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Corporate vs. Government Bonds

April 26, 2012 - 2 comments

Many investors are looking everywhere for yield these days. Historically, investors have been compensated for taking more credit risk with their bonds – at least in isolation. As investors, we need to be cautious when drawing conclusions from return data on its own – whenever possible, data should be viewed within an overall portfolio context. Take the chart below, as an example:

* Risk-free asset is the DEX 30 Day T-Bill Index with an annualized return of 3.26% from January 1995 to December 2011
Sources:  BMO Financial Group, Dimensional Returns 2.0

As we can see from the results, over all maturities (short, mid, and long term), corporate bonds had a higher return, as well as a lower standard deviation, relative to government bonds.  The risk-adjusted returns have also been higher for corporate bonds relative to government bonds.

So has the typical investor been rewarded more for investing in corporate bonds versus government bonds (from a portfolio perspective)?

For this answer, we turn to William Bernstein’s explanation of the “Rebalancing Bonus”:

 “assets with high volatility and low correlation with the remainder of the portfolio provide considerable excess return, or "rebalancing bonus."

If we consider a high volatility asset (such as the S&P/TSX Composite Index) and run a correlation analysis to find which type of bonds have historically exhibited the lowest correlation with it, we can easily see that government (federal) bonds have been less correlated with equities (further away from + 1) than corporate bonds across all maturities, making them a more ideal candidate for capturing the “rebalancing bonus”.

Sources: BMO Financial Group, Dimensional Returns 2.0

To determine whether corporate or government bonds have been a better addition to a portfolio, I have constructed a number of portfolios (using the S&P/TSX Composite Index as the stock component) with various asset allocations ranging from 80% bonds to 20% bonds and rebalanced them annually (see attached PDF for analysis).

The Results:
Long Term Bond Allocations

  • At all asset allocations, portfolios constructed entirely of long term corporate bonds had lower returns and higher standard deviation, than those constructed with government bonds. The risk-adjusted returns were also lower for all long term corporate bond portfolios.

Mid Term Bond Allocations

  • At more aggressive asset allocations (i.e. 80% stocks, 20% bonds), returns for portfolios of mid term government bonds were preferable to mid term corporate bonds. For more conservative allocations (i.e. 70% equities or less), mid term corporate bonds delivered similar or higher overall returns. In each case, the standard deviation of the portfolio was lower for mid term government bonds than for mid term corporate bonds. Consequently, the risk-adjusted returns were also higher for mid term government bonds than for mid term corporate bonds.

Short Term Bond Allocations

  • Across the board, returns and risk-adjusted returns for short term corporate bond portfolios were higher. The standard deviation was higher for short-term corporate bond portfolios across all asset allocations.

Although the results may be period specific, risk averse investors (which most are) should consider government bonds for their mid and long term bond allocations (where risk-adjusted portfolio returns have been higher). If an investor prefers to invest a portion of their portfolio in corporate bonds, they should consider remaining short term (i.e. 1 to 5 year maturities) for their corporate bond holdings.

By: Justin Bender with 2 comments.
Filed under: “Portfolio, Management”
  04/07/2016 11:36:24 AM
Justin Bender
@Park - I've never read an analysis comparing Canadian federal vs. provincial bonds, but this would be a good idea for a future post.
  03/07/2016 2:11:28 PM
The cost of corporate bond investing is likely greater than that of government bond investing. Nevertheless, this article didn't get the attention it deserved. Is there any similar comparison of federal government bonds to provincial government bonds?

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