I've been getting a lot of questions about investing in corporate bonds. I asked Jared Kizer, a fixed income analyst with my firm and my co-author on The Only Guide to Alternative Investments You'll Ever Need, to share his thoughts on investing in corporate bonds. Here's what he had to say.
We have long argued that corporate bonds should be a relatively small portion (perhaps as low as zero) of the fixed income portfolio, particularly lower-tier investment grade corporates (A and BBB) and especially high-yield bonds. The reasons for this are (at least) threefold. Let's explore why.
Corporate Bonds Mean Equity-Like Risk Exposure Most investors already have significant exposure to corporate credit risk in their equity portfolios. Adding corporate bonds is, in some sense, doubling up on this exposure. The end result could be that in periods when the equity market is doing poorly (such as 2008, when the S&P 500 Index lost 37 percent), your bond portfolio may be as well, especially relative to higher-quality fixed income such as Treasuries or agency bonds.
In 2008, the Barclays Capital U.S. Corporate Investment Grade Bond Index returned 19.9 percent less than a comparable portfolio of Treasury bonds. Another example, albeit less severe, is underperformance of 5.0 percent in 2000, when the S&P 500 was down 9.1 percent. If you look at the same two years for the Barclays Capital High Yield Index the underperformance relative to Treasuries was 38.3 percent in 2008 and 19.0 percent in 2000.
Returns Haven't Been Worth the Risk Investment-grade corporate bonds have outperformed Treasuries by much less than you might have guessed. For the period 1988-2010, Barclays Capital estimates that investment-grade corporate bonds outperformed Treasuries by about 0.6 percent per year. This is before accounting for any additional costs of owning corporate bonds relative to Treasuries, such as higher trading costs and higher fund expense ratios.
This is also despite the fact that investment-grade corporate bonds almost always have significantly higher yields than higher quality bonds. The problem is that a substantial portion of this initial yield advantage is lost due to defaults, call risk and downgrades. Stated differently, the yield of a diversified portfolio of corporate bonds significantly overstates the return you can expect to earn.
You Lose Asset Allocation Control Because the risk of corporate bonds contains an equity component, portfolios containing them have higher allocations to equity than it seems. If you own corporate bonds, you should treat some portion of that allocation as an allocation to equity and the balance as high-quality fixed income.
For example in 2008, you could argue that 60 percent of every dollar allocated to investment-grade corporate bonds should be treated as an allocation to equity and 40 percent as high-quality fixed income. In years such as 2004-2006, the portion allocated to equity should have been much lower, because default risk was lower during those years. So not only do you have a problem of how to allocate between equity and fixed income, but the division changes over time depending on the degree of credit risk embedded in the corporate bonds at the time.
Because the correlation of corporate bonds to equity risks changes over time, increasing when risks show up and decreasing when markets are calm, owning corporate bonds means ceding control of your allocation to the markets. Thus, you could end up taking more risk than is appropriate at the worst possible time, when the extra risk shows up.
Photo courtesy of Atli HarÃ°arson on Flickr.
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