Swedroe: Examining Bond Premiums

October 05, 2018

In my previous blog, we looked at the size and volatility of the three equity premiums of beta, size and value. Today we turn our attention to the two premiums that help explain the performance of bond portfolios, term and credit.

Unlike the case with the value premium, there’s no debate about these two factors being risk premiums rather than anomalies created by behavioral errors. The data covers the same 91-year period, 1927-2017, 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 years) and one-month Treasury bills. For the period 1927-2017, the average annual term premium has been 2.55%. The annual standard deviation of that premium has been 9.84%, or almost 4.0 times the size of the premium itself.

The term premium was negative 40 of the years, or 44% of the 91 years. The largest term premium was in 1982 at 29.82%, an almost-three-standard-deviation event. The most negative premium, 15.18%, occurred just two years earlier in 1980. Thus, the gap between the largest and most negative premium was more than 45%, or about 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 zero. That’s a positive from a portfolio perspective.

Default Premium      

The default premium is defined as the difference in returns between long-term corporate bonds (20 years) and long-term government bonds (20 years). For the period 1927-2017, the average annual default premium was just 0.41%. The annual standard deviation of that premium has been 4.5%, or more than 11 times the size of the premium itself.

The default premium was negative 36 of the years, or 38.5% of the 91 years. In contrast, the equity premium was only negative in 27 years, or 30% of the years. The largest negative default premium was in 2008, when it was -17.09%. The largest positive default premium occurred just one year later at 17.92%. Thus, the gap between the largest and most negative premium was more than 35%, or about 86 times the size of the premium itself. Clearly, there’s risk in the default premium.

It’s also important 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 (-17.09) occurred in the same year (2008) when we experienced the second worst year for returns on the S&P 500 Index (-37%).

The bottom line is that default premium has been the weakest of the five premiums, and it’s hard to make a case that it’s been well-rewarded, as have the factors of beta, size, value and term.

Note: Data presented in this blog is from Dimensional Fund Advisors.

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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