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Over long periods of time, the conventional wisdom of diversifying your bond portfolio with longer-term bonds and/or lower-credit bonds (in order to get higher yields) seems silly on a risk-adjusted basis. But let me explain the logic behind this assertion.
A few assumptions
- A diversified basket of equities might earn 8% nominally (meaning before factoring loss in purchasing power to inflation).
- A diversified basket of shorter-term, investment grade bonds (BBB or higher) might earn 4% nominally.
- Longer-term and/or higher credit risk bonds (BB and below) might earn 6.5% nominally.
Let’s assume we have an investor with a 50% equity / 50% fixed income portfolio, and that the fixed income portion consists of the shorter-term and high credit quality bonds. The investor might have a long term return of 6%, which is just the weighted average of 50% equities x 8% return added to 50% fixed income x 4% return.
Someone might advise this investor that they can add high-yield fixed income to their portfolio in order to increase their return – and they might take their 50% fixed income and split it into 25% high quality fixed income and 25% high yield fixed income. Therefore instead of earning 4% on their fixed income portion they would earn 5.25% on the fixed income portion of their portfolio (50% x 4% + 50% x 6.5%). If we then re-calculate the expected long term return of this new portfolio we would get 50% x 5.25% + 50% x 8% for a total expected return of 6.63%.
An alternative to adding high-yield fixed income to increase returns would be to simply have more exposure to equities. Doing some quick math we find that a 66% exposure to equities and a 34% exposure to high quality fixed income will give us a 6.64% long term return (66% x 8% + 34% x 4%).
Adding Equity Exposure Is A Better Solution
What’s described above does not tell you much about the risk-adjusted returns, so let’s explore that some more.
First, the equity premium (return of stocks over t-bills) has been 8.25% for the US stock market between 1927 and 2005. The “maturity” factor (excess return of long term government bonds over short term government bonds) is only 2.09%, and the “default” factor (excess return of long term corporate bonds over long term government bonds) is only 0.36% for the same 78 year period. To put it another way, you have to spend much more risk (in the form of lengthening terms or decreasing quality) to eek out higher returns from fixed income investments.
Secondly, short term US fixed income has very poor correlation with the S&P500, but the correlation gets larger as the maturities of the fixed income extends.
Maturity Correlation with S&P 500
1 Month -0.08
6 Month +0.01
1 Year +0.05
5 Year +0.22
20 Year +0.30
If you have multiple asset classes (each with net positive long term return expectations), the overall risk-adjusted returns will be higher if the correlations between asset classes are lower.
Taking this all together, the risk adjusted returns will be much higher by increasing the equity exposure as opposed to trying to seek a higher return through high-yield fixed income (by extending maturities or decreasing credit quality).