Is the reward for holding risky bonds material and distinct from the reward for holding stocks and the reward for holding longer term bonds? In their February 2015 paper entitled “Credit Risk Premium: Its Existence and Implications for Asset Allocation”, Attakrit Asvanunt and Scott Richardson measure and explore the predictability and diversification power of the credit (or default) risk premium associated with corporate bonds. They focus on the premium associated with creditworthiness of bonds by first removing the influence of duration/interest rates. They also test whether the credit risk premium diversifies the equity risk premium and the bond term premium. Using data for U.S. corporate bonds, the U.S. stock market, U.S. Treasury securities and economic indicators during 1927 through 2014 and for credit default swaps (CDS) during 2004 through 2014, they find that:
- The credit risk premium in the U.S. is material.
- During 1936 through 2014, modeling indicates that the average gross annualized return on investment-grade corporate bonds due to credit risk is about 1.3%, translating to a gross annualized Sharpe ratio of 0.38.
- During August 1988 through 2014, when modeling is more straightforward, gross annualized returns due to credit risk are about 0.5% for investment-grade bonds and 2.48% for high-yield bonds, respectively, translating to gross annualized Sharpe ratios of 0.13 and 0.26.
- From CDS data spanning 2004 through 2014, gross annualized Sharpe ratios for investment-grade and high-yield instruments are 0.45 and 0.68, respectively.
- As indicated by results for these different sample periods, the credit risk premium varies considerably with economic conditions (see the chart below).
- The premium tends to be larger when economic growth is high and slightly larger when inflation is high.
- The only condition with a negative premium is during low growth and high inflation.
- The credit risk premium substantially diversifies both the equity risk premium and the bond term premium.
- Credit risk returns exhibit a moderate positive correlation with stock market returns and a negative correlation with U.S. Treasuries.
- The in-sample (retrospective) mean-variance optimal long-only portfolio weights for stocks, U.S. Treasuries and corporate bonds are:
- 17%, 35% and 48%, respectively, during 1936 through 2014.
- 15%, 73% and 12%, respectively, during August 1988 through 2014.
- 6%, 46% and 48% during 2004 through 2014.
- Results based on European corporate bonds and CDS instruments are simliar.
The following chart, taken from the paper, summarizes gross annualized Sharpe ratios for the credit risk premium across different U.S. growth-inflation environments during 1972 through 2014. “Growth” is the simple average of the standardized Chicago Fed National Activity Index and the “surprise” in U.S. industrial production growth. “Inflation” is the simple average of standardized year-on-year inflation rate and “surprise” in U.S. Consumer Price Index. “Surprise” is the difference between actual values and consensus forecasts of economists from one year earlier. Growth and inflation are positive (negative) when their composite values are above (below) their respective historical medians.
Note that this analysis is descriptive (contemporaneous), not predictive (lagged). In other words, an investor operating in real time would not know the economic states.
In summary, evidence indicates that the credit risk premium is material overall, is a valid diversifier of stocks and government bonds (strategically useful) and is predictable to the extent that economic growth and inflation are predictable (possibly tactically useful).
Cautions regarding findings include:
- Reported returns are gross, not net. Trading frictions associated with exploitation of the credit risk premium would reduces these returns.
- For many investors, exploitation of the credit risk premium would be via funds, thereby incurring fund fees and expenses.
- As noted, association of the credit risk premium with economic indicators is retrospective (ideal) and thereby useful only to the extent an investor can predict economic growth and inflation better than economists.
