Most people within my world understand that diversification across a large number of stocks is vitally important. This means that the most efficient way to take the risks associated with investing in stocks is to mitigate your exposure to any single company. Far less well understood by the public at large and the advisor community is whether it’s generally more efficient to take risk through stocks or through lower quality bonds.
As an example, let’s say I had originally decided to allocate 40 percent to a diversified stock fund portfolio and 60 percent to high-quality bonds. However, I’ve now determined that I need a higher expected return to reach my financial goals. Should I:
- Sell all or most of my high quality bonds and instead own lower quality bonds
- Continue to hold high quality bonds but slightly increase my allocation to stocks?
I’m firmly in the camp that believes B is the better choice for three reasons:
- Generally better tax efficiency
- The poor historical risk-adjusted returns associated with taking credit risk
- The fact that you know which portion of your portfolio is taking credit risk (the stock portion) and which isn’t (the bond portion)
Stocks generally receive more favorable tax treatment than bonds, since interest on bonds is typically taxed at ordinary income tax rates and a significant portion of the long-term return of stocks is taxed at lower capital gains rates (if the stock is held long enough to receive long-term capital gains treatment). So, all else equal, this means that stocks provide a more efficient way to take risk than bonds.
The historical risk-adjusted returns of lower-quality bonds have been very poor compared to stocks. Over the period August 1998–June 2012, the annualized Sharpe ratios of the equity premium, investment grade credit premium and high-yield credit premium have been 0.43, 0.07 and 0.21, respectively. These values indicate that you would have been better served by increasing your allocation to stocks and keeping credit quality high (again that’s choice B above). As a ballpark measure, moving 10 percent of your portfolio from high-quality to lower-quality bonds is roughly equivalent to increasing your allocation to stocks by about one or two percent.
There are times when lower-quality bonds (such as investment-grade corporate bonds) are riskier than normal. The chart below illustrates this, answering the following question: At a given point, what percentage allocation to stocks is roughly equivalent to allocating 100 percent of your portfolio to investment-grade corporate bonds? The answer is that it depends because at times corporate bonds behave roughly similar to Treasury bonds and at other times a 100 percent allocation to corporate bonds is basically equivalent to having 30 percent or so of your portfolio in stocks.
And when does this latter scenario occur? Typically, it occurs when stock market risk is very high. This means that a 60/40 allocation where the 40 percent is in Treasury bonds, for example, is a lot different than a 60/40 allocation where the 40 percent is in corporate bonds (or lower-quality bonds in general). In fact, during periods of heightened stock market volatility, every dollar allocated to corporate bonds should be thought of as roughly the same as putting 25 cents in stocks and 75 cents in high-quality fixed income. Most investors don’t account for corporate bonds in this way and therefore get surprised by how much risk they have in their portfolio when stock market risk shows up.
Random Links and Commentary of the Week
I’ve always been a fan of SportsCenter’s commercials, but this may well be the best.