What should and should not be included in strategic asset allocation is a hotly debated topic. But should an asset class be rejected entirely… on the grounds that it is basically a combination of two others? Quantitative researchers Laurens Swinkels, Patrick Houweling and Frederik Muskens make the case for the corporate bond.
When institutional investors perform long-term asset liability management studies, their strategic asset allocation is typically not linked to the macroeconomic cycle, asset class valuations or sentiment. In September 2017, a Norwegian sovereign wealth fund advised the country’s government to exclude corporate bonds from the fund’s strategic asset allocation.
It wasn’t because the fund’s asset allocator thought that corporate bonds – also known as credits – were too risky, underperforming or generally unpalatable. The main argument was that their returns are merely a combination of the returns on government bonds and equities, making the entire corporate bond asset class redundant. Here, we discuss why corporate bonds should be included.
Let’s start by decomposing the returns of investment grade and high yield corporate bonds into the risk-free rate, the interest rate return and the credit spread return. We can then compare the credit spread returns to the returns on government bonds and equities. The results are shown in the table below:
The risk-free rate contributes 3.00% to the average total return for the 1988-2017 sample period. For investment grade bonds, the interest rate return contributes 3.46% and the credit spread 0.61%. For high yield, the interest rate return contributes 2.66% and the credit spread 2.69%. The contribution of the interest rate component for high yield is smaller than it is for investment grade, due to the combination of the shorter interest rate duration of high yield bonds, and the structural decrease in interest rates over the sample period.
These figures suggest that the credit spread return is not sufficiently different from zero to warrant a separate allocation to credits. However, we can run another test to see what would happen if they were indeed then replaced with equities or government bonds. Here, we look at the equity premium relative to the one-month risk-free rate, shown as RMRF beta in the chart below, and the total returns of US Treasuries minus the one-month risk-free rate, known as TERM beta.
This gives a regression (R2) of 32.9% for investment grade bonds, and 48.5% for high yield bonds, meaning that two-thirds or one half of the returns for each asset class respectively cannot be attributed to dumping credits, but are due to other market factors which change. Put simply, the replication here is weak; removing corporate bonds from a portfolio and replacing them with equities and government bonds results in different month-to-month return fluctuations.
Then there are the diversification benefits to consider. A ‘market portfolio’ containing equities, government bonds and credits in varying proportions is one of the most broadly diversified. According to the Capital Asset Pricing Model, the market is the only risk factor that should price all other assets. Therefore, a fund that deviates from the market portfolio contains risk that can be diversified away, and should not therefore contain a risk premium.
The pie chart below shows that at the end of 2017, corporate bonds made up close to 20% of the invested global market portfolio, while listed equities has a weight of just over 40%. Excluding an asset class that is half the size of listed equity markets increases diversification risks relative to the market portfolio that can not necessarily be compensated for elsewhere.
There is an additional reason why allocating to corporate bonds can be beneficial for investors – the presence of factor premiums. In corporate bond markets, the evidence suggests that the factors of size, low risk, value and momentum all apply in some degree, making harvesting factor premiums possible.
The size factor is based on research that shows the stocks and bonds of smaller firms tend to outperform those of larger companies. Low-risk bonds have been proven to have better risk-adjusted returns than high-risk bonds, while value investing studies have shown that stocks and bonds that are undervalued tend to outperform the market, while overvalued securities tend to underperform. Finally, the momentum factor follows the principle that companies that have recently performed well tend to continue to perform well, and vice versa.
So, should corporate bonds remain part of strategic asset allocation? Yes. Replication with other assets – while possible – is weak, while excluding corporate bonds reduces diversification benefits that are not compensated by higher returns. And allocating to corporate bonds may harvest factor premiums that are unrelated to factor premiums in equities.
Therefore, an investor who believes that diversification is important, or that factor premiums exist, should conclude that corporate bonds should be part of a strategic asset allocation.
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