In addition to adding sub-AA government bonds you should consider adding a board portfolio of corporate bonds to your portfolio (see Figure E.1).
Traditionally, whenever investment books like this one have proposed investment in corporate bonds (as most do) they were referring to US-based bonds. This was because their audience was often made up of US or dollar-based investors, and besides, foreign bonds were expensive and impractical to buy. While the ease of investing in non-US bonds is rapidly improving, the US dominance is still prevalent, at least relative to the US share of world GDP, at around 20%. We saw earlier that the world equity portfolio’s largest constituent by a wide margin is also the US, and if you only add US corporate bonds you will not get the diversification benefits of international exposure. But this is not just true of US investors. Any investor that adds corporate bonds only in their home geography may have diversified asset classes, but at the same time have increased geographic concentration. Adding a broad portfolio of international corporate bonds can rectify this concentration issue.
Looking to the future, the non-US portion of world corporate debt is likely to increase further and thus augment the importance of getting both the asset class diversification of adding bonds and also the geographic diversification of adding international ones to your rational portfolio.1
When you add corporate bonds to your rational portfolio, consider Figure E.2 and make sure you diversify internationally. At this time, around 55% of the world’s corporate bonds are non-US, and like the US ones represent thousands of individual bonds of different maturities, industries, geographic areas and credit qualities. Ignoring the great diversification benefits from adding index-tracking ETFs or funds made up of these many thousand foreign bonds to your rational portfolio would be an omission.
Figure E.2 World corporate debt in $ billions
Based on data from Bank for International Settlements, end 2016, www.bis.org
Figure E.3 Placement in the capital structure
It makes sense that while there are very high-yielding bonds, in general return expectations from bonds are lower than equities. As a bond holder you are a lender – to either a corporation or government – whereas as an equity holder you are an owner. The seniority of the capital structure reflects this. In receiving the distribution of the cash flows of a company the debt holders are entitled to their interest payments before dividends are paid to equity holders. Likewise, in default, debt holders have the first claim on the assets of a company. A lower expected return is the price of this superior place in the capital structure (see Figure E.3).
Just as all the various layers of seniority in the capital structure are represented in the world corporate bond portfolio, the bonds vary significantly in maturity. And as with the case of government bonds the longer-maturity corporate bonds of similar credit quality typically yield more than their shorter-term peers.2
Compared to equity returns, figuring out historical returns for broad bond indices is not straightforward. Until fairly recently there was a dearth of investable index products available to investors who wanted bond exposure, other than perhaps that of the major country government bonds or US corporate bonds. Things are slowly getting better and the next decade will see further expansion in the amount of fixed-income products available for the retail investor.
The historical indices that do go back some time have a heavy US bias and until recently broad-based indices were hard to come by, much less ones you could actually create as a product. Table E.1 shows the performance data for some broad bond indices.
Although the time period shown in Table E.1 is far too short to make meaningful conclusions, 2008 stands out as an interesting data point. Both the US aggregate and global government bond indices had positive returns in a terrible equity market.
The outperformance of highly rated bonds in a tough market environment points to the potential advantage of adding fixed income to the rational portfolio. As equity markets collapsed, investors sought security in highly rated bonds. There was a belief that whatever happened, the bonds would be repaid at maturity, while nobody knew what would happen to equities.
Table E.1 Various bond indices performance 2002–16 (%)
The large decline in the Barclays US High Yield index in 2008 was no surprise. Companies with high-yield bonds outstanding were dependent on a benign economic environment to repay their debts. With a collapsing market and grim forecasts as a result of the crash, those future repayments were put in doubt and investors sold high-yield bonds as a result.
Generally, I would caution investors about reading too much from this short data period. There is not saying that future crises or correlations will be like those of the past. In fact, as a writer based in Europe I find it entirely conceivable that a future crisis could easily involve government credit issues with their bonds declining in value instead of being a safe asset. If so, you could easily see both equities and government and corporate bonds collapsing at the same time.
So while there is no certainty as to what might happen in a future crisis, adding other government and corporate bonds to the portfolio makes good sense. We are adding bonds from a very broad range of countries, maturities, currencies and risk levels, and with both government and corporate issuers. This kind of asset class diversification to the world equity portfolio as a return generator is likely to serve the portfolio well, with lower-risk and more diversified returns.
As we look to add corporate bonds to the portfolio, here are a few pointers:
In the chapter discussing implementation I described a couple of good alternatives to gain broad and cheap bond exposure as part of your rational portfolio (see Chapter 12).
Earlier we discussed how the equity risk premium to the minimal risk bonds is about 4–5% a year. What about risky governments and corporate bonds?
Corporate bonds rank above equities in the capital structure of firms and therefore have superior rights to cash flows or capital. It therefore seems reasonable that corporate bonds should have a lower return expectation than equities. How much lower obviously depends on the mix of corporate bonds in the index. At the time of writing, the yield to redemption for the Finra/Bloomberg US investment grade and high-yield indices were as follows:
Current yield | |
US investment grade | 3.76% |
US high yield | 6.06% |
For government bonds, we saw earlier what the yield on a 10-year bond was for various ‘risky’ countries. But as was the case with those government bonds we can’t simply deduce from the data above that high-yield bonds always will do better than investment grade ones. The high-yield bonds are likely to have a much higher default rate (just like higher-yielding government bonds will default more often), and the return net of those defaults will be lower than in the unlikely case where all the high-yielding bonds are repaid in full.
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1 We have left out the large and broad market of financial institution debt. This includes interbank debt, but also various obligations issued by financial institutions. This is less of a transparent market for the rational investor and someone with the broad exposures discussed in this book already has a lot of the same exposures via the existing bond and equity positions in their portfolio.
2 Occasionally the yield curve is inverted (long-term yields are lower than short-term ones). This is when the market is expecting the interest rate to drop in the future.
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