Can you think of anything more obvious? Here’s one: when you make a loan, it’s important to get your money back. Granted, it’s not as funny, but it’s equally true.
In the bond world, the risk of not getting your money back is called credit risk (or sometimes default risk). Credit risk and term risk (the length of your loan) are the two most important sources of risk when investing in bonds.
They can also be sources of return since investors require additional compensation when taking extra risk. Think about it, who would rather lend money to, Warren Buffet or me?
If Warren will only pay one percent in interest, you might consider loaning money to me if I am willing to pay 15 or 20 percent in interest. Depending on the potential return, there is a tipping point for the additional risk.
This plays out in the data just as you would expect. The chart below shows the risk and return characteristics for various Barclay’s indexes back to mid-1983, the inception of their High Yield index. High yield is an excellent euphemism for non-investment grade, or better yet, junk.
Over the long run, the relationship between risk and return bears out almost exactly how you might predict. Treasury bonds, which are (in theory) free from default have the lowest return and the lowest volatility.
As the credit quality decreases, the realized return and expected volatility rise. The additional return is referred to as the credit premium and is calculated by subtracting the return from credit bonds with the default-risk free Treasury equivalent.
Academics are generally interested in the credit differential between Treasury bonds and AAA-rated bonds because, in theory, they have the same creditworthiness (well, now Treasury bonds are AA by S&P, but you get the point). For this period, the ex-post premium is 0.30 percent, which is roughly in line with what longer-term academic data would suggest
I think it’s also useful to look at the entire credit market as a whole minus the Treasury market. It isn’t in my chart, but the realized return of the credit index over this period was 8.4 percent, which is right between A and BBB+ in my chart. If I subtract the return for credit from Treasury, I get a credit premium of 0.90 percent, which makes credit more interesting for investors.
Another application would be to look at the junk rate minus Treasury rates, which would have netted 1.9 percent per year in additional return.
If you look back at the chart, however, you can see that the risk-reward tradeoff substantially degrades for junk bonds compared to the other categories.
A good measure to see the risk-return relationship is the Sharpe ratio, which looks at the realized return of an asset class over the risk-free rate (one-month Treasury bills in this case) and divides that excess return over the realized volatility.
For the most part, the Sharpe Ratios are about the same until you get to junk bonds and stocks, where they fall off considerably.
Part of the reason that junk bonds are so volatile is that they are highly sensitive to changes in the economy. Investment grade bonds are too, but not nearly as much. The chart below shows the global default rate as calculated by Standard & Poor’s Global Fixed Income Research.
Keep in mind that the returns above are net of defaults. So, even though junk bonds defaulted at much higher rate than investment grade bonds, there was enough yield initially to more than compensate for the lost interest and principal.
Like junk bonds, stocks are also very sensitive to changes in the economy, so it makes sense that stocks and junk bonds are highly correlated.
The key to effective diversification is low correlation. Two asset classes that are highly correlated may offer some diversification benefits, but the lower the correlation, the more highly diversified your portfolio.
Treasury bonds are an excellent tool for diversification since they have had zero correlation with the S&P 500 over this period, and while it may not stay at zero, there is considerable evidence that correlations will be low in the future.
As the credit quality decreases, the correlation with stocks increases and jumps substantially when looking at junk bonds and stocks. Therefore, junk bonds offer the least diversification for an all stock portfolio. That said, for an all bond portfolio, junk bonds are lowly correlated with Treasury bonds (0.06), so the diversification may make sense. As always, it depends on what you are trying to accomplish.
Investing in credit can be an attractive proposition, especially when rates are low. However, since risk and return are so closely tied together, it’s important to understand that credit doesn’t represent a free lunch. While returns may be higher, volatility increases and the diversification benefits decrease.
To paraphrase Steve Martin, you might say “Credit bonds are like Treasury bonds except, you know, risky.”
About David Ott
David Ott is the Chief Investment Officer for Acropolis Investment Management, LLC., a St. Louis-based Registered Investment Advisor that he co-founded in 2002. Today, Acropolis manages more than $1 billion for private clients, institutions and retirement plans. You can subscribe to his newsletter, Dave Ott’s Due Diligence, by clicking here.