Are Corporate Bonds a Good Investment?

At the end of 2008, there were many articles pointing out that stocks had not outperformed bonds during the past 40-year period. However, there was much less written about another missing risk premium -- the corporate risk premium.

For the period 1969-2008, the S&P 500 Index and 20-year Treasury bonds both returned 9.0 percent, with the S&P 500 experiencing far greater volatility (15.4 percent versus 10.6 percent). While the fact that stocks could underperform Treasuries for 40 years surprised many people, it really shouldn't have. The reason is that no matter how long the horizon, there must be the risk that stocks will underperform safer investments. Otherwise, there would be no risk.

However, the lack of a corporate risk premium received very little attention. Over the same period, 20-year corporate bonds returned 8.4 percent per year, underperforming the 9.0 percent returns of 20-year Treasury bonds. The fact that there was no corporate credit risk premium at a time that there was no equity risk premium really should not surprise investors because corporate bonds are really hybrid securities (a mix of stocks and Treasury bonds) that don't have all that much unique risk in them.

The more surprising finding is the following. For the period 1926-2009, the riskier S&P 500 provided a significant return premium over safer long-term Treasuries, outperforming them by 4.4 percent per year (9.8 versus 5.4). Over the same period, riskier long-term corporate bonds outperformed safer long-term Treasuries, but by just 0.4 percent -- 5.8 percent versus 5.4 percent. That doesn't seem to be much of a premium for the additional risk.

As we have discussed many times, you shouldn't consider assets in isolation. Instead, you should consider how their addition impacts your portfolio's risk and return. The following table covers the period 1926-2009, and compares the results of two 60/40 portfolios that are rebalanced annually. Portfolio A's allocation is 60 percent S&P 500/40 percent long-term corporate bonds. Portfolio B substitutes long-term Treasury bonds for the fixed income allocation.

On Friday, we'll look at some other factors that make the picture even less favorable for corporate bonds.