Swedroe: Reconsidering Corporate Bonds

A number of articles were written at the end of 2008 noting the fact that, for the prior 40-year period, stocks had not outperformed safer bonds. For the period 1969 through 2008, the S&P 500 Index returned 9%, and so did long-term (20-year) Treasury bonds. Results for large-cap growth and small-cap growth stocks were even worse. The Fama-French large-cap growth index returned 7.8%, while the small-cap growth index returned just 5.1%.

Making matters worse, while producing the same returns as long-term Treasurys, the S&P 500 Index experienced far greater volatility. Its annual standard deviation during the period was 15.4% compared with just 10.6% for Treasurys. That equities could underperform Treasurys for 40 years surprised many people, but it really shouldn’t have. No matter how long the horizon, there must be at least some risk that stocks will underperform safer investments.

Another risk premium also failed to appear over this same 40-year period, one that has received far less—if any—attention. Specifically, there was no corporate credit risk premium. From 1969 through 2008, 20-year corporate bonds returned 8.4% a year and underperformed 20-year Treasury bonds, which had returned 9.0%.

Having no corporate credit risk premium at a time when there also was no equity risk premium shouldn’t especially have surprised investors either, because corporate bonds are really hybrid securities (a mix of the risks of stocks and Treasury bonds) that don’t have all that much unique risk in them.

However, what perhaps is more surprising is the following: For the 90-year period from 1926 through 2015, the riskier S&P 500 Index provided a significant return premium over safer long-term Treasurys, outperforming them by 4.4 percentage points a year (10.0% versus 5.6%). Over the same period, riskier long-term corporate bonds outperformed safer long-term Treasurys, but only by 0.4 percentage points (6.0% versus 5.6%).

That doesn’t seem to be much of a premium for taking the incremental risks associated with corporate bonds, especially once you consider the greater implementation costs involved with them—which we’ll cover shortly.

The Only Right Way To See Things

As I have discussed many times, investors should not consider assets in isolation. Instead, they should consider how an asset’s addition impacts their portfolio’s risk and return. The following table covers the 90-year period from 1926 through 2015, and compares the results of two 60/40 portfolios rebalanced annually. Portfolio A’s allocation is 60% to the S&P 500 Index and 40% to long-term corporate bonds. Portfolio B substitutes long-term Treasury bonds for the fixed-income allocation.

We see there was just an 8-basis-point advantage for the portfolio with corporate bonds, and that slightly higher return came with slightly more volatility. However, there are some other factors to consider that make the picture less favorable for corporate bonds.

First, the table understates the case for avoiding corporate credit risk, at least for individual investors who have access to the CD market. FDIC-insured CDs, which also have no credit risk (as long as you remain within the limits of the insurance), typically carry significantly higher yields that likely would more than wipe out the advantage in yield corporate bonds have over Treasurys.

For example, as I write this, the yield on five-year Treasurys was just 1.23%. CDs of the same maturity were available with a yield of 1.85%. That’s an improvement of 0.62 percentage points. For 10-year CDs, the gap was even greater, with 10-year Treasurys yielding 1.7% and 10-year CDs available with a yield of 2.4%, or 0.7 percentage points higher.

In addition, CDs don’t come with the call risk that corporate bonds do. (Martin Fridson’s 2008 study, “Original Issue High-Yield Bonds,” found that call risk was a negative contributor to the return on high-yield bonds.) Another benefit of CDs relative to corporate bonds is that CDs often have very low early redemption penalties, allowing investors to benefit from rising rates, which is the opposite of what happens with corporate bonds. But we are not done yet.

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 where there is a state income tax, a taxable investor would require different yields from a Treasury bond and a corporate bond of the same maturity. The corporate yield would have to be higher.

This is 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 Treasurys and investment-grade bonds widen, as shown by the widening credit default swap premium, the liquidity premium also widened. And the weaker the credit, the wider both the credit and liquidity premiums became.

This is important for investors because it shows that, just as is the case with stocks, corporate credit has significant tail risk. Note that the tail risk of corporate bonds has been well-documented in the literature, including by 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 BBB bonds saw their liquidity premium rise from 5 basis points before the financial crisis to 93 basis points during the crisis.

I would add that, due to increased capital requirements for the banking industry, which historically had supplied most of the liquidity for corporate bonds, corporate bond liquidity has diminished. As a result, liquidity risk is now higher than it has been historically.

It must also be observed that the liquidity and the 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 90 years. But the negative news doesn’t end there, as 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 do entail credit risk; thus, diversification is the prudent strategy. And that requires the use of a mutual fund. Even low-cost mutual funds and ETFs can cost 10 to 20 basis points, wiping out much of the slim premium corporate bonds have earned. Because the trading costs for corporate bonds are also higher than they are for Treasurys, the realizable premium would be even slimmer, if there was any premium remaining at all.

Summary

The Federal Reserve’s long-standing policy of zero interest rates left many investors hungry for yields, and taking incremental risks. However, the historical evidence suggests investors may be best served by excluding corporate bonds from their portfolios, instead using CDs, Treasurys and municipal bonds as appropriate (given their marginal tax rate).

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.

However, if you are going to invest in corporate bonds, the evidence suggests you should stick with only the highest-quality investment-grade bonds (their risks—not just credit, but liquidity as well—mix better with the risks of equities) and avoid bonds that are callable. And be sure that you have not only considered the default risk inherent in corporate bonds, but the liquidity risk as well.

Finally, remember these twin risks tend to show up at exactly the same time that equity risk does. While Treasurys tend to serve as a safe harbor during the storms that impact equities, corporate bonds do not. Thus, a portion of your corporate bond allocation should be considered equity risk, not bond risk. And the lower the credit rating, the higher that percentage should be. Forewarned is forearmed.

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