Swedroe: Credit Risk Not Worth It

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stlutz
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Swedroe: Credit Risk Not Worth It

Post by stlutz »

Interesting article from Larry S.:

http://www.etf.com/sections/index-inves ... nopaging=1

Or to go to the underlying paper (of course from AQR):

http://papers.ssrn.com/sol3/papers.cfm? ... id=2563482
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nedsaid
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Re: Swedroe: Credit Risk Not Worth It

Post by nedsaid »

This is a very good article about bonds. The article reinforces what I have posted about several times on this forum, that is corporate bonds are more complex instruments than they appear. Coupon rate on the bond, effective yield, call dates, how high up the corporate debt structure your bonds are (who gets paid back first if the company goes bust), and credit ratings all affect the price of your bonds. A pretty good argument can be made that corporate bonds are more complex than stocks.

The article also got me thinking about a new concept. The equity premium is really a default premium if the company goes bust. Common stocks get paid last from the assets of a bankrupt company. Since corporate bonds have claim to company assets, the company may default but bondholders will likely get some of their money back. Since corporate bonds have a default risk, they capture a bit of the equity premium. Very interesting.

I also thought that Larry Swedroe's comment that good old FDIC Insured Certificates of Deposit give you an interest rate spread over treasuries was quite interesting. One could have a fixed income portfolio of treasuries and CDs with no default risk. The risk with CDs is that your bank could go belly up and that the new bank would lower your interest rate. But you have no risk of loss of principal.

Larry doesn't like high yield corporates at all. I am pretty neutral on this subject, my only exposure to such bonds are in a famous but rather quirky balanced fund that invests in high-yield debt and higher yielding stocks. So this fund does the two things Larry says not to do but the fund has a good track record. My thought is that it is okay to own high-yield debt as part of your fixed income portfolio but don't go hog wild with it.
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Re: Swedroe: Credit Risk Not Worth It

Post by magellan »

When it comes to bonds, Mr. Swedroe knows his stuff. In just a few paragraphs he gets right to the heart of the matter and enumerates clear counters to the paper's conclusion. However, despite my great respect for Larry's knowledge of the subject, I don't agree with his conclusion that credit risk is not worth it.

As I read it, Larry's counters to the study are 1) that credit risk 'shows up' at the wrong time and so it isn't a good diversifier, 2) that state and local taxes on non-treasuries aren't taken into account, and 3) that the impact of call features on risky bonds wasn't included in the analysis.

Of these three points, Larry's strongest case is probably with number 3. Determining how much of the credit risk premium might be from taking on call risk is a tough one. OTOH, call risk is clearly different from equity risk and I don't know of research proving that markets aren't efficient at pricing call risk. With that in mind, I don't see the harm in lumping it in with credit risk. Credit risk is a unique exposure you get from risky bonds and it has some call risk mixed in, which itself is a unique risk that includes its own risk premium.

The point about different taxation between treasuries and corporates at the state and local level is valid, however for individual investors using tax sheltered accounts this argument doesn't apply.

Finally, I think where I disagree most with Larry is with his idea that credit risk shows up at the wrong time. During a panic, all risky assets tend to drop together regardless of the type of risk. Sure, some portfolio assets may spike during a panic due to flight-to-safety effects, but you can't count on this and IMO you shouldn't design your portfolio around this. Who would have predicted that treasury bonds would spike while TIPS were getting slammed?

The point is, smoothing out short term impacts from panics should NOT be a goal of portfolio construction. Portfolio diversification is a mechanism that works over multiple years and decades, not months or even a year or two. Investors should pick an appropriate level of risk and diversify that risk by including portfolio assets that mix well together to meet their goals. For retirement investors, the goal is to sustain withdrawals over a period of 30 or more years. For these investors, what happens over a year or less is inconsequential (unless they panic). For 2007-2008 retirees who held steady with a diversified portfolio that included risky bonds, the risk DID NOT show up at the wrong time. They're doing just fine.
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Re: Swedroe: Credit Risk Not Worth It

Post by baw703916 »

I don't personally own corporate bonds to any significant extent. Still, I keep wondering about the following conundrum: If credit risk isn't worth it, that's equivalent to saying that the market is not giving it an adequate risk premium. So why can't an efficient market price credit risk correctly?
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Re: Swedroe: Credit Risk Not Worth It

Post by jeffyscott »

nedsaid wrote:Common stocks get paid last from the assets of a bankrupt company. Since corporate bonds have claim to company assets, the company may default but bondholders will likely get some of their money back.
Since I don't trust the corporate managers, I really prefer being a lender to being an owner (though in practice I am both). The feature that they have to pay bonds first does not applies more generally, not just in the case bankruptcy.
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Re: Swedroe: Credit Risk Not Worth It

Post by Johno »

nedsaid wrote: I also thought that Larry Swedroe's comment that good old FDIC Insured Certificates of Deposit give you an interest rate spread over treasuries was quite interesting. One could have a fixed income portfolio of treasuries and CDs with no default risk. The risk with CDs is that your bank could go belly up and that the new bank would lower your interest rate. But you have no risk of loss of principal.

Larry doesn't like high yield corporates at all. I am pretty neutral on this subject, my only exposure to such bonds are in a famous but rather quirky balanced fund that invests in high-yield debt and higher yielding stocks. So this fund does the two things Larry says not to do but the fund has a good track record. My thought is that it is okay to own high-yield debt as part of your fixed income portfolio but don't go hog wild with it.
Part of the article refers to the AQR paper which is along the lines of evidence presented in (AQR affiliated) Ilmanen's book "Expected Returns". Corporate bond *indexes* have produced little excess return over treasuries in part because while a lot of the (relatively small) spread in corporates is for taking risk not actually taking default losses, a good deal of that risk premia is then handed on to junk bond investors when investment grade bonds drop below BBB-/Baa3 and are dumped from the fund. It's pretty rare for bonds to default straight from investment grade.

That significant technicality doesn't apply to junk funds where Swedroe applies his own much less thorough and sophisticated analysis to rule out junk. Actually some levels of junk (like BB) have performed a lot better in risk/return than others like (CCC and below).

Also back to the book, some evidence has shown that *short term* investment grade credit risk is significantly better compensated than long term.

The point about CD's is true but applies just as much to CD's v treasuries, whereas here it seems to be offered as if it were just a reason not to take credit risk.

Likewise it's not useful IMO to lump call risk (though a call on corporate bond *is* a combination of credit and rate option, not just a rate option) entirely with credit risk, nor to assume the 'efficient market' is clueless how to value it. But again with (direct) CD's you get a put option (break option) which *is* manifestly mispriced, in the investor's favor (give or take marginal uncertainty of the bank's willingness to live up to the agreement).

As noted, tax effect can't be given as a general reason not to take credit risk, obviously depends on the investor's tax situation, also applies to CD's in taxable (though they are still generally superior to treasuries) and it's irrelevant to tax deferred accounts.

Personally I find IG corporate bond funds to be worthless except short term ones as way to 'park' money where the tax effects aren't particularly unfavorable, and CD's are far superior to cash treasuries in today's market unless you absolutely need instant liquidity or have an extremely high state tax rate, and in that case bank accounts (taxable or tax deferred) plus treasury futures (leveraged, in tax deferred) also beat cash treasuries: you just don't the get the put option of the CD. I agree that junk can have its place, and find Swedroe's categorical argument unconvincing there, but by same token junk bonds are among many potentially legitimate bells and whistles to a portfolio (REIT's, pursuit of various 'factors' like small etc) that aren't absolutely necessary. Eschewing them all in favor of 'keep it simple' can be a reasonable position.
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Re: Swedroe: Credit Risk Not Worth It

Post by backpacker »

baw703916 wrote:I don't personally own corporate bonds to any significant extent. Still, I keep wondering about the following conundrum: If credit risk isn't worth it, that's equivalent to saying that the market is not giving it an adequate risk premium. So why can't an efficient market price credit risk correctly?
I've wondered about this too. Here's a theory. Many investors seem to be irrationally attached to using the stock/bond split of their portfolio as the measure of its riskiness. They feel safer owning 60% stocks and 40% corporate bonds than they would feel owning 70% stocks and 30% treasuries. This despite the fact that the risk of the two portfolios is about the same. Those investors are willing to pay more (i.e. accept lower expected returns) to add risk on the bond side than on the stock side. So the price of corporate bond risk is reliably bid higher than it should be.

Our very own Jack Bogle seems to suffer from this curious illusion. He thinks that total bond has too much in government bonds, so leaves investors missing out on much-needed higher returns. But what's the big deal? If you need higher returns, sell bonds and buy stock. You'll get the same result without tilting your bond portfolio away from the market. Ah, but if adding corporate bonds feels safer to you than owning more stock, even when the total risk is the same, you'll have a preference for overweighting corporate bonds.

At the institutional level, investment policy statements often have a firm split between stocks and bonds but no such firm split between government bonds and corporate bonds. Given such constraints, the only way to increase the risk/return of the portfolio is to add risk on the bond side.
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Re: Swedroe: Credit Risk Not Worth It

Post by lack_ey »

baw703916 wrote:I don't personally own corporate bonds to any significant extent. Still, I keep wondering about the following conundrum: If credit risk isn't worth it, that's equivalent to saying that the market is not giving it an adequate risk premium. So why can't an efficient market price credit risk correctly?
Could be a fluke in the results of this particular period. Or say that the market didn't have enough information to fairly price these things over much of the period. In some sense there aren't many "independent" 20-year periods to look at between 1926 and 2014, for example, and financial theory was even weaker before then. With more data, the trend should be for the market's pricing to become better over time. Or perhaps the buyers for long-dated corporate debt are constrained in implementation and not able to take advantage of stocks or other assets, so they bid down the stuff while hunting for yield on bonds (see above post).

Or the markets aren't necessarily that efficient at everything, and/or the models for asset pricing aren't quite right. It wouldn't be the first "anomaly" (if you want to call it that) that would rub some people the wrong way.
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Re: Swedroe: Credit Risk Not Worth It

Post by stlutz »

Interesting points thus far. A few things I would add:

a) Actually the paper itself does take call risk into account in its analysis. At least for the last 30 years where it is based on real indexes that had detailed data, they were looking at the option-adjusted spread between corporates and treasuries, which does take into account call features when equalizing duration between corporates and treasuries.

In an earlier thread I looked at call risk on some individual muni bonds and concluded that the risk probably was worth it in many cases. So, don't agree with Larry that it is always bad.

b) In terms of actual fund returns, if I look at the year-by-year performance of Vanguard's Long-Term investment grade fund, I'm not seeing anything too scary in the down years:

http://finance.yahoo.com/q/pm?s=VWESX+Performance

Granted that rates were trending down during most of the history of this fund--but it certainly didn't plummet during down years in stock market.

c) One of the interesting things in the paper was that the "optimal" portfolio split between corporates, treasuries, and equities was to have the highest concentration in corporate bonds with the other two classes having lower allocations. That does suggest that it's better to approach portfolio construction from a "risk budget" perspective as opposed to simply stocks vs. bonds. All investments have their risk and the goal is to find a proper balance between them.

d) In actual practice, it doesn't seem that short-term corporate bonds provide the advantage that Ilmanen suggests they should. I've noticed that 1-3 year corporate ETFs like CSJ or SCPB tend to trail their indexes by about .2%/yr. more than their expense ratios. This doesn't happen with longer-duration corporate funds, which suggests that much of the supposed "premium" gets lost in transaction costs.

Overall thoughts:

In this discussion, I definitely tend toward the treasury side of things as I'm not seeing that corporates add anything significant to a balanced portfolio while treasury bonds do. That said, I am at least intrigued by the iShares funds that track the Barclay's "universal" indices, which include junk bonds. They don't have to worry about the move back and forth between BB and BBB, which the research seems to show would be an advantage (much in the same way that a total market stock fund is better than splitting between a Russell 1000 fund and a Russell 2000 fund). Those ETFs still trade with too-large spreads for me, however, so I'm just an interested watcher and not an investor at this point.
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Re: Swedroe: Credit Risk Not Worth It

Post by stlutz »

Or the markets aren't necessarily that efficient at everything, and/or the models for asset pricing aren't quite right. It wouldn't be the first "anomaly" (if you want to call it that) that would rub some people the wrong way.
It's always worth remembering that not all market participants experience "risk" in the same way. What might make sense for a pension fund might not make sense for my individual portfolio (for example, my future obligations are real while many institutions have future obligations that are nominal). Market pricing simply reflects the weighted average of these considerations. Because one investment in priced in such a way to be a fairly obvious choice for me does not mean that the market is "wrong" or "inefficient".
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Re: Swedroe: Credit Risk Not Worth It

Post by magellan »

backpacker wrote:I've wondered about this too. Here's a theory. Many investors seem to be irrationally attached to using the stock/bond split of their portfolio as the measure of its riskiness. They feel safer owning 60% stocks and 40% corporate bonds than they would feel owning 70% stocks and 30% treasuries. This despite the fact that the risk of the two portfolios is about the same.
I thought the point of the research paper was that the risk of those two portfolios is not the same.

The 60/40 portfolio is better diversified because it has a unique risk called credit risk that the 70/30 portfolio is missing.
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Re: Swedroe: Credit Risk Not Worth It

Post by lack_ey »

stlutz wrote:
Or the markets aren't necessarily that efficient at everything, and/or the models for asset pricing aren't quite right. It wouldn't be the first "anomaly" (if you want to call it that) that would rub some people the wrong way.
It's always worth remembering that not all market participants experience "risk" in the same way. What might make sense for a pension fund might not make sense for my individual portfolio (for example, my future obligations are real while many institutions have future obligations that are nominal). Market pricing simply reflects the weighted average of these considerations. Because one investment in priced in such a way to be a fairly obvious choice for me does not mean that the market is "wrong" or "inefficient".
Yes, we need both a model for market information and efficiency, as well as one for how securities are priced. And it seems pretty uncontroversial that the goals and risks of different market players are not all quite the same, as you point out, which should affect pricing.

Maybe another example to point to is global equities. A US investor has currency risk investing abroad. Anywhere else, you have currency risk the other way, investing in the US. Even with perfect knowledge of future return distributions and perfectly rational market participants who are all looking to allocate globally and trying to maximize risk-adjusted return in the same exact way, there are still differences in risk/return for each investor just based on where they are (which currency they use), which would be reflected in some kind of optimum equilibrium pricing between country markets.
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Re: Swedroe: Credit Risk Not Worth It

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magellan wrote:
backpacker wrote:I've wondered about this too. Here's a theory. Many investors seem to be irrationally attached to using the stock/bond split of their portfolio as the measure of its riskiness. They feel safer owning 60% stocks and 40% corporate bonds than they would feel owning 70% stocks and 30% treasuries. This despite the fact that the risk of the two portfolios is about the same.
I thought the point of the research paper was that the risk of those two portfolios is not the same.

The 60/40 portfolio is better diversified because it has a unique risk called credit risk that the 70/30 portfolio is missing.
This is what the article says:
For a long-only portfolio of treasury, equity and credit, we find that the mean-variant optimal weights to be allocated to these asset classes are 35, 17 and 48 percent, respectively, for the full sample period (193601-201412), and 73, 15 and 12 percent, respectively, for the shorter sample period (198808-201412).
I don't have an easy way to check the returns since 1936. But since 1988, Portfolio Visualizer says that a 20/80/0 portfolio had lower drawdowns and lower standard deviation than the 15/73/12 portfolio. The same is true if we look at returns since 1989. Even if adding corporates helps, it looks like it only helps if you have a very low stock allocation. And even then, there's not that much difference.

Edit: I see now that the paper uses long-treasuries instead of intermediate treasuries. Even then, it's easy to find a treasury-only portfolio that has a higher sharp ratio than the proposed portfolio.
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Re: Swedroe: Credit Risk Not Worth It

Post by Aptenodytes »

As if it weren't confusing enough to have Rick Ferri and Larry Swedroe, two people many of us look to for sage counsel, taking polar opposite views on this question, but they are both citing AQR papers as among their core references.

Ferri cites this AQR paper: Investing with Style in Corporate Bonds

Swedroe cites this AQR paper: Credit Risk Premium: Its Existence and Implications for Asset Allocation

When I read the two AQR papers side by side I see far less difference than when I read the bottom-line conclusions by Ferri and Swedroe. Swedroe is clear in his essay that he is making use of the AQR paper but bringing in several other factors, from other strands of the literature, to support his conclusion. Ferri's reasoning is almost entirely reflected in the AQR paper he cites (I believe; I'm no expert on this stuff).

When I read Ferri's and Swedroe's on this matter I find both convincing. One must choose, and I choose to hedge (half my liquid bond fraction high-yield corporate; half treasuries). Eventually I may end up replicating the Total Bond Market fund where the ultra-simplicity people have been all along.
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Re: Swedroe: Credit Risk Not Worth It

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magellan wrote: Finally, I think where I disagree most with Larry is with his idea that credit risk shows up at the wrong time. During a panic, all risky assets tend to drop together regardless of the type of risk. Sure, some portfolio assets may spike during a panic due to flight-to-safety effects, but you can't count on this and IMO you shouldn't design your portfolio around this. Who would have predicted that treasury bonds would spike while TIPS were getting slammed?

The point is, smoothing out short term impacts from panics should NOT be a goal of portfolio construction. Portfolio diversification is a mechanism that works over multiple years and decades, not months or even a year or two. Investors should pick an appropriate level of risk and diversify that risk by including portfolio assets that mix well together to meet their goals. For retirement investors, the goal is to sustain withdrawals over a period of 30 or more years. For these investors, what happens over a year or less is inconsequential (unless they panic). For 2007-2008 retirees who held steady with a diversified portfolio that included risky bonds, the risk DID NOT show up at the wrong time. They're doing just fine.
Well said.
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Re: Swedroe: Credit Risk Not Worth It

Post by mptfan »

Aptenodytes wrote: When I read Ferri's and Swedroe's on this matter I find both convincing. One must choose, and I choose to hedge (half my liquid bond fraction high-yield corporate; half treasuries). Eventually I may end up replicating the Total Bond Market fund where the ultra-simplicity people have been all along.
It is not unusual for two equally well informed experts in the same field to hold different opinions on the same subject. Sometimes there is no right or wrong, just reasonable differences of opinion. On this issue, I share Ferri's view.
Last edited by mptfan on Sat May 09, 2015 3:52 pm, edited 1 time in total.
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Re: Swedroe: Credit Risk Not Worth It

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When I read Ferri's and Swedroe's on this matter I find both convincing... Eventually I may end up replicating the Total Bond Market fund where the ultra-simplicity people have been all along.

Yup, I'm kind of in the same boat. I agree with Ferri that corporate and high-yield bonds are valid asset classes and there is no a-priori reason to assume that they are priced irrationally while every other assets class is rationally priced. A well-diversified portfolio includes lots of different types of assets, and as such, these should be included.

On the other hand, I agree with Swedroe's approach of focusing on what does well in really bad times for the stock market (e.g. 29-32, 73-74, 08), and treasuries look best in all three cases.

In the abstract, I'm most comfortable with the Swedroe approach. Yet my actual portfolio looks more Ferri-like because of the way the target retirement funds in my 401K are constructed and because holding some munis makes sense in my taxable account.

With all of the backtesting discussion, one also has to throw in the caution that the past is not always prologue. Up until ~20 years ago (i.e. the start of my investing lifetime), any backtest would show that short-term treasuries were the best types of bonds to hold in a balanced portfolio. Over the subsequent 20 years, the person who just went with the default position (total bond) would have done better.
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Re: Swedroe: Credit Risk Not Worth It

Post by heyyou »

The point is, smoothing out short term impacts from panics should NOT be a goal of portfolio construction. Portfolio diversification is a mechanism that works over multiple years and decades, not months or even a year or two. Investors should pick an appropriate level of risk and diversify that risk by including portfolio assets that mix well together to meet their goals. For retirement investors, the goal is to sustain withdrawals over a period of 30 or more years. For these investors, what happens over a year or less is inconsequential (unless they panic). For 2007-2008 retirees who held steady with a diversified portfolio that included risky bonds, the risk DID NOT show up at the wrong time.
Very well said. That is a more thorough explanation of how staying the course for decades benefits an investor, instead of just chanting the slogan at someone who is considering a somewhat speculative move soon.
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Re: Swedroe: Credit Risk Not Worth It

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stlutz wrote:It's always worth remembering that not all market participants experience "risk" in the same way. What might make sense for a pension fund might not make sense for my individual portfolio (for example, my future obligations are real while many institutions have future obligations that are nominal). Market pricing simply reflects the weighted average of these considerations. Because one investment in priced in such a way to be a fairly obvious choice for me does not mean that the market is "wrong" or "inefficient".
magellan wrote:The point is, smoothing out short term impacts from panics should NOT be a goal of portfolio construction.
Why not? During '08 it was nice to have that extra boost from Treasuries price increase to buy the fire sale in equities. It is not a matter of having the total portfolio be "smoothing out short term impacts" but to be able to take advantage of rebalancing opportunities. Sitting on your butt because your total portfolio doesn't budge when Lehman crashes may make you feel good but it doesn't aid your portfolio's performance in either the long or short run. And if Lehman never happens again in your investing lifetime so what. My house may never burn down but that doesn't mean I don't buy relatively inexpensive fire insurance. Taking a small cost for using Treasuries over corporates is good insurance against the equity bear. And if Swedroe is more right then Ferri that small cost may actually be non-existent even if you never use the insurance.
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Re: Swedroe: Credit Risk Not Worth It

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Doc wrote:During '08 it was nice to have that extra boost from Treasuries price increase to buy the fire sale in equities. It is not a matter of having the total portfolio be "smoothing out short term impacts" but to be able to take advantage of rebalancing opportunities. Sitting on your butt because your total portfolio doesn't budge when Lehman crashes may make you feel good but it doesn't aid your portfolio's performance in either the long or short run. And if Lehman never happens again in your investing lifetime so what. My house may never burn down but that doesn't mean I don't buy relatively inexpensive fire insurance. Taking a small cost for using Treasuries over corporates is good insurance against the equity bear. And if Swedroe is more right then Ferri that small cost may actually be non-existent even if you never use the insurance.
Designing your portfolio so you have enough liquidity for rebalancing makes sense. However, '08 was both unprecedented and unpredictable. Perhaps all panics are. The next panic could just as easily include a flight-to-safety away from Treasuries. My point was that you shouldn't and really can't design a portfolio to smooth out short term returns. The worst case drop during a panic mostly depends on the amount of risk in your portfolio, not the types of risk and how they interact.

IMO, selectively removing some types of risk from your portfolio isn't like insurance at all and could very well increase your risk of failure over the long run, compared to being more diversified. If the folks predicting lower equity returns going forward turn out to be right, it's possible that a few dozen extra basis points earned on IG bonds over several decades compared to treasuries+slightly more equities could mean the difference between success and failure. (an example not a prediction.)

Personally, I don't believe credit risk is the same as equity risk and I want both risks represented in my portfolio. I'd rather be more diversified than less diversified. That said, it's possible and perhaps even likely that credit risk and equity risk will perform similarly and it won't matter.
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Re: Swedroe: Credit Risk Not Worth It

Post by columbia »

I'm leaning towards moving out of TBM and into the intermediate fund with 1/2 corporates; and then add a reasonable (20% of FI perhaps) slice of short term treasuries upon retirement.
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Re: Swedroe: Credit Risk Not Worth It

Post by bayview »

heyyou wrote:
The point is, smoothing out short term impacts from panics should NOT be a goal of portfolio construction. Portfolio diversification is a mechanism that works over multiple years and decades, not months or even a year or two. Investors should pick an appropriate level of risk and diversify that risk by including portfolio assets that mix well together to meet their goals. For retirement investors, the goal is to sustain withdrawals over a period of 30 or more years. For these investors, what happens over a year or less is inconsequential (unless they panic). For 2007-2008 retirees who held steady with a diversified portfolio that included risky bonds, the risk DID NOT show up at the wrong time.
Very well said. That is a more thorough explanation of how staying the course for decades benefits an investor, instead of just chanting the slogan at someone who is considering a somewhat speculative move soon.
True for accumulators; a bit different if you're dealing with RMD's.
The continuous execution of a sound strategy gives you the benefit of the strategy. That's what it's all about. --Rick Ferri
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Re: Swedroe: Credit Risk Not Worth It

Post by magellan »

bayview wrote:True for accumulators; a bit different if you're dealing with RMD's.
IMO, thinking of diversification as an antidote for short-term volatility is a bad idea for both accumulators and retirees, including those taking RMDs.

Concerns about volatility affecting RMDs or the availability of liquidity from retirement accounts are best handled by making good asset location choices. In terms of withdrawal plan sustainability, sequence of returns risk takes at least a few years to become an issue. Market panics aren't what kills marginal withdrawal plans. It's longish periods of subpar returns lasting years if not decades.

My main point is that it's not possible to build a portfolio that reliably smooths out dips from panics, so don't try. Get the overall risk level right and then diversify the types of risks in the portfolio as best you can.
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Re: Swedroe: Credit Risk Not Worth It

Post by Doc »

magellan wrote:My main point is that it's not possible to build a portfolio that reliably smooths out dips from panics, so don't try. Get the overall risk level right and then diversify the types of risks in the portfolio as best you can.
It is actually possible to build a portfolio that reliably smooths out dips ... You just won't like the resulting income. Of course we don't know what the next crisis looks like or when it will occur or even if it will occur in our investment lifetime. But given that, do we not try and just stick our heads in the sand? If you are the type of person who thinks he will react unwisely in a panic situation then the best course of action may be to have a well diversified Three Fund Portfolio and just ignore the sand in your eyes. For one likely to panic in a crisis or lacks the knowledge and/or time to understand the nuances a simple Three Fund Portfolio may be the best course. But if you can develop a rational well thought out plan based on the data however uncertain, that we have available then a portfolio that is not only diversified but which contains components that have been shown to be uncorrelated to each other with a good though uncertain probability you would probably be better served in the long run to take that course.
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Re: Swedroe: Credit Risk Not Worth It

Post by mptfan »

magellan wrote: My main point is that it's not possible to build a portfolio that reliably smooths out dips from panics, so don't try.
I agree with most of what you said, but I think you went to far here. It is possible to build a portfolio that reliably smooths out dips from panics, how about 100% short term bond fund (VBISX)? The return would be reliably smooth, even in panics. In 2008 the return was 5.43% while the stock market was down -37%, and since inception in 1994 the average annual return is 4.49% with an estimated standard deviation of only 3.35%. I'm not suggesting that it would be wise to put all of your investments into this fund, and I agree with you that smoothing out dips from panics should not be your primary goal, but I do think it is possible.
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Taylor Larimore
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High Yield Bonds in a bear market ?

Post by Taylor Larimore »

For 2007-2008 retirees who held steady with a diversified portfolio that included risky bonds, the risk DID NOT show up at the wrong time.
Bogleheads:

Sorry, the above statement is misleading.

In 2008 Vanguard's S&P 500 Index Fund (VFIAX) plunged -37.0%. Vanguard's High-Yield Bond Fund (VWEHX) ALSO fell -21.3%. Total Bond Market (VBMFX) GAINED +5.1%.

In my opinion, bonds are for safety. Stocks are best for higher returns.

Bonds let us sleep well. Stocks let us eat well.

Best wishes.
Taylor
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Re: Swedroe: Credit Risk Not Worth It

Post by Doc »

Taylor Larimore wrote:Bonds let us sleep well. Stocks let us eat well.
Worth repeating.
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Bonds and stocks in the 30s

Post by jimkinny »

I am not much concerned about any short term volatility. Looking at graphs and seeing a bond fund's performance in 2008/2009 vs equities is not really why I have a large percentage of FI in federal gov backed accounts. I take my lesson from the 1930s.

As they say, "mistakes were made" and the 1930s could happen again.
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Re: Swedroe: Credit Risk Not Worth It

Post by Taylor Larimore »

Jim:

Thanks for the reminder. This is what happened in the bond and stock markets when I was a boy.
As you say, "the 1930s could happen again":

YEAR.....5-YR. Treas....Large Cap Stocks
1929........+3.8%..............-31.2%
1930........+6.7%..............-24.9%
1931........-2.3%..............-43.3%
1932........+8.8%...............-8.2%

Source: Outperforming the Market by John Merrill

Best wishes.
Taylor
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Re: Swedroe: Credit Risk Not Worth It

Post by Robert T »

.
FWIW - I agree with Larry (and Swenson) on this, I have not seen any convincing evidence that adding credit risk (corporate bonds) to the bond side of a 75:25 global stock (with small cap and value tilt):bond portfolio has added any value over the long-term. Most studies that show the historical value added of corporate bonds seem to: (i) only look at them in isolation (not in a portfolio context), which is only relevant if you are holding a 100 percent bond portfolio, or (ii) in context of bond heavy portfolio (as per the AQR referenced papers) - neither of which apply to me.

The paper sometimes quoted to justify inclusion of short-term credit in a portfolio is Ilmanen et al's 2004 paper on "Which risks have been rewarded?: Duration, equity market, and shorted-dated credit risk." But again this looks at bonds in isolation. And in his recent book on "Expected Returns on Major Asset Classes" he says "I have some sympathy for David Swensen's (2009) extreme view that nongovernment bonds may not deserve a strategic allocation ..", but says "...Yet, corporates certainly can be useful for tactical investments, as they were in 2003 and 2009 ...". So better for market timing than long-term strategic allocation? I'll stick to the latter.

Obviously no guarantees.

Robert
.
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Re: Swedroe: Credit Risk Not Worth It

Post by Boglenaut »

Aptenodytes wrote:As if it weren't confusing enough to have Rick Ferri and Larry Swedroe, two people many of us look to for sage counsel, taking polar opposite views on this question, but they are both citing AQR papers as among their core references.

Ferri cites this AQR paper: Investing with Style in Corporate Bonds

Swedroe cites this AQR paper: Credit Risk Premium: Its Existence and Implications for Asset Allocation
This is fantastic! I can now have strong confirmation bias for whichever mood I am in today! When I am leaning towards High Yield and corporate, I can read Rick's. If I lean toward not having it, I can read Larry's. I win either way.

Actually, I am not opposed to high yield, but I need to be able to get Admiral shares and still not have it go over a certain percentage of my portfolio. So I'll read Larry for now, and if my investment portfolio goes up, I'll read Rick's. Right now I have a corporate over-weight, but no high yield, so I guess I am in-between.
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Re: Swedroe: Credit Risk Not Worth It

Post by baw703916 »

Taylor Larimore wrote:Jim:

Thanks for the reminder. This is what happened in the bond and stock markets when I was a boy.
As you say, "the 1930s could happen again":

YEAR.....5-YR. Treas....Large Cap Stocks
1929........+3.8%..............-31.2%
1930........+6.7%..............-24.9%
1931........-2.3%..............-43.3%
1932........+8.8%...............-8.2%

Source: Outperforming the Market by John Merrill

Best wishes.
Taylor
Taylor,

Does that reference give any data on corporate bonds in 1929-32? From reading his posts over the years, it appears that Larry Swedroe's view is that TBM and Vanguard's muni funds still contain too much credit risk. While TBM did fine in 2008-09, IT Treasury did a lot better. Vanguard's commentary in the 2009 annual report for their bond funds pointed out that the Treasury component of TBM did really well, and compensated for the investment grade component, which did pretty badly.

If 1929-32 is a benchmark that we should be using for deciding which bonds to own (I pretty much agree that it is), then it's helpful to know how investment-grade did in that time period.

Thanks,
Brad
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Re: Swedroe: Credit Risk Not Worth It

Post by Dandy »

I also thought that Larry Swedroe's comment that good old FDIC Insured Certificates of Deposit give you an interest rate spread over treasuries was quite interesting.

I think some are not considering CD allocations because CDs were usually never part of the investment allocation discussion. They were the province of the people that didn't understand investing like maybe grandma.

A few months back VG was offering a 10 yr brokerage CD that was 1% higher than a 10 yr Treasury bond. There are some reasons to still want to own the Treasury Bond (liquidity for example) so it isn't necessarily a no brainer to take the CD. But--if you have a large TIRA and a large allocation to it in fixed income it was a viable option that should have been considered.

I added a bit of late dated VG Brokerage CDs when the rates were higher also some short term corporate bond funds. Not worried about selling the CDs before maturity since they are well down the list of assets to sell when taking my RMD in a few years.

Don't think the short term corporate bond funds risk/reward issue is anything like the longer term corporates.
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Re: Swedroe: Credit Risk Not Worth It

Post by magellan »

Doc wrote:
Taylor Larimore wrote:Bonds let us sleep well. Stocks let us eat well.
Worth repeating.
This gets repeated a lot, but I've never seen any research to back it up. IMO, bonds are a risk asset and their risks tends to blend well with equities in a portfolio to help investors meet their goals.

While it's essential for investors to chose an asset allocation with the right amount of risk for them, IMO believing that stocks are risky and bonds are safe is a dangerous misunderstanding of fundamental investing principles.
Bogleheads Principles wrote:For US bonds, two periods of extreme duress occurred from August 1915 to June 1920, when treasury bonds provided a -51.0% real return. Bonds recovered the loss in August 1927. Treasury bonds lost -67.0% in real value from December 1940 to September 1981. Treasuries recovered the loss in September 1991.
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Re: Swedroe: Credit Risk Not Worth It

Post by Doc »

magellan wrote:While it's essential for investors to choose an asset allocation with the right amount of risk for them, IMO believing that stocks are risky and bonds are safe is a dangerous misunderstanding of fundamental investing principles.
The problem is that a lot of Bogleheads here think that bonds means a Total Bond Market index fund. Go back to Sharpe. The riskless security is bonds - specifically 4 wk Treasury bills. Once you start adding term and credit risk to those t-bills then bonds are not "safe".

People also tend to think of bond "safety" in terms of only the bond portfolio not the portfolio as a whole as others have noted and therefore CD's become safer than nominal Treasuries in terms of not losing money. But the CD's are not as "safe" in the overall portfolio because in an equity crash the CD's price remains constant while the Treasury's price tends to increase.

Hence we wind up in a "bond thread" where you seem to have different posters talking about entirely different aspects of the question without even acknowledging the existence of the other definition of "safe".

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Re: Swedroe: Credit Risk Not Worth It

Post by Tier1Capital »

HY corporate bonds have negative returns during market meltdowns. This isn't breaking news. On a relative basis, S&P 500 was down far more than HY bonds in 2008, exactly what should be expected given the capital structure ranking of equities & corporate bonds.
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magellan
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Re: Swedroe: Credit Risk Not Worth It

Post by magellan »

Doc wrote:It is actually possible to build a portfolio that reliably smooths out dips ... You just won't like the resulting income. Of course we don't know what the next crisis looks like or when it will occur or even if it will occur in our investment lifetime. But given that, do we not try and just stick our heads in the sand? If you are the type of person who thinks he will react unwisely in a panic situation then the best course of action may be to have a well diversified Three Fund Portfolio and just ignore the sand in your eyes. For one likely to panic in a crisis or lacks the knowledge and/or time to understand the nuances a simple Three Fund Portfolio may be the best course. But if you can develop a rational well thought out plan based on the data however uncertain, that we have available then a portfolio that is not only diversified but which contains components that have been shown to be uncorrelated to each other with a good though uncertain probability you would probably be better served in the long run to take that course.
I think we're talking past each other. I agree with everything you say, except that I believe this 'smoothing out' magic from diversification happens over a period of years or decades, and not days or months.

I worry about the 'Risk shows up at the wrong time' meme because it sets an expectation that a risky but well diversified portfolio will be immune to short-term spikes, thanks to the smoothing magic of diversification. This results in investor panic when they look at their nightly quotes and see that both bonds and stocks went down. Next thing you know we're seeing lots of posts about diversification not working anymore.

The 'biggest daily drop' that an investor is likely to see is a function of how risky their portfolio is and not a function of how well diversified it is. OTOH, how reliably a portfolio can meet an investing goal over the long run is usually a function of how well diversified it is.
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Re: Swedroe: Credit Risk Not Worth It

Post by ginmqi »

Very interesting.

This confirms what I've already been suspicious of....the very "meh" status of corporate bonds. Which from the beginning I was not a real big fan of, especially after reading Swensen.

You're already taking the big risk premia in equities...and since bonds are supposed to be the balanced/"safer" bet of the portfolio...why put it into more equity-like assets like corporate bonds? Makes no sense to me. I'm gonna be even more sleeping well knowing my preference for US treasuries as the bonds to own.
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Re: Swedroe: Credit Risk Not Worth It

Post by 555 »

magellan wrote:I think we're talking past each other. I agree with everything you say, except that I believe this 'smoothing out' magic from diversification happens over a period of years or decades, and not days or months.
Could you give a more precise mathematical definition of "this 'smoothing out' magic from diversification" and explanation of how and why it "happens over a period of years or decades, and not days or months"? Otherwise, the way you have been discussing this comes across as being fluff.
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Re: Swedroe: Credit Risk Not Worth It

Post by Valuethinker »

baw703916 wrote:I don't personally own corporate bonds to any significant extent. Still, I keep wondering about the following conundrum: If credit risk isn't worth it, that's equivalent to saying that the market is not giving it an adequate risk premium. So why can't an efficient market price credit risk correctly?
There is a puzzle there to be sure. Possible explanations:

- taking into account defaults but also higher yields, risky bonds aren't actually more risky than safe bonds

- structural explanation around who owns risky bonds eg the prices are overinflated (yields are too low) due to bond fund managers chasing yield

- in the great Monte Carlo analysis that is our historic financial data, we just haven't done a run where the risky bonds outperform the safe ones. Eventually, they will
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Re: Swedroe: Credit Risk Not Worth It

Post by in_reality »

Valuethinker wrote:
baw703916 wrote:I don't personally own corporate bonds to any significant extent. Still, I keep wondering about the following conundrum: If credit risk isn't worth it, that's equivalent to saying that the market is not giving it an adequate risk premium. So why can't an efficient market price credit risk correctly?
- in the great Monte Carlo analysis that is our historic financial data, we just haven't done a run where the risky bonds outperform the safe ones. Eventually, they will
I don't own much in corporate bonds but wonder if stocks don't crash but stay flat for sometime (since valuations are high), and interest rates stay low (since the global economy isn't growing), then credit risk may be worthwhile since not much else would be earning anything.

Of course, if it's rollercoaster high and fear of death bottoms, then of course treasuries would clearly be the way to go for their ability to retain or increase value in the drops and usefulness in rebalancing.

In the end I am taking mostly term risk in longer dated CDs (which can't be broken) alongside total bond and munis because understanding corporate bonds is too complicated for me.
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Re: Swedroe: Credit Risk Not Worth It

Post by magellan »

555 wrote:Could you give a more precise mathematical definition of "this 'smoothing out' magic from diversification" and explanation of how and why it "happens over a period of years or decades, and not days or months"? Otherwise, the way you have been discussing this comes across as being fluff.
This Vanguard paper covers a lot of ground, but it roughly conveys what I'm trying to say w.r.t. diversification benefits disappearing during panics and being more reliable over longer periods.
https://personal.vanguard.com/pdf/s130.pdf
Vanguard research paper wrote: And in a flight to quality, risky assets tend to perform more similarly than differently. Figure 4 shows the observed correlations for the same assets from October 2007 through February 2009. Comparing the long-term correlations in Figure 3 to the correlations presented in Figure 4, we can see the impact of a flight to quality. Correlations to both U.S. stocks and U.S. bonds increased significantly—virtually across the board. As a result, the long-term diversifying properties at least temporarily largely disappeared.
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Re: Swedroe: Credit Risk Not Worth It

Post by backpacker »

Doc wrote: Backpacker, I'm headed to the Ozarks for three days. No showers, no toilets, no cell phones and no Bogleheads. Want to come? :D
That sounds incredible. Have fun! :beer
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Re: Swedroe: Credit Risk Not Worth It

Post by Erwin »

The above discussions do not consider the fact that in a world of absurdly low interest rates, treasuries, safe or not, may not make it for those in retirement. So, one tend to go for the second best, which is corporate bonds. Using CDs is theoretically great, but in practice a big pain, moving IRA money from your broker to different banks is not irrelevant. Brokerage CDs, the easy way, yield too little.
Erwin
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