Appendix E

Adding corporate bonds to the rational portfolio

Figure E.1 Add diversified corporate bonds to the portfolio

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

If history is any guide …

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.

Getting practical

As we look to add corporate bonds to the portfolio, here are a few pointers:

• Buy a broad-based corporate bond exposure, both in terms of geography and type of bond.
• Buy index-tracking products where available. You generally don’t want to pay the higher fees of active management, but in the case of adding bonds cheaply actively managed funds may be a good choice when index trackers are unavailable.
• Look for new product development. Particularly in the bond space this will be important. My prediction is that the broadly available bond offering will be much expanded in the years ahead and you will probably be able to benefit from this.

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).

Corporate bond returns also depend on credit quality

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:

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.