data covers the same 87-year period, 1927-2013, that we used in looking at the equity premiums.

Term Premium

The term premium is defined as the difference in returns between long-term government bonds (20-year) and one-month Treasury bills. For the period 1927-2013, the average annual term premium was 2.36 percent. The annual standard deviation of that premium was 9.41 percent, or 4.0 times the size of the premium itself.

The term premium was negative in 39 of the years during this period, or 45 percent of them. The largest term premium was in 2011, when it was 28.18 percent. That’s an almost three-standard-deviation event.

The most negative premium, at -14.98 percent, had occurred just two years previously in 2009. Thus, the gap between the most positive and most negative premiums was more than 43 percentage points, or more than 18 times the size of the premium itself. Clearly, there is risk in the term premium.

It’s also important to examine how term risk mixes with equity risk. Over the period, the annual correlation of the term and equity premiums was 0. That’s a positive occurrence from a portfolio diversification perspective.

Default Premium

The default premium is defined as the difference in returns between long-term corporate bonds (20-year) and long-term government bonds (20-year). For the period 1927-2013, the average annual default premium was just 0.29 percent. The annual standard deviation of that premium was 4.24 percent, or almost 15 times the size of the premium itself.

The default premium was negative in 36 of the years during this period, or 41 percent of them. In contrast, the equity premium was negative in only 28 years, or 32 percent of them.

The largest negative default premium was in 2008, when it was -13.75 percent. The largest positive default premium occurred just one year later, when it was at 19.36 percent. Thus, the gap between the largest and most negative premium was more than 33 percentage points, or about 115 times the size of the premium itself. Clearly, there’s also risk in the default premium.

As with the term premium, it’s critical to examine how the default premium mixes with equity risk. Over the period, the annual correlation of the default and equity premiums was 0.3.

While the correlation is relatively low, the risks tend to show up at the wrong time. For example, the most negative default premium (-19.36 percent) occurred in the same year (2008) when we experienced the second-worst year for returns on the S&P 500 Index (-37 percent).

The default premium has been the weakest of the five premiums we considered this week, and it’s hard to make a case that it’s been well rewarded. The beta, size, value and term factors, however, clearly have.

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