Swedroe: Credit Risk Isn't Worth It

May 08, 2015

From 1926 through 2014, the default premium (the annual return on long-term, investment-grade corporate bonds minus the annual return on long-term Treasurys) has been just 0.22 percent. Such a small premium has led many observers, including me, to conclude that investors willing to accept higher levels of portfolio risk in exchange for higher expected returns should seek those higher returns in places other than corporate debt.

In addition to the miniscule realized premium, another problem for holders of corporate debt is that default risk doesn’t mix well with equity risk. The risk of default has a nasty tendency to appear at just the same time the risks associated with owning equities show up.

In their paper—“Explaining the Rate Spread on Corporate Bonds,” which appeared in the February 2001 issue of The Journal of Finance—Edwin Elton, Martin Gruber, Deepak Agrawal and Christopher Mann demonstrated that a substantial portion of the credit spread is in fact attributable to factors related to the equity risk premium.

They found that expected losses account for no more than 25 percent of the corporate spread. In the case of a 10-year, A-rated corporate bond, just 18 percent of the spread was explained by default risk. They also found that the Fama-French three-factor model explains as much as 85 percent of the portion of the spread that isn’t explained by taxes and expected default loss.

Finally, they found that the lower the credit rating (and the longer the maturity), the greater the explanatory power of the model. Thus, much of the expected return to high-yield debt is explained by risk premiums associated with equities, not debt. These risks are systematic and cannot be diversified away.

Evidence Supported by Theory

The case for an equity component to higher-yield bonds, turning them into hybrid securities, is supported by financial theory.

As Martin Fridson explained in his paper, “Do High-Yield Bonds Have an Equity Component?”, which appeared in the summer 1994 issue of Financial Management: “In effect, a corporate bond is a combination of a pure interest rate instrument and a short position in a put on the issuer’s equity. The put is triggered by a decline in the value of the issuer’s assets to less than the value of its liabilities, resulting in a default—putting the equity to the bondholders. For a highly-rated company, the put is well out of the money and is not likely to be exercised. The option consequently has a negligible impact on the price movement of the bonds, which is more sensitive to interest rate fluctuations. In the case of a high-yield bond, however, default is a realistic enough prospect to enable the equity put to affect the bond’s price materially. With the equity-related option exerting a greater influence on its price movement, the high-yield bond will track government bonds (pure interest rate instruments) less closely than the investment-grade bond does.”

A New Look

Attakrit Asvanunt and Scott Richardson, authors of the March 2015 paper “Credit Risk Premium: Its Existence and Implications for Asset Allocation,” took a new and interesting look at the credit premium issue.

Their innovation was to first remove the influence of interest rates. Most past research computes the credit premium as the difference between long-term corporate bond returns and long-term government bond returns. However, this creates a problem because these two types of bonds have different exposures to interest-rate sensitivities.

The higher yields on long-term corporate debt results in shorter duration than long-term term government bonds. And given the historical term premium, matching maturities (instead of duration) will result in an understating of the credit premium. Another issue raised by the authors is that, if you only look at the safest issuers (investment-grade debt), you could underestimate the credit premium.



Find your next ETF

Reset All