Swedroe: The Truth About Credit Premiums

January 04, 2016

Interest rates, which have sat at or near historical lows during the past seven years, have led many investors to seek additional yield in the form of credit risk. The recent trend, and its popularity, gives us an opportunity to determine if this risk historically has been rewarded by examining the credit risk premium in investment-grade as well as high-yield corporate bonds.

To measure the credit risk premium, my colleague Brian Haywood first looked at how investment-grade and high-yield corporate bonds have performed relative to Treasurys:

1989–2014 Investment-Grade
Credit Premium
High-Yield Credit
Average (%) 0.51 3.25
Standard Deviation (%) 6.69 17.19
Sharpe Ratio 0.08 0.19
T-Stat 0.4 1.0
Negative Years (%) 42 38

The table above shows the investment-grade credit premium and high-yield credit premium as measured by the difference in returns between the Barclays U.S. Corporate Investment Grade Index (duration of about 7.2 years), the Barclays U.S. Corporate High Yield Index (duration of about 4.2 years) and their respective Treasury counterparts.

To make sure we are measuring securities with similar duration risk, we've also used data from Barclays that computes a comparable Treasury index that closely matches the duration and convexity of each bond index. In doing so, the credit premium can be measured accurately.

Keeping durations as close as possible, we find that over the past 26 years, the investment-grade credit premium has averaged 0.51% per year, with a Sharpe ratio of only 0.08 and a t-statistic (a measure of statistical significance) of 0.4. A t-stat of 2.0 signifies statistical significance at the 5% confidence level. Thus, the investment-grade credit premium hasn't been robust.

However, this result does not consider implementation costs. Because there is no credit risk in Treasury securities, there isn't any need to diversify them. Thus, there is no need to own them through a mutual fund (with the exception of the possible benefit of convenience).

On the other hand, because of the need to diversify the credit risk inherent in corporate bonds, investors are generally better served by owning such bonds indirectly through a mutual fund (or ETF).

That involves expenses in the form of expense ratios and possibly commissions (and in the case of ETFs, bid/offer spreads will be incurred as well). It's also important to note that the investment-grade credit premium has been negative about 42% of the time.

At 3.25% per year, the high-yield credit premium might look enticing (it certainly is economically significant). But when you examine its Sharpe ratio of 0.19, it becomes much less appealing thanks to the significant increase in volatility as measured by standard deviation.

Much like the investment-grade credit premium, the t-stat for the high-yield credit premium is also statistically insignificant at 1.0. In addition, the high-yield credit premium was negative 38% of the time. Also consider that the high-yield credit premium was actually negative over the full 20-year period from 1989 through 2008.

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