Don't Undermine Diversification By Reaching For Yield
Investors with diversified stock-bond portfolios sometimes choose to reach for yield within their safe fixed income allocation. In practice, this often means owning investment- grade corporate bonds of lower credit quality over high-grade bonds. This behavior has been documented in bond mutual funds, particularly in periods of low interest rates.1
We will use modern portfolio theory to illustrate how this practice can be suboptimal, because it can sacrifice portfolio diversification and related total return benefits. Modern portfolio theory shows the diversification benefit of combining different assets. A portfolio’s risk is a function of the risk and correlations of its underlying assets. For each level of possible return, there is an optimal mix of assets that offers the lowest risk. Together, these portfolios comprise an efficient frontier.
Baa-rated bonds are the tier of investment-grade bonds with the lowest credit quality – the tier just above speculative-grade, high-yield bonds. A Baa-rated issuer has sufficient financial strength to meet its obligations, but adverse economic or business conditions could weaken that ability. Although the average annual credit loss rate for Baa-rated bonds has been low over history, it has increased during recessions.2 Baa-rated corporate bonds now represent 50% of the U.S. investment- grade corporate bond market.
The Bloomberg Barclays U.S. Corporate Baa bond index includes a broad universe of Baa-rated corporate bonds. With annual returns beginning in 1973, this index offers a 45-year return history that spans different interest rate, inflation and economic growth environments. The average maturity of this index has been approximately 12 years. It serves as our proxy for investment-grade bonds of lower credit quality.
In contrast to Baa-rated corporate bonds, U.S. Treasury bonds have no real default risk. The Ibbotson Associates SBBI U.S. Intermediate-Term and Long-Term Government bond indices represent the returns of five-year and 20-year Treasury bonds, respectively. We construct a blended index to represent the returns of U.S. Treasuries with an approximately 12-year average maturity by equal weighting the two Ibbotson government bond indices. This blended index serves as our proxy for high-grade bonds.
Exhibit 1 shows the historical mean returns, standard deviations (risk) and correlations to global equity of the U.S. Treasury and Baa corporate bond proxies from 1973 to 2017.3
Baa-rated corporate bonds have produced a higher return than U.S. Treasury bonds of the same average maturity. The difference in average yields over the 45-year period is even greater. This observation is consistent with a preference among some investors to reach for yield by owning lower-quality, investment- grade bonds instead of high-grade bonds in a diversified stock-bond portfolio. However, Baa-rated corporate bonds were somewhat riskier and far more highly correlated to global equity. In contrast, U.S. Treasury bonds were uncorrelated to global equity, and low correlation is the key feature of a highly diversifying asset according to modern portfolio theory.
We take the return and risk parameters in Exhibit 1 and employ mean-variance optimization from modern portfolio theory to test the benefit to a stock-bond portfolio of owning high-grade bonds (using U.S. Treasuries as a proxy) vs. investment-grade bonds of lower quality (using Baa corporates as a proxy).
Exhibit 2 shows two efficient frontiers, one composed of U.S. Treasuries (UST) and global equity and the other composed of Baa corporates (Baa) and global equity.
The efficient frontier of U.S. Treasuries and global stocks is superior to the efficient frontier of Baa corporate bonds and global stocks. For the same level of risk (standard deviation), stock-bond portfolios with U.S. Treasuries offer a higher total return than stock-bond portfolios with Baa corporate bonds – despite the fact that Baa corporate bonds had a higher return. The benefit is greatest among the lower-risk portfolios that contain a larger proportion of bonds, though the benefit exists across the entire frontier. Additionally, the frontier with U.S. Treasuries offers a broader opportunity set of risk-based portfolios to choose from, including the minimum variance (lowest risk) portfolio. The results are largely due to the higher correlation of Baa corporate bonds to global equity and the near-zero correlation between U.S. Treasuries and global equity. This suggests that when seeking higher return, it is better to select a stock-bond mix further up a more diversified efficient frontier of high-grade bonds and equity than to reach for yield from investment- grade bonds of lower quality.
These results do not mean there is no role for lower quality, investment-grade bonds alongside high-grade bonds in a diversified stock-bond portfolio. Rather, investors should be careful not to reach for yield by avoiding high-grade bonds because doing so could undermine their diversification and the related total return benefits.
The primary risk factors of term and market dominate the return and risk of multi-asset portfolios. Term represents interest rate risk while market represents equity and equity-like default risk. As independent risk premiums, term and market factors are uncorrelated and offer different return and risk profiles. We use regression to decompose Baa corporate bond returns into exposures to U.S. Treasury returns (term beta) and global equity returns (market beta). Both betas are large and statistically significant while the alpha is small and statistically insignificant, indicating that the compensated portion of Baa corporate bond returns is fully explained by exposures to term and market factors. These two factors are already present in pure form along the efficient frontier of high-grade bonds and global equity.
Diversification is not just about the number of securities or issuers in a portfolio. The Baa proxy contains far more bonds and issuers than the U.S. Treasury proxy. Diversification is also about the mix of independent risk factors in a portfolio. This same diversification benefit can extend beyond stocks and bonds to select alternative investments that offer sources of uncorrelated return.
1 See Choi and Kronlund, “Reaching for Yield in Corporate Bond Mutual Funds,” The Review of Financial Studies, 2018.
2 For example, the average annual credit loss rate for Baa-rated bonds from 1983 to 2017 was 0.1% according to Moody’s. In comparison, annual loss rates were 0.7% and 0.6% in 2008 and 2009, respectively.
3 Global equity is represented by MSCI World. Return and risk parameters are computed from annual returns.
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