Much like REITs, Corporate Bonds are another “asset class” that have not added much to a portfolio historically. This is another place you can cut down on the number of funds in your portfolio and hopefully reduce some costs and complexity.
When we think about what a Corporate Bond is, there are two main components:
- Credit – The biggest determinant of yields on corporate bonds are usually set based upon the credit-worthiness of the company. A company like Apple can pay a lower yield than Dr. Pepper Snapple Group Inc. because they are considered a “safer” company.
- Term – The maturity of the bond is set by the company (Usually anywhere from 1-30 years), but in general, the longer the term of the bond (Or maturity) the higher the yield, because you have to wait longer to receive your principle back which opens the investor up to increased interest rate risk (Rates rising) & increased default risk (The company going bankrupt).
A 1 Year Bond from Apple will have a lower yield than a 30 Year Bond from Dr. Pepper Snapple. Like everything in investing, to take on more risk, an investor requires the chance for more reward.
So in essence, you have elements of the stock market in credit risk and then elements of government bonds in term risk. I wonder if you could replicate corporate bonds by using just stocks and government bonds…
I wonder if we could do the same thing with High-Yield Corporate Bonds?
Well, it turns out we can, but I would suggest one change. Instead of all U.S. Stocks, we should use Value stocks since those tend to have higher credit risk, much like high yield bonds in comparison to investment grade bonds.
Once again, it seems that we have found another area of a portfolio that we can possibly cut back on…but wait, there’s more!
There is another downside to Corporate Bonds:
They have higher correlations to stocks compared to government bonds, and a lower long-term expected return compared to stocks. In English, this means that in order to hold corporate bonds in a comparable expected risk portfolio, we have to hold less stocks. Historically, that has hurt a portfolio:
All three portfolio mixes lost the same amount in 2008 even though the portfolio with treasury bonds had 24% more stocks compared to the portfolio with high-yield bonds. With that extra stock exposure, the portfolio with treasuries beat the portfolio with high-yield bonds by 0.40% per year…
On a similar note, it is important to point out that everyone’s preferred bond fund, the Total U.S. Bond Market Fund holds Corporate Bonds. So for one last test, lets see what happens when we compare using the Total U.S. Bond Market Fund versus an Intermediate Treasury Fund in combination with a Total U.S. Stock Fund:
Same results: Same risk, but a higher return for the portfolio with U.S Government Treasuries.
Now, the Total US Bond Market Fund holds over 60% U.S. Government Bonds, so for those that use this as their preferred bond holding, I would continue to “stay the course”, it is a good bond fund that prioritizes “safe” bonds.
The main point of this exercise was to once again try and dispel this notion that adding more funds and/or asset classes means more diversification in a portfolio. Instead of adding an explicit Corporate Bond Fund (Investment Grade or High Yield or Both!) to your portfolio, think about taking that allocation and splitting it into stocks and safe government bonds. It will cut down on the number of funds you need to worry about, and in the case of a high-yield fund, it will definitely lower your overall expenses.
Have fun out there!