Larry Swedroe: Liquidity Risk Not Worth It

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Random Walker
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Larry Swedroe: Liquidity Risk Not Worth It

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

In this essay, Larry reviews a paper that looks at liquidity risk in the corporate bond market. The conclusion is that liquidity risk is poorly compensated. This contradicts what economic theory would predict and contradicts some previous literature. For me this essay was simply a reminder to take risk on the equity side.
How the study was constructed was also a good reminder about factors in general. They isolated and evaluated the liquidity factor by Identifying multiple measures of liquidity and creating a portfolio that is long on the least liquid bonds and short on the most liquid. For people doubtful of factor investing in general, I think it is important they appreciate how factors are defined with long/short portfolios. It is this definition, excluding the overall market and isolating the factor, that can show whether a given factor is unique and independent from the market. Once isolated, one can then view return premia and correlations of the factor to other factors, including the market factor.

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Re: Larry Swedroe: Liquidity Risk Not Worth It

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Thank you Mister Dave for the link to the article.

Mister Swedroe is no longer active here, our loss.

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Re: Larry Swedroe: Liquidity Risk Not Worth It

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Larry is correct, there are large segments of the US Corporate Bond Market that are not all that liquid. Treasuries, on the other hand, trade like water. What you are getting in greater yield with the lower quality Corporates, you in part sacrifice with higher bid-ask spreads.

But let's look a real life example of the difference in returns between Treasuries and Corporates. The Vanguard Intermediate Term Treasury Admiral (VFIUX) has a 10 year growth of $10,000 of $13,687. The Vanguard Intermediate Term Investment Grade Admiral (VFIDX) consists of 68% corporates and has a 10 year growth of $10,000 of $16,065. I don't know, but to my untrained eye that is quite a difference in return. I would say in this case, the liquidity risk and additional volatility would be worth it.

I might not be the sharpest tack in the drawer but I would rather take $16,065 than $13,687. Yes, I would have taken additonal volatility risk but would only have seen it during the 2008-2009 financial crisis. VFIUX (Intermediate Treasury) was up during the crisis while VFIDX (Intermediate Investment Grade) was down. What has even weirder was that the Vanguard Intermediate Term Investment Grade Fund was below the category average for Corporate Bond Funds which had ten year growth of $10,000 of $16,856. It would appear that an investor paid a pretty high price for the relative safety and the diversification effect of US Treasuries. Both funds are Intermediate Term and Investment Grade.

This isn't just a Vanguard thing, I have seen this at other fund companies as well. To my untrained eye, investors were more than compensated for the additional risk. But again, I am just eye-balling.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

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Random Walker wrote: Fri Apr 27, 2018 9:29 am http://www.etf.com/sections/index-inves ... nopaging=1

In this essay, Larry reviews a paper that looks at liquidity risk in the corporate bond market. The conclusion is that liquidity risk is poorly compensated. This contradicts what economic theory would predict and contradicts some previous literature. For me this essay was simply a reminder to take risk on the equity side.
How the study was constructed was also a good reminder about factors in general. They isolated and evaluated the liquidity factor by Identifying multiple measures of liquidity and creating a portfolio that is long on the least liquid bonds and short on the most liquid. For people doubtful of factor investing in general, I think it is important they appreciate how factors are defined with long/short portfolios. It is this definition, excluding the overall market and isolating the factor, that can show whether a given factor is unique and independent from the market. Once isolated, one can then view return premia and correlations of the factor to other factors, including the market factor.

Dave
As always, Dave, thanks for sharing and summarizing Larry's stuff for us.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by Kevin M »

The title of this thread and the article make the point sound more general than actually made in the article. It's really more like "(il)liquidity risk not worth it in corporate bonds".

A counterexample of the general point is the yield premium we see in brokered CDs relative to Treasuries. One explanation for this is the much higher liquidity for Treasuries than for CDs. The bid/ask spread on a CD can easily be 50 bps or more, while on Treasuries it's more likely in the single-digit bps. Treasuries at Fidelity are offered in maximum quantities of 25,000 ($25,000,000 face value), while CDs are offered in maximum quantities of 250 ($250,000 face value).

Although this premium has declined a lot compared to a couple of years ago, it still exists. A new-issue 2-year CD at 2.75% provides a yield premium of about 25 basis points (bps) over a 2-year Treasury at 2.50% (and . Similarly, a new-issue 3-year CD at 2.90% provides a similar yield premium compared to 3-year Treasury at 2.64%.

And the potential yield premiums are even higher for investors investing less than $100K or so into a single issue, since you will get a somewhat lower yield for quantities smaller than 100 Treasuries at actual 2-year and 3-year maturities, and you probably can earn an extra 5-10 bps on the 2-year and 3-year CDs in the secondary market. The quotes above are from the Fidelity fixed-income yields summary page, and the Treasury yields are likely for minimum quantity of 400 and maturity as long as 1-month longer than indicated. So my yield premium probably would be closer to 30-35 bps if I bought a good secondary CD today, especially at quantity smaller than 100.

As long as you plan to hold maturity, the illiquidity premium of CDs is worth it--it certainly is to me. If you may not hold to maturity, then it may not be worth it.

And incidentally, Larry agrees with this, having long been a proponent of taking advantage of the yield premiums of CDs in preference to Treasuries. Although now he's more into alternative fixed-income investments.

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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by alpenglow »

nedsaid wrote: Fri Apr 27, 2018 12:00 pm Larry is correct, there are large segments of the US Corporate Bond Market that are not all that liquid. Treasuries, on the other hand, trade like water. What you are getting in greater yield with the lower quality Corporates, you in part sacrifice with higher bid-ask spreads.

But let's look a real life example of the difference in returns between Treasuries and Corporates. The Vanguard Intermediate Term Treasury Admiral (VFIUX) has a 10 year growth of $10,000 of $13,687. The Vanguard Intermediate Term Investment Grade Admiral (VFIDX) consists of 68% corporates and has a 10 year growth of $10,000 of $16,065. I don't know, but to my untrained eye that is quite a difference in return. I would say in this case, the liquidity risk and additional volatility would be worth it.

I might not be the sharpest tack in the drawer but I would rather take $16,065 than $13,687. Yes, I would have taken additonal volatility risk but would only have seen it during the 2008-2009 financial crisis. VFIUX (Intermediate Treasury) was up during the crisis while VFIDX (Intermediate Investment Grade) was down. What has even weirder was that the Vanguard Intermediate Term Investment Grade Fund was below the category average for Corporate Bond Funds which had ten year growth of $10,000 of $16,856. It would appear that an investor paid a pretty high price for the relative safety and the diversification effect of US Treasuries. Both funds are Intermediate Term and Investment Grade.

This isn't just a Vanguard thing, I have seen this at other fund companies as well. To my untrained eye, investors were more than compensated for the additional risk. But again, I am just eye-balling.
If Larry were here, he'd probably say, "don't confuse strategy with outcome." That being said, I also invest in Corporate bonds because I'm will to accept the risks. I often wonder if the liquidity risk is overstated. Then again, you never really know when certain risks will show up.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

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alpenglow wrote: Fri Apr 27, 2018 12:24 pm
nedsaid wrote: Fri Apr 27, 2018 12:00 pm Larry is correct, there are large segments of the US Corporate Bond Market that are not all that liquid. Treasuries, on the other hand, trade like water. What you are getting in greater yield with the lower quality Corporates, you in part sacrifice with higher bid-ask spreads.

But let's look a real life example of the difference in returns between Treasuries and Corporates. The Vanguard Intermediate Term Treasury Admiral (VFIUX) has a 10 year growth of $10,000 of $13,687. The Vanguard Intermediate Term Investment Grade Admiral (VFIDX) consists of 68% corporates and has a 10 year growth of $10,000 of $16,065. I don't know, but to my untrained eye that is quite a difference in return. I would say in this case, the liquidity risk and additional volatility would be worth it.

I might not be the sharpest tack in the drawer but I would rather take $16,065 than $13,687. Yes, I would have taken additonal volatility risk but would only have seen it during the 2008-2009 financial crisis. VFIUX (Intermediate Treasury) was up during the crisis while VFIDX (Intermediate Investment Grade) was down. What has even weirder was that the Vanguard Intermediate Term Investment Grade Fund was below the category average for Corporate Bond Funds which had ten year growth of $10,000 of $16,856. It would appear that an investor paid a pretty high price for the relative safety and the diversification effect of US Treasuries. Both funds are Intermediate Term and Investment Grade.

This isn't just a Vanguard thing, I have seen this at other fund companies as well. To my untrained eye, investors were more than compensated for the additional risk. But again, I am just eye-balling.
If Larry were here, he'd probably say, "don't confuse strategy with outcome." That being said, I also invest in Corporate bonds because I'm will to accept the risks. I often wonder if the liquidity risk is overstated. Then again, you never really know when certain risks will show up.
Well, for Corporates, the risk showed up in 2008-2009 and you can see it on the Growth of $10,000 graphs. But being investment grade, the Vanguard Intermediate Term Investment Grade Fund did rebound relatively quickly. If we had seen a depression rather than a recession in the aftermath of the crisis, the Intermediate Treasuries would definitely have fared better.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by Chip »

nedsaid wrote: Fri Apr 27, 2018 12:00 pm But let's look a real life example of the difference in returns between Treasuries and Corporates. The Vanguard Intermediate Term Treasury Admiral (VFIUX) has a 10 year growth of $10,000 of $13,687. The Vanguard Intermediate Term Investment Grade Admiral (VFIDX) consists of 68% corporates and has a 10 year growth of $10,000 of $16,065. I don't know, but to my untrained eye that is quite a difference in return. I would say in this case, the liquidity risk and additional volatility would be worth it.

I might not be the sharpest tack in the drawer but I would rather take $16,065 than $13,687.
If you believe that there is some equity risk in corporate bonds then I believe the answer to the puzzle is to buy Treasuries but raise your equity allocation a bit.

If I compare two portfolios at Portfolio Visualizer from 1/08 to 3/18, one with 100% VFIDX and the other 76% VFIUX and 24% VTSAX, I get essentially the same total return. But the second portfolio has lower volatility, a lower max drawdown and a better "worst year". Plus higher Sharpe and Sortino ratios.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by nedsaid »

I did get a message from Larry Swedroe and he did make a couple of points below. This is reposted in its entirety without editing, so this is 100% Larry.
Larry Swedroe said:
Re your statement about the liquidity risk being rewarded in your example
Don't think that is right at all despite the returns being higher. What you did not account for, which the authors did, was the incremental returns were likely compensation for the CREDIT RISK and the CALL risk embedded in the corporates that are not in Treasuries. And credit risk is highly related to equity risk and much better rewarded over the long term there. In addition, call risk has generally not been well rewarded in corporates either because it doesn't mix well with equity risk (you get called at wrong time, when rates down and equities killed like 08
Best wishes
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What I will say in response is that Vanguard is a pretty conservative Fixed Income manager. Their funds will take less risk than similar funds offered by other mutual fund companies. The average corporate bond fund returned more than Vanguard but one can only imagine the extra risks they took to get that return particular when you consider the difference in expense ratios.

As far as Call risk, that is a good point. What I will say is that during the 2008-2009 financial crisis, corporate bonds fell in price and the credit markets save for treasuries were frozen. AAA rated GE Commercial Paper didn't even trade and Warren Buffett orchestrated a bailout for GE. This environment would have made call and refinance impossible until liquidity was restored to the credit markets. Also, you normally don't call bonds in a temporary situation where the market yields on investment grade corporates are up.

Call risk would happen in an environment of falling rates as corporations would do what individuals do with their home mortgages, and that is refinance. Calling of bonds would eliminate the premium at which the bonds would trade in a falling interest rate environment.

The authors discussed the liquidity risk and quantified it. I didn't see discussion of the Call risk or any calculation of its effect.

Bond discussions bring out the point that these are more complex instruments than what most investors realize.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

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Chip wrote: Fri Apr 27, 2018 12:44 pm
nedsaid wrote: Fri Apr 27, 2018 12:00 pm But let's look a real life example of the difference in returns between Treasuries and Corporates. The Vanguard Intermediate Term Treasury Admiral (VFIUX) has a 10 year growth of $10,000 of $13,687. The Vanguard Intermediate Term Investment Grade Admiral (VFIDX) consists of 68% corporates and has a 10 year growth of $10,000 of $16,065. I don't know, but to my untrained eye that is quite a difference in return. I would say in this case, the liquidity risk and additional volatility would be worth it.

I might not be the sharpest tack in the drawer but I would rather take $16,065 than $13,687.
If you believe that there is some equity risk in corporate bonds then I believe the answer to the puzzle is to buy Treasuries but raise your equity allocation a bit.

If I compare two portfolios at Portfolio Visualizer from 1/08 to 3/18, one with 100% VFIDX and the other 76% VFIUX and 24% VTSAX, I get essentially the same total return. But the second portfolio has lower volatility, a lower max drawdown and a better "worst year". Plus higher Sharpe and Sortino ratios.
Excellent point and excellent post. I am willing to take a bit of risk on the bond side of my portfolio. Pretty much for me the key words are "Intermediate Term" and "Investment Grade". I reach for yield and return but not by very much.

There is another school of thought that says, "Take your risk on the equity side." Folks that I respect like Swedroe and Merriman are in this camp. They would recommend 100% Treasury bonds for fixed income portfolios.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by Day9 »

Random Walker wrote: Fri Apr 27, 2018 9:29 amThis contradicts what economic theory would predict and contradicts some previous literature. For me this essay was simply a reminder to take risk on the equity side.
I agree but to clarify Mr Swedroe would say to just take only term or duration risk on the bond side -- and not even that much (5 year CDs or Treasuries). Liquidity risk is poorly compensated and credit/default risk is equity risk in disguise.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

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Chip wrote: Fri Apr 27, 2018 12:44 pm
nedsaid wrote: Fri Apr 27, 2018 12:00 pm But let's look a real life example of the difference in returns between Treasuries and Corporates. The Vanguard Intermediate Term Treasury Admiral (VFIUX) has a 10 year growth of $10,000 of $13,687. The Vanguard Intermediate Term Investment Grade Admiral (VFIDX) consists of 68% corporates and has a 10 year growth of $10,000 of $16,065. I don't know, but to my untrained eye that is quite a difference in return. I would say in this case, the liquidity risk and additional volatility would be worth it.

I might not be the sharpest tack in the drawer but I would rather take $16,065 than $13,687.
If you believe that there is some equity risk in corporate bonds then I believe the answer to the puzzle is to buy Treasuries but raise your equity allocation a bit.

If I compare two portfolios at Portfolio Visualizer from 1/08 to 3/18, one with 100% VFIDX and the other 76% VFIUX and 24% VTSAX, I get essentially the same total return. But the second portfolio has lower volatility, a lower max drawdown and a better "worst year". Plus higher Sharpe and Sortino ratios.
Let's try an out-of-sample test. (FIXED) Here's a counterexample. Let's pick a Canadian investor willing to invest hist portfolio 50/50 into Canadian stocks and bonds.

I'll use Portfolio Visualizer and adjust the stocks/bonds allocation so as to keep the same standard deviation with all three portfolios:
1) Canadian stocks and total bonds (50% stocks / 50% bonds)
2) Canadian stocks and government bonds (allocation-adjusted to match standard deviation)
3) Canadian stocks and corporate bonds (allocation-adjusted to match standard deviation)

Source: Portfolio Visualizer

Image

Image

Image

Over the longest available period, which includes the 2008-2009 crisis, the allocation-adjusted portfolio (46.8% stocks / 53.2% bonds) using corporate bonds had the highest returns, Sharpe ratio, and Sortino ratio. The 50/50 portfolio using total bonds was second, and the allocation-adjusted portfolio (51.0% stocks / 49.0% bonds) using government bonds was last.
Last edited by longinvest on Fri Apr 27, 2018 3:14 pm, edited 1 time in total.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by saltycaper »

longinvest wrote: Fri Apr 27, 2018 1:27 pm
Let's try an out-of-sample test. Let's pick a Canadian investor willing to invest hist portfolio 50/50 into Canadian stocks and bonds.
That's not an out-of-sample test. That's just making different observations altogether.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by Theoretical »

One thing I have thought about recently is that I wonder if there is a recency bias against the credit premium with most of the data being for a period of falling rates and Volkerized inflation.

Namely that while corporate bonds will lose value from rising rates, their ability to pay on their fixed income (and commensurately their credit ratings) go up, causing prices to rise. In addition, the liquidity may improve as a consequence.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by longinvest »

saltycaper wrote: Fri Apr 27, 2018 2:02 pm
longinvest wrote: Fri Apr 27, 2018 1:27 pm
Let's try an out-of-sample test. Let's pick a Canadian investor willing to invest hist portfolio 50/50 into Canadian stocks and bonds.
That's not an out-of-sample test. That's just making different observations altogether.
Let's say that it would have been more appropriate to call it a counterexample to the claim that was being made.

I've fixed my post.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by dodonnell »

Chip wrote: Fri Apr 27, 2018 12:44 pm
nedsaid wrote: Fri Apr 27, 2018 12:00 pm But let's look a real life example of the difference in returns between Treasuries and Corporates. The Vanguard Intermediate Term Treasury Admiral (VFIUX) has a 10 year growth of $10,000 of $13,687. The Vanguard Intermediate Term Investment Grade Admiral (VFIDX) consists of 68% corporates and has a 10 year growth of $10,000 of $16,065. I don't know, but to my untrained eye that is quite a difference in return. I would say in this case, the liquidity risk and additional volatility would be worth it.

I might not be the sharpest tack in the drawer but I would rather take $16,065 than $13,687.
If you believe that there is some equity risk in corporate bonds then I believe the answer to the puzzle is to buy Treasuries but raise your equity allocation a bit.

If I compare two portfolios at Portfolio Visualizer from 1/08 to 3/18, one with 100% VFIDX and the other 76% VFIUX and 24% VTSAX, I get essentially the same total return. But the second portfolio has lower volatility, a lower max drawdown and a better "worst year". Plus higher Sharpe and Sortino ratios.
+1

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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by nisiprius »

I think I agree with Nedsaid, assuming I understand what he's saying. Larry's article and the study it references don't seem to jibe with what I see in "corporates." At least, not in "corporates" as understood by investors in plain vanilla Vanguard bond funds. So I'm happy to shrug my shoulders and invest in the natural mix in Total Bond, without either leaning toward or away from corporates.

PortfolioVisualizer is showing me that,
--compared to the Vanguard Intermediate-Term Treasury Fund (VFITX), Portfolio 1, blue,
--the (corporate-heavy) Vanguard Intermediate-Term Investment Grade Bond Fund (VFICX), portfolio 2, red, and ---the (pure) Vanguard Intermediate-Term Corporate Bond Index Fund (VICSX), portfolio 3, orange,
have had distinctly higher Sharpe ratios.

So I don't know what's going on here, but certainly investors in these two Vanguard funds, over the time period shown, certainly were rewarded with extra return, more than commensurate with any extra risk they took. Perhaps the corporates in these funds are so liquid that liquidity risk doesn't really come into play at all. Perhaps the study Larry Swedroe is citing was looking at bonds in dark corners of the bond universe where mainstream Vanguard bond funds don't go. Maybe this is just saying one shouldn't dig deep and start building long-short portfolios in hopes of isolating yet another factor of some sort.

Source
Image

If we remove VICSX, we can get 23 years of data, and again, corporates (portfolio 2, red) had a higher Sharpe ratio than Treasuries (portfolio 1, blue).

Image
Last edited by nisiprius on Fri Apr 27, 2018 3:42 pm, edited 2 times in total.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by saltycaper »

longinvest wrote: Fri Apr 27, 2018 3:16 pm
saltycaper wrote: Fri Apr 27, 2018 2:02 pm
longinvest wrote: Fri Apr 27, 2018 1:27 pm
Let's try an out-of-sample test. Let's pick a Canadian investor willing to invest hist portfolio 50/50 into Canadian stocks and bonds.
That's not an out-of-sample test. That's just making different observations altogether.
Let's say that it would have been more appropriate to call it a counterexample to the claim that was being made.

I've fixed my post.
That may be a counter-example to the claim that investors in all countries should prefer mixing bonds issued by their government with domestic stocks and avoid domestic credit, but the claim here seems to pertain only to US Treasuries given their liquidity and perceived safety, which are attributes not necessarily shared by bonds issued by other governments.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by nedsaid »

nisiprius wrote: Fri Apr 27, 2018 3:35 pm I think I agree with Nedsaid, assuming I understand what he's saying. Larry's article and the study it references don't seem to jibe with what I see in "corporates." At least, not in "corporates" as understood by investors in plain vanilla Vanguard bond funds. So I'm happy to shrug my shoulders and invest in the natural mix in Total Bond, without either leaning toward or away from corporates.

PortfolioVisualizer is showing me that,
--compared to the Vanguard Intermediate-Term Treasury Fund (VFITX), Portfolio 1, blue,
--the (corporate-heavy) Vanguard Intermediate-Term Investment Grade Bond Fund (VFICX), portfolio 2, red, and ---the (pure) Vanguard Intermediate-Term Corporate Bond Index Fund (VICSX), portfolio 3, orange,
have had distinctly higher Sharpe ratios.

So I don't know what's going on here, but certainly investors in these two Vanguard funds, over the time period shown, certainly were rewarded with extra return, more than commensurate with any extra risk they took. Perhaps the corporates in these funds are so liquid that liquidity risk doesn't really come into play at all. Perhaps the study Larry Swedroe is citing was looking at bonds in dark corners of the bond universe where mainstream Vanguard bond funds don't go. Maybe this is just saying one shouldn't dig deep and start building long-short portfolios in hopes of isolating yet another factor of some sort.

Source
Image

If we remove VICSX, we can get 23 years of data, and again, corporates (portfolio 2, red) had a higher Sharpe ratio than Treasuries (portfolio 1, blue).

Image
Mark this down, Nedsaid was right about something on April 27, 2018. Seeing that I am right about anything I say around here only about every 6 months or so, you can ignore all my posts from now until October 28, 2018! This is a big event, sort of like a rare meteorological event, so best to celebrate when it happens. Woo hoo!

Seriously, my rather unscientific eyeballing of Morningstar Growth of $10,000 charts backed up my observations. As the late, great American philosopher Yogi Berra once said, "You can observe a lot by watching." Pretty much, I have learned a lot about investments and the markets by owning them and watching how they react in different circumstances.

It would seem from Nisiprius' graphs, that assuming that the bonds were Intermediate Term and Investment Grade, the more Corporates the better. Again, this is eyeballing and probably more rigorous analysis is needed.

I guess what I am trying to say is that Investment Grade, Intermediate Term is "good enough" for fixed income portfolios. It seems that a lot of return is given up by investing in the safe treasuries. The numbers cited from Morningstar are not insignificant. A lot of return sacrificed for maybe a 6 month diversification benefit during the financial crisis where Treasuries went up while Corporates fell. Edit: You can see a two year period from which treasuries and corporates started to diverge in early 2008, it took until 2010 for corporates to catch up and then surpass treasuries. This illustrates the diversification benefit of treasuries in a crisis. The question is, how much is that worth to an investor. My holding period on bonds is in excess of two years.
Last edited by nedsaid on Fri Apr 27, 2018 4:15 pm, edited 3 times in total.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by nedsaid »

Want to make it clear that I am not anti-treasuries. A portfolio, in my opinion, should be diversified across both the equity and the bond side. If you look at the composition of the bond funds that I own, you will see Treasuries, TIPS, Corporates, and Agency Bonds, particularly GNMAs. That diversification includes treasuries. Really, the point is this, does an investor benefit by adding investment grade corporates to an otherwise 100% treasury bond portfolio? My wild unscientific guess is yes.

There is a point of diminishing returns, I am not advocating a 100% corporates bond portfolio. Just saying, it might be worth adding them. John Bogle has made similar comments, he has suggested added a slice of corporates to a Total Bond Market fund to boost yields a bit.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by dodonnell »

@nispirus

VFITX versus VFICX
The last recession ... the last time anyone really needed their fixed income :wink:

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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by nisiprius »

Dodonnell, sure. I'm aware of that nasty -10% notch in corporates in 2008-2009. Although if you plot it on the same chart with -50% in stocks it doesn't look that bad. Was that, in fact, a liquidity problem? I don't know.

Basically what happened in 2008-2009 at the level of detail I pay attention to is: yeah, Treasuries went up, but it wasn't all that exciting because they went up a little when stocks went down a lot. Sure, they went in opposite directions, but bond gains wouldn't have done much to offset stock losses unless your stock/bond allocation was something like 15/85.

Corporates went down -10%.

And Total Bond, with its mix of Treasuries and corporates, basically sailed straight through, not much up or down.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by nedsaid »

nisiprius wrote: Fri Apr 27, 2018 4:14 pm Dodonnell, sure. I'm aware of that nasty -10% notch in corporates in 2008-2009. Although if you plot it on the same chart with -50% in stocks it doesn't look that bad. Was that, in fact, a liquidity problem? People fuss and argue about bonds, but basically what happened in 2008-2009 at the level of detail I pay attention to is: yeah, Treasuries went up, but it wasn't all that exciting because they went up a little when stocks went down a lot. Sure, they went in opposite directions, but bond gains wouldn't have done much to offset stock losses unless your stock/bond allocation was something like 15/85.

orporates went down -10%.

And Total Bond, with its mix of Treasuries and corporates, basically sailed straight through, not much up or down.
Well, actually 2008-2009 was a bond bear market as well as a stock bear market. The reason most Bogleheads didn't panic is that Treasuries and Government Agency Bonds did fairly well during that period and those two categories make up 70% of Total Bond Index. Any Investment Grade Intermediate Term Bond portfolio diversified across Treasuries, Agency Bonds, TIPS, and Corporates would have done okay during the crisis. TIPS and Corporates were down 10%-12% but those losses would have been cushioned by Treasuries and Agency Bonds. Total Bond Market was briefly down about 3% in the crisis, but that was hardly a ripple. So pretty much, I am saying Nisiprius was right.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by stlutz »

For people who jumped to the discussion and skipped the paper, the paper was not about corporate bonds vs. treasuries. It was about more liquid corporate bonds vs. less liquid corporate bonds.

For most of us, I don't know that there is anything actionable from this paper--when/if I want corporate bond exposure, I'll access through a broadly diversified mutual fund or ETF, so I won't be comparing the trading characteristics of bond A vs. bond B.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by nedsaid »

stlutz wrote: Fri Apr 27, 2018 6:53 pm For people who jumped to the discussion and skipped the paper, the paper was not about corporate bonds vs. treasuries. It was about more liquid corporate bonds vs. less liquid corporate bonds.

For most of us, I don't know that there is anything actionable from this paper--when/if I want corporate bond exposure, I'll access through a broadly diversified mutual fund or ETF, so I won't be comparing the trading characteristics of bond A vs. bond B.
I did read it through a couple of times. Yes, it was about less liquid corporate bonds vs. more liquid corporate bonds. Pretty much, the study that Larry cited said that bond investors DID NOT get an illiquidity premium whereas a previous research said that bond investors DID get a illiquidity premium. Sort of like coffee is bad for you. No wait! Coffee is good for you.

Larry has discussed the Corporates vs. Treasuries many times and I suppose we read those discussions into the article. Pretty much Larry believes risk should be taken on the equity side of a portfolio and that the bond side of the portfolio should be invested in SAFE bonds which are Treasuries. And certainly, we see that in a crisis you receive a higher diversification benefit from Treasuries than from other types of bonds.

The independent broker that I work with started out in the bond market working for a firm that pioneered Corporate Junk Bonds. He said that large portions of the corporate bond market were not all that liquid. Not only that, but there were surprises out there, what you thought was liquid was not necessarily so. Some big name corporate bonds don't trade all that much. Further, he said that Dodd-Frank put restrictions on bank bond portfolios and as a result the big banks really don't act of market makers anymore, sort of like the specialist firms on the New York Stock Exchange. So if there is a big imbalance between buy and sell orders for a particular bond, there really isn't a market maker that will step in and provide liquidity, thus creating greater volatility in bond prices as well as higher bid/ask spreads. Market makers maintain an inventory and thus can help resolve buy/sell order imbalances. Dodd-Frank may have reduced risks to the banks but has probably increased the risks to the bond market. The effects of the legislation have likely reduced the liquidity of the corporate bond market as a whole.

So we read a lot into the article that wasn't really there as I didn't see any reference to Treasuries in the article. There was a mention of the differences in liquidity between the stock market and the corporate bond market. I guess we read an article and then rode our own hobby horses that had little to do with the article or its topic. Oh well!
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by stlutz »

So we read a lot into the article that wasn't really there as I didn't see any reference to Treasuries in the article. There was a mention of the differences in liquidity between the stock market and the corporate bond market. I guess we read an article and then rode our own hobby horses that had little to do with the article or its topic. Oh well!
And in terms of something actionable, the corporates vs. treasuries argument is more relevant. :sharebeer
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by dodonnell »

@to all: sorry to fork this thread off the Corporate liquidity premium article and toward Treasuries v Corporates.
To me, it feels like debating the attributes of a seat belt that feels much more comfortable when your driving, however, fails when you crash

@nisiprius: updated chart below, sorry for delay
nisiprius wrote: Fri Apr 27, 2018 4:14 pm Dodonnell, sure. I'm aware of that nasty -10% notch in corporates in 2008-2009. Although if you plot it on the same chart with -50% in stocks it doesn't look that bad. Was that, in fact, a liquidity problem? I don't know.
IMHO, not a liquidity problem, but a liquidation problem. Buying an individual corporate bond was easy, selling one, a very different story, no bids. Lehman failed in Sep 2008 with over $600B in debt. IMHO: Lehman Brothers, Bear Sterns, Wachovia, Washington Mutual, Fannie Mae, Freddie Mac, Countrywide, AIG ... were insolvent and their corporate bondholders were looking at a permanent impairment of capital. Additionally, on deck were: GE, Merrill Lynch, Morgan Stanley, etc... all Investment Grade, right up until the bids disappeared.

If the dominos weren't stopped, Corporate Bonds would have been down far more than 10%. 40% of VFCIX is Financials. At the end of the day owners were kept whole, but only by the herculean efforts of .gov.

Basically what happened in 2008-2009 at the level of detail I pay attention to is: yeah, Treasuries went up, but it wasn't all that exciting because they went up a little when stocks went down a lot. Sure, they went in opposite directions, but bond gains wouldn't have done much to offset stock losses unless your stock/bond allocation was something like 15/85.

Corporates went down -10%.

And Total Bond, with its mix of Treasuries and corporates, basically sailed straight through, not much up or down.
Agreed. The outcome for corporate bonds in 2008/9 was satisfactory. We were lucky. However, that doesn't justify a correct decision.
In the Great Depression, stocks lost over 80% of their value and Corporate Bond defaults exploded. Treasuries behaved as expected.

thanks

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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by lazyday »

dodonnell wrote: Sat Apr 28, 2018 11:35 amThe outcome for corporate bonds in 2008/9 was satisfactory. We were lucky. However, that doesn't justify a correct decision.
In the Great Depression, stocks lost over 80% of their value and Corporate Bond defaults exploded. Treasuries behaved as expected.
And today there's much more BBB not-quite-junk debt outstanding than before the crisis.

https://www.bloomberg.com/news/articles ... rs-on-edge
Bonds with the lowest investment grade have been a market darling over the past decade, ballooning [see the first chart] in size as low global interest rates drew fund managers seeking higher returns. But as borrowing costs climb to a four-year high just as investors begin to anticipate a downturn in the global economy ....
The high-grade bond market in the U.S. already has the lowest credit quality mix since the 1980s, according to CreditSights....
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by dodonnell »

lazyday wrote: Sat Apr 28, 2018 2:52 pm
dodonnell wrote: Sat Apr 28, 2018 11:35 amThe outcome for corporate bonds in 2008/9 was satisfactory. We were lucky. However, that doesn't justify a correct decision.
In the Great Depression, stocks lost over 80% of their value and Corporate Bond defaults exploded. Treasuries behaved as expected.
And today there's much more BBB not-quite-junk debt outstanding than before the crisis.

https://www.bloomberg.com/news/articles ... rs-on-edge
Bonds with the lowest investment grade have been a market darling over the past decade, ballooning [see the first chart] in size as low global interest rates drew fund managers seeking higher returns. But as borrowing costs climb to a four-year high just as investors begin to anticipate a downturn in the global economy ....
The high-grade bond market in the U.S. already has the lowest credit quality mix since the 1980s, according to CreditSights....
Very disturbing chart. The waive of downgrades associated typical associated with a recession forces selling by Investment Grade Bond Funds of their downgraded BBB.

Actionable tip: check your Corporate Bond funds' allocation to BBB. Vanguard is very disciplined on this.

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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by willthrill81 »

Hasn't Vanguard's Wellesley Income fund been using corporate bonds as part of their bond holdings for nearly 50 years now? It's hard to argue with their success rate, unless one contends that they would have had even better performance without them.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by Valuethinker »

nedsaid wrote: Fri Apr 27, 2018 12:00 pm Larry is correct, there are large segments of the US Corporate Bond Market that are not all that liquid. Treasuries, on the other hand, trade like water. What you are getting in greater yield with the lower quality Corporates, you in part sacrifice with higher bid-ask spreads.

But let's look a real life example of the difference in returns between Treasuries and Corporates. The Vanguard Intermediate Term Treasury Admiral (VFIUX) has a 10 year growth of $10,000 of $13,687. The Vanguard Intermediate Term Investment Grade Admiral (VFIDX) consists of 68% corporates and has a 10 year growth of $10,000 of $16,065. I don't know, but to my untrained eye that is quite a difference in return. I would say in this case, the liquidity risk and additional volatility would be worth it.

I might not be the sharpest tack in the drawer but I would rather take $16,065 than $13,687. Yes, I would have taken additonal volatility risk but would only have seen it during the 2008-2009 financial crisis. VFIUX (Intermediate Treasury) was up during the crisis while VFIDX (Intermediate Investment Grade) was down. What has even weirder was that the Vanguard Intermediate Term Investment Grade Fund was below the category average for Corporate Bond Funds which had ten year growth of $10,000 of $16,856. It would appear that an investor paid a pretty high price for the relative safety and the diversification effect of US Treasuries. Both funds are Intermediate Term and Investment Grade.

This isn't just a Vanguard thing, I have seen this at other fund companies as well. To my untrained eye, investors were more than compensated for the additional risk. But again, I am just eye-balling.
Very dangerous to use those endpoints.

By April 2008 credit risk was well and truly in the market. Corporate bonds would already have taken a hit. The the comparison looks a lot better.

A big chunk of corporate bonds are issued by financial institutions. Thus in a bear market you get a lot of correlation. Btw next crisis those bonds will be "bailed in" not bailed out. Read heavily diluted. Everyone remembers Ireland. Regulators are emphatic about this.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by Leif »

cfs wrote: Fri Apr 27, 2018 11:43 am Thank you Mister Dave for the link to the article.

Mister Swedroe is no longer active here, our loss.

Gracias por leer ~cfs~
Check again. He has made some postings recently. Just much fewer then in the past.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by cfs »

Leif wrote: Sun Apr 29, 2018 11:53 pm
cfs wrote: Fri Apr 27, 2018 11:43 am Thank you Mister Dave for the link to the article.

Mister Swedroe is no longer active here, our loss.

Gracias por leer ~cfs~
Check again. He has made some postings recently. Just much fewer then in the past.
I will. Good luck y gracias por leer / cfs
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by nedsaid »

Valuethinker wrote: Sun Apr 29, 2018 6:45 pm
nedsaid wrote: Fri Apr 27, 2018 12:00 pm Larry is correct, there are large segments of the US Corporate Bond Market that are not all that liquid. Treasuries, on the other hand, trade like water. What you are getting in greater yield with the lower quality Corporates, you in part sacrifice with higher bid-ask spreads.

But let's look a real life example of the difference in returns between Treasuries and Corporates. The Vanguard Intermediate Term Treasury Admiral (VFIUX) has a 10 year growth of $10,000 of $13,687. The Vanguard Intermediate Term Investment Grade Admiral (VFIDX) consists of 68% corporates and has a 10 year growth of $10,000 of $16,065. I don't know, but to my untrained eye that is quite a difference in return. I would say in this case, the liquidity risk and additional volatility would be worth it.

I might not be the sharpest tack in the drawer but I would rather take $16,065 than $13,687. Yes, I would have taken additonal volatility risk but would only have seen it during the 2008-2009 financial crisis. VFIUX (Intermediate Treasury) was up during the crisis while VFIDX (Intermediate Investment Grade) was down. What has even weirder was that the Vanguard Intermediate Term Investment Grade Fund was below the category average for Corporate Bond Funds which had ten year growth of $10,000 of $16,856. It would appear that an investor paid a pretty high price for the relative safety and the diversification effect of US Treasuries. Both funds are Intermediate Term and Investment Grade.

This isn't just a Vanguard thing, I have seen this at other fund companies as well. To my untrained eye, investors were more than compensated for the additional risk. But again, I am just eye-balling.
Very dangerous to use those endpoints.

By April 2008 credit risk was well and truly in the market. Corporate bonds would already have taken a hit. The the comparison looks a lot better.

A big chunk of corporate bonds are issued by financial institutions. Thus in a bear market you get a lot of correlation. Btw next crisis those bonds will be "bailed in" not bailed out. Read heavily diluted. Everyone remembers Ireland. Regulators are emphatic about this.
My observation that bond funds that include corporates do better over time than treasury only bond funds extends over a period of many years. I was seeing this even before the 2008-2009 financial crisis.

I have also said that if we entered a second Great Depression in the aftermath of the financial crisis, that Treasuries would have done better and probably a lot better than corporates.

There is the issue of potential US Government insolvency. Don't think that can happen because our sovereign debt is denominated in US Dollars and more US Dollars can always be created. We could default if we made a political decision to do so, however. One could argue that the US has technically defaulted at least a couple of times, once when Roosevelt changed the relationship of the dollar to gold during the Great Depression and the second time when Nixon took the U.S. off the Gold Standard. A possible third example was the post WWII period where interest rates were held artificially low by the US Government and treasuries did not keep up with inflation.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by saltycaper »

nedsaid wrote: Tue May 01, 2018 3:15 pm
My observation that bond funds that include corporates do better over time than treasury only bond funds extends over a period of many years. I was seeing this even before the 2008-2009 financial crisis.
I would hope so, but the only situation in which that should matter, even after taking risk-adjusted returns into account, is if Treasuries and corporate bonds were the only investments considered. If the portfolio contains other investments, or if it could contain other investments, then whatever conclusions are drawn by isolating Treasury bond vs. corporate bond performance don't really matter.
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Re: Larry Swedroe: Liquidity Risk Not Worth It

Post by nedsaid »

saltycaper wrote: Tue May 01, 2018 3:42 pm
nedsaid wrote: Tue May 01, 2018 3:15 pm
My observation that bond funds that include corporates do better over time than treasury only bond funds extends over a period of many years. I was seeing this even before the 2008-2009 financial crisis.
I would hope so, but the only situation in which that should matter, even after taking risk-adjusted returns into account, is if Treasuries and corporate bonds were the only investments considered. If the portfolio contains other investments, or if it could contain other investments, then whatever conclusions are drawn by isolating Treasury bond vs. corporate bond performance don't really matter.
For the record, I advocate for a diversified bond portfolio like Total Bond Market Index. Not here telling people to invest 100% in corporates, just as I would not tell people to invest 100% in TIPS.
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