Focusing on the spread between government and corporate bonds disguises returns, according to AQR, and investors need to dig down deeper into what is producing the numbers.
“It is important to know if the credit risk premium is nothing more than the equity risk premium in disguise.” — AQRIn a paper entitled “Credit risk premium: its existence and implications for asset allocation”, AQR’s Attakrit Asvanunt and Scott Richardson highlighted the lack of investigation into what creates the return from bond portfolios—and why investors should be aware.
“We first confirm the existence of a positive premium for bearing exposure to default risk,” the authors said. “Using a combination of data sources, we compute returns for corporate bonds after first removing the influence of interest rates.”
They found this credit excess return, on an average monthly basis between 1936 and 2014, to be 11 basis points, with an annualized Sharpe ratio of 0.37. Between 1998 and 2014, the aggregate high yield corporate bond index number was 21 basis points a month, with an annualized Sharpe ratio of 0.26.
These numbers, the authors said, stood as “robust evidence of a credit risk premium”.
“A skeptical investor will, and should, ask the question as to whether exposure to credit risk is beneficial in a broader portfolio context,” the paper said. “It is important to know if the credit risk premium is nothing more than the equity risk premium in disguise. You may be paying more for a well-known source of risk (credit indices are still more expensive to trade, and have less capacity, than equity indices).”
By examining three long-only portfolios allocated to treasury, equities, and credit, and credit default swap index data, the authors claimed there is a credit risk premium to be had—and it is “sufficiently different to the equity risk premium”.
The authors next looked at fluctuations in this risk premium, assessing timescales and macroeconomic events. They found them to be larger during periods of economic growth and when aggregate default rates were lower than expected.
“This suggests that investors interested in tactical variation in exposure to credit risk premium require good forecasts of (i) changing expectations of economic growth, and (ii) aggregate default rates,” the authors said. “Of course, to be useful for tactical allocations, these forecasts need to be superior to the anticipated growth and default rates that will already be incorporated into current spreads.”
To read the full paper, visit the AQR website.
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