- Don’t be tempted by higher yields because there are more efficient ways to take on risk.
- The lower a bond’s credit rating, the higher its correlation with equities. It’s essentially equity risk in disguise.
- Higher-yielding bonds don’t make the most effective diversifiers, and they tend to make worst-case losses even worse.
Earlier this week, we looked at whether adding credit risk in the form of lower investment-grade municipal bonds was an efficient approach to improving returns. The evidence is clear that this isn't the case. In fact, taking more credit risk resulted in worse relative performance. Today, we'll apply the same approach to determine whether adding corporate credit risk, again in the form of lower investment-grade bonds, is an efficient way to improve returns.
Each of our two examples will cover the 30-year period from 1984-2013. The first example compares returns from a typical 60 percent equity and 40 percent bond portfolio using investment-grade bonds to returns from a portfolio that limits its bond holdings to Treasuries. The equity portion of the first portfolio is split 40 percent to the S&P 500 index and 20 percent to the MSCI EAFE index. The investment-grade bonds are represented by the Barclays Capital Credit index. To compensate for the lower yields on Treasury bonds, we'll shift our allocation in the second portfolio to 67 percent equity and 33 percent bonds. The equities are split 45 percent to the S&P 500 index and 22 percent to the MSCI EAFE index. The bonds are represented by the Barclays Capital Treasury Bond index.
60/40 With IG Corporates
67/33 With Treasuries
Average Monthly Return
As you can see, the returns and volatility were identical. However, the portfolio with credit risk had a 3 percent greater worst-case loss (-24.7 percent versus -21.8 percent) in 2008. As we've noted previously, including in the post from earlier this week, the size of a portfolio's worst-case loss is particularly important for investors in the withdrawal stage of their investment life cycle.
The second example uses the same analysis, but now compares a portfolio holding the even higher-yielding bonds in the Barclays Capital High Yield Corporate Bond index to our portfolio with Treasuries, again with its equity allocation shifted higher to account for lower yields. Remember that the lower a bond's credit rating, the higher its correlation with equities - it's essentially equity risk in disguise. We then compare returns from the typical 60 percent equity and 40 percent bond portfolio using high-yield corporate bonds with equities allocated 40 percent to the S&P 500 index and 20 percent to the MSCI EAFE index to returns from a portfolio with 85 percent equities and 15 percent bonds using bonds in the Barclays Capital Treasury Bond index. Equities in this case are split 57 percent to the S&P 500 index and 28 percent to the MSCI EAFE index.
60/40 With HY Corporates
85/15 With Treasuries
Average Monthly Return
Here we get similar results. The portfolio with Treasuries produced a slightly higher return (10.6 percent versus 10.5 percent) while experiencing slightly lower volatility (15.3 percent versus 15.7 percent). It also experienced a better worst-case loss (-31.2 percent versus -33.9 percent).
These examples demonstrate that while higher-yielding bonds do have a low correlation to equities, they don't really add much to a portfolio in the way of unique risk. Instead, their risk can be replicated using a combination of stocks and the highest quality bonds. The low average correlation between lower-rated bonds and stocks has a nasty tendency to dramatically increase at exactly the wrong time, such as when equity risk shows up. In other words, higher-yielding bonds don't make the most effective diversifiers. And they tend to make the worst-case losses even worse. That's why we invest only in the highest investment-grade bonds, limiting purchases to AAA/AA bonds, Treasuries, government agencies and FDIC-insured CDs.
For investors who need a higher return than such high-quality bonds provide - and who also have the ability and willingness to accept greater risk - we believe the superior strategy is to increase either a portfolio's equity allocation accordingly or increase its exposure to small and value stocks while holding the equity allocation unchanged to access the higher expected returns of these asset classes. Bottom line: Don't be tempted by higher yields because there are more efficient ways to take on risk.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.