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.