Expected Returns: An Investor's Guide to Harvesting Market Rewards

10

Credit risk premium

• Bonds exposed to credit risk have outperformed Treasuries only marginally over long histories (by 0.2–0.5% annually for investment-grade credits), arguably giving poor compensation for their lower liquidity and poor timing of losses. Long-dated corporate bonds have performed especially poorly, while barely speculative-grade bonds (BB-rated) have performed best.

• In this generally bleak picture, short-dated top-rated credit bonds have given an attractive reward–volatility ratio. Levered arbitrageurs cannot remove this opportunity because of the financing rates they face. This group of bonds is also risky, with the largest losses occurring during financial crises.

• Credit spreads are observable measures of the prospective return advantage of risky assets over “riskless” Treasuries. However, spreads overstate this advantage due to expected losses from default or downgrading losses, and due to embedded options.

• Historical average yield spreads for investment-grade debt have by far exceeded average default rates. Yet, it does not necessarily follow that investors have earned the bulk of the spread as excess returns. Indeed, evidence suggests the contrary. One explanation for the apparently contradictory sets of evidence is that index investors constrained by rating requirements, unlike buy-and-hold investors, sell exactly the types of corporate bonds that subsequently tend to perform well (BB-rated “fallen angels” and short-dated debt).

• Spread variation ...