A Flight from Safety
Money managers at endowed institutions have made a massive shift in asset allocation over the last 25 years. They have moved about 20% of their portfolios from fixed income into alternative asset classes. As yields fell, investors took money from ever-less-attractive bonds and put the money into strategies that offered higher returns at similar volatility.
Figure 1: Institutional Allocation to Fixed Income and Alternatives vs. BBB Bond Yields (1993–2018)
Source: NACUBO Endowment Study & FRED
What—or who—drove this massive flight from safety, this shift from boring bonds to sexy and expensive hedge funds? The what is falling interest rates, which made bonds harder to justify for institutions trying to hit target returns and payout ratios. The who is David Swensen: Yale’s influential endowment chief’s book Pioneering Portfolio Management, originally published in 2000, savages corporate fixed-income investing in favor of alternatives. He goes as far as to exclude corporate bonds from his chapter on traditional asset classes, relegating them instead to an appendix entitled “Impure Fixed Income.”
Swensen argues that corporate debt simply isn’t worth the effort: it doesn’t provide the safety characteristics of US Treasury bonds, and it doesn’t provide the returns of equities. But corporate debt is neither meant to replace equity’s high returns and high volatility nor to replace US Treasury bonds’ safe yields and defensive characteristics. Corporate credit has an attractive risk-return profile on its own and deserves to reclaim an honorable place in investors’ asset allocations. To explain why, we address Swensen’s arguments against corporate credit.
A “Negative Skew”?
One of Swensen’s arguments against bonds is what he calls the “negative skew” of returns. “The best outcome for holding bonds to maturity consists of receiving regular payments of interest and return of principal,” he writes. “The worst outcome represents default without recovery. The asymmetry of limited upside and substantial downside produces a distribution of outcomes that contains a disadvantageous bias for investors.”
To investigate Swensen’s point, we took every stock and every corporate bond larger than $100M and looked at one-year returns from 2004 to 2018 and graphed the distribution of outcomes for stocks versus bonds to evaluate the skew of returns.
Figure 2: Returns by Percentile of Individual Stocks & Bonds (2004–2018)
Source: Capital IQ
Swensen’s point is hard to see in the above graph. The most obvious conclusion from the above chart is that stocks have a much steeper skew than bonds, with a much larger left tail of negative returns. Stocks need asymmetric upside to make up for a large negative tail, but bonds do not. This is exactly the point. Bond investors give up upside to gain positive returns most of the time. Capped upside is a feature, not a flaw. And the tradeoff works to their advantage. As we see below, bonds have had significantly higher Sharpe Ratios with much lower drawdowns than equities.
Figure 3: Risk & Return Characteristics of Stocks vs. Bonds (1996–2019)
Source: FRED
The skew of returns is an argument in favor of corporate debt, not a justification for excluding it.
“No valuable portfolio role”?
Swensen also argues that the premium corporate bonds’ earn over Treasuries is “insufficient compensation for the array of risks inherent in corporate debt” (those risks being credit risk, illiquidity, and callability).
But Swensen bases this conclusion on an estimate that corporate bonds only earn a 50bps premium over treasuries, which does not accord with the bulk of the empirical research. In a paper published a decade after Swensen’s book, AQR performed a rigorous comparison of investment-grade corporate credit to treasuries from 1936 to 2014. The study found a 1.37% credit risk premium over the full period and a 2.48% risk premium for high yield from 1988 to 2014. Long-term data from Ibbotson shows that long-term corporate bonds outperformed long-term Treasuries even in a rising rate environment, earning a 0.9% annualized premium from 1953 to 1981 during a period when 10-year rates rose from 2.6% to 13.1%. Today, BBB bonds yield 4% and BB bonds yield 4.6% in comparison with Treasuries of comparable duration that yield 2.3–2.5%, implying a 1.5–2.3% premium going forward.
Swensen’s argument does not hold. Investors clearly earn a healthy premium for bearing corporate credit risk. To see that corporate credit is an additive, diversifying return stream, we can look at the long-term data. High-yield data are only available starting in 1980, so to get a long-term view we need to use BBB corporate bond returns. Below, we compare a 60/40 portfolio of stocks and Treasuries to a portfolio of 60% stocks, 20% Treasuries, and 20% BBB corporate bonds from 1953 to 2019. We divided the sample into the period when interest rates were rising (1953–1981) and when interest rates were falling (1982–2019) to ensure that the findings were robust across different interest rate environments. To start, we show the performance of the baseline portfolio of 60% stocks, 40% Treasuries below.
Figure 4: Performance of the Baseline Portfolio (1953–2019)
Sources: FRED, Ken French data library. Portfolios are rebalanced monthly.
The baseline portfolio delivered a 9.3% return since 1953 with an attractive Sharpe Ratio of 0.95. As expected, this performance was lower during the period of rising interest rates and higher during the cycle of falling interest rates, as changing rates affected the bond holdings. Next, we look at the portfolio that includes BBB corporate bonds.
Figure 5: Performance of the Comparison Portfolio (1953–2019)
Sources: FRED, Ken French data library. Portfolios are rebalanced monthly.
A simple decision to add corporate bonds to the fixed-income allocation would have improved outcomes across all interest rate cycles, improving returns and Sharpe ratio even during a long cycle of rising interest rates. The portfolio with BBB corporate bonds outperformed the baseline by 26bps per year and improved the Sharpe Ratio by 0.04. For context, an investor starting with $1 million in 1953 would have $60 million of additional wealth relative to the baseline in 2019.
Poor “Alignment of Interests”?
Finally, Swensen is highly critical of bonds due to a perceived poor “alignment of interests.” In short, he believes bondholders “expose their positions to potential impairment” when “taking a seat across the table from corporate management.” We’ve written before about our skepticism about the value of having “aligned incentives” with CEOs.
Bond holders get something better than “aligned incentives”: a significant body of bankruptcy law and precedent that favor debt over equity. As Stanford Law professor George Triantis recently wrote, “absolute priority among prebankruptcy creditors is strictly enforced in the confirmation of the reorganization plan.” In good times, debt claimants generally get what they freely signed up for, and in bad times, trustees/management are compelled to favor their interests. Equity owners roll the dice on alignment in good times and are legally the red-headed stepchild in bad times.
Conclusion
Swensen’s arguments against corporate fixed-income look long on theory and short on evidence. His preferred alternative to fixed income—hedge funds—have failed to beat corporate bonds over the past decade. (This is not even to mention the lack of alignment of interests between hedge fund managers and investors, the illiquidity of many funds, and the margin call risk implied by their leveraged structures.) Since 2008, BBB bonds have outperformed hedge funds in terms of returns, Sharpe ratio, and drawdowns.
Figure 6: Performance of Hedge Funds vs. BBB Bonds (2008–2018)
Source: FRED, HFRI
Yet a stubborn problem remains: yields are near all-time lows. And since current yields are a good upper-bound on future returns, it can feel hard to get excited about investing in corporate bonds today. If interest rates follow an upward trajectory over the next few decades, that would present a headwind for bond returns going forward since bond prices are inversely related to their yield.
This explains why so many investors are flooding money into alternative asset classes and ripping money out of bonds. So what should investors do with their fixed-income allocation? Is there a way to capture the historical benefits of corporate fixed-income at an attractive yield? Or is our best answer the fool’s yield of private credit or just taking money out of fixed income and putting it into hedge funds or private equity? Next week, we will share our thoughts on how to best approach corporate fixed income.