Certain basic investment models are based on only two investment options: safe assets such as U.S. government bonds and risky assets such as stock market index funds. The basic idea is that you can choose the risk of your preferred portfolio by increasing or decreasing the proportion of safe assets. For example, a person who has reached retirement may decide to reduce risk by reducing the proportion of their portfolio invested in stocks.
But where do corporate bonds fit into this scenario? There are $66 trillion in corporate bonds outstanding around the world. Some of that debt is highly rated „investment grade“ bonds, which in some ways resembles government debt. In other words, it is safe, but the interest rate is low. The other part is high-yield bonds, sometimes called „junk bonds,“ which are thought to be similar to stocks in that they offer higher risk and return. (My professor used to refer to „junk bonds“ as „drugs in equity.“) How do corporate bonds fit into the financial ecosystem?
Elroy Dimson, Paul Marsh and Mike Staunton provide a long-term perspective in „Corporate Bonds and Credit Premiums.“ Published in the public section. UBS Global Investment Returns Yearbook 2024, subtitled “Using Deep History to Navigate the Future.” They begin with sarcastic comments such as: “Traditionally, bonds have been seen as boring compared to stocks.”
Ian Fleming, who plays Bond, said: „I wanted the simplest, boringest, most plain-sounding name I could find.''
But bonds involve huge amounts of money. “The value of (government) bonds around the world is about $136 trillion, while the global value is about $100 trillion.”
stock. Total debt consists of approximately USD 70 trillion of government debt and his USD 66 trillion of bonds issued by corporations. Of this, corporate bonds account for approximately $45 trillion, with the remainder being other corporate bonds. ”
This is a diagram showing the distribution of bonds around the world. The United States dominates the corporate bond market partly because of its large economy, but also because of the depth of its financial markets. Additionally, the role of corporate bonds in the U.S. economy is different than in many other countries. In a „bank-centric“ economy, companies often have very close relationships (including cross-ownership) with one or more banks and are therefore able to raise funds through those connections. . In contrast, U.S. financial markets are more likely to direct companies wishing to raise funds „to market“ and raise funds from outside investors.
What will the return on corporate bond investments be over the long run? In this chart, the light gray line represents the return on U.S. Treasury bonds, and the dark gray line represents the return on U.S. corporate bonds. The red line shows the gap between the two. In other words, how much additional return or „premium“ does an investor receive by taking on the additional risk of a corporate bond? The mean was 1.58% and the standard deviation was 0.73%. The lowest spread was 0.42% in 1965, while the highest was 4.53% in 1931. ”
Corporate bonds have higher risks, so they also have higher returns. As a result, they should outperform safe U.S. Treasuries over the long term.
One obvious risk of corporate bonds when compared to U.S. government bonds is that corporations are more likely to default than the U.S. government. Of course, a default does not mean that an investor loses 100% of his value, but he can often lose more than half. However, the proportion of total US non-financial corporate debt that has defaulted has declined over time.
Returning to the opening question, what role should corporate bonds play for investors? Are corporate bonds superfluous when you have safe assets like government bonds and risky assets like stock market index funds? The UBS authors are not offering advice on future investments. It is emphasized that there is no. It's like an investment advertisement that says, „Past performance is no guarantee of future results.“
However, they cite several studies that have looked back and calculated what the optimal portfolio would be if you had a choice between government debt, corporate bonds, and stocks. Looking back, at least an optimal long-term portfolio would have included corporate bonds. In fact, one study found that over the long term, the optimal portfolio from 1936 to 2014 would have had a higher proportion of corporate bonds than government bonds or stocks.
What about short-term profit strategies with bonds? Again, the author is careful to point out that it is easy to point to investments that would have worked in the past. However, there is no guarantee that such a strategy will continue to work in the future, especially after it has been made public. However, for the sake of completeness, the author also mentions some limited and interesting exceptions. One is a corporate bond called a „fallen angel,'' which was once highly regarded as a safe, investment-grade bond, but now its credit rating has declined and it has become a high-yield „junk bond.'' Here are the dynamics that could play out:
Most obligations to investment grade (IG) corporate bond managers require that a bond be sold within a relatively short period of time if it is downgraded from IG to HY (high yield) status (usually when a bond is downgraded to BB). is required. Such bonds are commonly referred to as „fallen angels.“quite a few
Investors seeking to sell within a limited window appears to have created price pressure, pushing prices temporarily below fair value. Historically, purchasing these fallen angels has been profitable. Ben Doll et al. (2021) analyze the fallen angel effect and report a widespread pattern of strong price reversals. Their results suggest that investors begin selling in anticipation of a downgrade before it occurs and continue selling until about three months later. The price decline has since reversed, with fallen angels outperforming by a total of 6.6% in the two years following the downgrade. The greater the initial underperformance, the higher the subsequent returns. They conclude that this is due to price pressure rather than an overreaction.
to the information implied by the downgrade.
The price trend of this „fallen angel“ has been attracting attention for several years even after it was published in the literature, but the last time I checked, it seems that it has not disappeared yet. Of course, in the future it can easily disappear.