Pioneering Portfolio Management is Yale endowment manager David Swensen's seminal work on portfolio asset allocation. One major principle of asset allocation is that every asset plays a specific role in the portfolio. Assets can pursue growth, hedge the portfolio, or reduce volatility. In the back of the book is a twenty-five-page appendix entitled "Impure Fixed Income," where Swensen argues that investors should avoid all types of bonds that are not U.S. government bonds. Fixed coupon U.S. government bonds provide steady income generation, capital preservation, and a hedge against economic downturn. In a frothy macroeconomic environment such as this one, investors should appreciate the diversifying characteristics of government bonds. However, in Swensen's own words, "investment grade corporate bonds, high yield bonds, foreign bonds, and asset-backed securities contain unattractive characteristics that argue against inclusion in well-constructed portfolios" (349). Foreign bonds contain currency exchange risk and the complexity of asset-backed securities argues for their avoidance.
This article argues that corporate bonds contain credit risk, liquidity risk, call risk, a poor risk/reward ratio, and a misalignment of interests that make them poor capital preservers and hedges. This is a novel and contrarian argument that, even if they should disagree, investors should consider when investing in fixed income.
Credit Risk and Misalignment of Interests in Corporate Bonds
A corporate bond owner pays a loan to a corporation in need of financing and accepts fixed payments plus a premium (at a lower expected return than equities due to the lower risk incurred). The main risk of corporate bonds is credit/default risk or the possibility that the corporation will not meet its debt service obligations. Corporate bond ratings range from triple-A to triple-B, with higher rated bonds containing less credit risk. High yield, or junk, bonds have a rating of double-B and below. Today, triple-A rated bonds have a yield of 4.2% while junk bonds have a yield of 6.7%. Meanwhile, with the 10-year yielding 3.13% and contracting credit conditions of rising interest rates and balance sheet normalization, corporate bond owners are taking some form of risk for a 1-3.6% yield over the risk-free rate.
Today's macroeconomic environment has record high corporate debt to GDP and near record low high yield default rates. In fact, as the chart below indicates, the normal lockstep relationship between high debt and high default rates appears to have broken down entirely. John Lonski, Chief Economist at Moody's Capital Markets Research, argues that increased globalization and exceptionally loose credit conditions since the 2008 financial crisis has led companies to borrow with little consequence. As increasing interest rates lead to high debt service payments for highly leveraged companies, expect some semblance of mean reversion to bring about a wave of high yield defaults. High-yield bonds contain speculative elements that make them more income generators than capital preservers. If an investor wants income generation, they are best off investing in equity, with a theoretically unlimited upside, than bonds, with a clearly fixed upside. More on this subject later.
(Source: Moody's Analytics)
Highly rated bonds also face a fair share of risk. Bond issuances for acquisitions, investments, or debt refinancing represent responsible use of debt. However, many companies (Apple (NASDAQ:AAPL) and Starbucks (NASDAQ:SBUX) to name a few) are issuing bonds to fund dividends and stock buybacks, further proving that corporate management's interests align much more with equity holders than bondholders. As the chart below shows, debt-financed stock buybacks have been a staple of this bull market. Using debt to purchase shares at high price/book ratios incurs more risk to the bondholder while pumping up prices for the stockholder. Unless the company is using debt responsibly and has a pristine balance sheet, investors of highly rated corporate bonds are taking unrecognized risk for a 1.07% return and are better off investing in the stock itself or a government bond if they seek adequate diversification. Additionally, companies with great credit often have nowhere else to go but down. The slide can be gradual, such as IBM's 28-year slide from triple-A to single-A in the late 1970s, or it can be rapid, such as WorldCom's three-month decline from single-A to defaulting on $23 billion worth of bonds in July 2002 (Swensen, 351).
Liquidity, Callability, and Risk/Reward
Corporate bonds trade much more infrequently than U.S. Treasuries, as corporate bondholders pursue buy and hold strategies while government bond investors value liquidity. Corporate bond owners, because they cannot trade bonds as easily, take a certain amount of liquidity risk over government bondholders. In fact, the daily turnover rate of U.S. Treasuries since 2002 has been 23.6 times greater than that of corporate bonds.
Yet, this constitutes a minor trade-off compared to call risk. Swensen describes callability as a "'heads you win, tails I lose' situation" (354). Like a call option, a callable bond means that the company has the right to buy back its bond at a set price before the maturity date. If rates decline, the company can call its bonds and refinance at lower rates, preventing corporate bondholders from benefiting from a higher coupon. If rates rise, the investor will simply hold a lower-coupon bond.
Lastly, corporate bondholders face a theoretical hurdle. Investors often claim that equities have limited downside but unlimited upside as a stock's price can't go below $0 but can double or triple in a matter of months or years. While stocks have a theoretically unlimited upside but a limited downside, corporate bonds are limited in both upside and downside. The best outcome involves regular payments of interest with a return of principal after holding the bond to maturity. Meanwhile, much like equities, the downside involves default and a loss of principal.
Swensen's argument is a salient one given today's environment. U.S. Treasuries are backed by the full faith and credit of the U.S. government. The U.S. government has monetary and fiscal policy tools to prevent it from defaulting. Corporate bonds do not have that same luxury. With corporate debt to GDP at all-time highs and interest rates rising, the additional risk incurred for a 1-3.6% return above the risk-free rate may not be worth it. If investors want growth, they should pursue equity. If they want preservation, they should pursue U.S. treasuries or cash. Investors who buy corporate bonds believing them to be adequate substitutes for U.S. Treasuries may be disappointed if and when default rates rise again.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.