Swedroe: A Closer Look At Evaluating Risk

February 04, 2015

For example, they found that four-factor alpha decreases from 2.88 percent per month to 0.17 percent for firms with high CDS spread levels compared with firms with low CDS spread levels. And the data is statistically significant.

The authors also noted that their results were robust when splitting the full sample period (January 2001 to April 2010) into pre-crisis (January 2001 to June 2007) and crisis (July 2007 to April 2010) subsamples. They found that outcomes didn’t depend on whether they calculated equal- or value-weighted portfolio returns. Furthermore, they remained unchanged when excluding financial and utility firms.

These findings are all consistent with economic theory, which is always good to see. In addition, they demonstrate that there’s little unique risk in corporate debt because the default risk is related to, and priced in, the equities of the issuers. It’s also worth observing that equity risk is easier and less costly to diversify. And for taxable investors, the risk premium is earned in a more tax-efficient manner.

When we also consider the fact that the default premium—the return on long-term corporate bonds minus the return on long-term Treasury bonds—has been only about 0.2 percent per year, and the fact that credit and equity risk are positively related (thus, credit risk doesn’t mix well with equity risks because crashes tend to happen at the same time), then including credit risk in the bond portion of the portfolio is not an efficient way to construct it.

It’s more efficient to take the risk on the equity side.


Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.

 

 

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