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June 8, 2015

Are corporate bonds worth the risk?

Investors are often overwhelmed when it comes to deciding which asset classes should be part of a long-term portfolio. Equities, bonds and property for sure – but what about sub-categories such as corporate bonds? When many 10 year government bonds barely yield more than 1%, investors eagerly eye asset-classes that offer even a small yield pick-up.

The following analysis shows that adding credit risk (i.e. corporate bonds) to a well-balanced portfolio consisting of equities and government bonds is not worth it. The risk premium for holders of corporate bonds relative to safe government bonds is much smaller than investors commonly believe.

Only 0.22% additional return historically

Data-driven research is at the heart of our process – and not the advertising of the investment industry. The historical data show there is only a tiny premium for taking credit risk: from 1926 to 2014, the incremental return of corporate bonds with an investment-grade rating over and above safe government bonds was only 0.22% p.a. Let’s be clear: an additional 0.22% return is not worth the additional risk. Whenever investors are presented with credit spreads of investment products, they will generally see a higher number but that is misleading because it needs to be adjusted by several factors, in particular the default rate. Just because the default rate is currently unusually low by historical standards, doesn’t mean it will stay like this forever. Therefore investors should not extrapolate current credit spreads into the future.

Even a 0.22% yield pick-up is an illusion

Investors will not even get the 0.22% additional return. Why? Because of the expenses of a corporate bond fund that are at least 0.2% (index funds/ETF) or 0.70% (mutual fund). When it comes to government bonds for the US or Germany, investors can own them directly without the need to buy expensive funds. There is no need to diversify because there is no credit risk – all of the risk is interest-rate risk. However, as investors move down the spectrum from safe government bonds of AAA rated issuers to investment grade corporate bonds and then to high-yield bonds, they take on risk that needs to be diversified away. As most private investors should categorically not buy individual corporte bonds, they will have to rely on funds which come with high expenses. The end result is that investors in a credit fund often receive lower returns (net of fees) and higher risk than if they were to hold government bonds directly. This just doesn’t make sense.

No diversification benefit

A corporate bond is a combination of an interest rate instrument (government bonds) and an equity instrument (shares). For investors that already hold government bonds and equities, adding corporate bonds therefore does not help to diversify risk. Worse, corporate bonds typically have the nasty tendency to show their default risk at exactly the same time when equities start falling due to a recession. For example during the financial crisis in 2008, European corporate bonds dropped by ca. 15% from January to October. While this was better than the losses in the equity market, it clearly shows that both tend to happend at the same time and the magnitude of the draw-down far outweighs the minuscule additional premium during the preceding years in our opinion.

What about high yield bonds?

High yield bonds (or junk bonds as they are sometimes called) sit between equities and investment-grade corporate bonds. They offer two potential benefits:

  • Lower interest-rate sensitivity (due to low duration and early callability by the issuer)
  • Less efficient market creates potential for active fund managers to add value by picking improving credits.

High-Yield bonds undoubtedly offer better returns over the long-term than investment-grade bonds. However, what is really the additional spread investors can expect and is it enough to compensate for taking the risk? The high-yield market has a much shorter history and index funds even less, so we will concentrate on the last 15 years when individual investors could participate in this market via ETF. Again, what do the historical data show? High Yield ETF(VWEHX) returned a respectable 6.39% p.a., however they outperformed the investment-grade bond ETF (VFICX) by only 0.05% annually and the intermediate term government bond ETF (VFITX) by just 0.58%. In our opinion, this yield pick-up is not enough to include high yield bonds in a portfolio for long-term holders.

Never say never

One of the biggest draw-backs of High-Yield bonds is also the reason why we do not categorically say that investors should never own high yield bonds. High-Yied bonds are fairly illiquid and during times of panic they can trade significantly below fair value. It is exactly in those days when investors should be looking to add High Yield bonds to their portfolio. Interestingly, while equitiy markets were very cheap during the financial crisis in 2008, high yield bonds were even cheaper and at that time, offered the best risk-return profile of any major asset class. In today’s calm water (thanks to the volatitlity being repressed by the stimulative central bank monetary policy), high-yield bonds are an unattractive investment. We would even go so far and call the European High-Yield bond market ‚expensive‘. As the following table shows, investors can at best expect 2-3% annual returns (in the most optimistic scenario). In our opinion, High-Yield bonds are trading assets, not assets for long-term holding.

High Yield ETF (1)3,65%
– annual management expense0,50%
+ lending fee0,10%
– default rate 2% with 50% recovery rate (2)1,00%
= net return after expenses2,25%

 

Summary: not worth the risk

Less is more. The same is true for portfolio construction. Many wealth advisors try to impress their clients by adding a large number of assets or funds to the portfolio even if they have only questionable diversification benefits. Over the last 20 years, a 50%/50& portfolio of equities (S&P 500) and treasuries (10y) would have delivered superior returns and lower volatility than corporate bonds.

Fewer positions also help to reduce the complexity and costs whenever the portfolio needs to be rebalanced.

In our opinion, the fixed-income side of a portfolio should be a safety net, not a place to reach for maximum yield.

A fitting conclusion is the advice from David Swensen, the highly regarded chief investment officer of the Yale endowment: the portfolio he suggests in his book includes only government bonds on the fixed-income side. Swensen argues that the marginally higher returns of investment-grade corporate bonds are not worth the added risk: „Under normal circumstances investors receive scant compensation for the disadvantageous traits of corporate debt,” he writes. Investors in high-yield bonds face an even worse risk-return trade-off.

Sources:
(1) http://www.ishares.com/de/individual/de/produkte/251843/ishares-euro-high-yield-corporate-bond-ucits-etf
(2) This is a highly optimistic assumption in any case. In the past, the average default rate in the US and EU for HY bonds was >2x bigger.

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