Corporate Bonds or Government Bonds?
Investment grade corporates have offered better yield, better capital protection and more efficient portfolios
The Corporate Bond Trifecta
Many would agree that two core tenets of owning bonds in an investment portfolio are to generate income (yield) and provide captial protection. When building a bond portfolio, one of the most basic choices for investors is whether to invest in government bonds or corporate bonds (“corporate bond” refers to investment-grade corporate bonds for the purpose of this paper). The distinction between the two can be subtle. Government bonds are generally perceived as having better capital protection characteristics and better suited to more-risk averse investors, and corporate bonds are generally perceived as having better yield characteristics while sacrificing capital protection qualities, and better suited for less risk-averse investors.
Analyzing the returns of Canadian corporate bonds (via the ICE BAML Canada Corporate Bond Index) and Canadian government bonds (via the ICE BAML Canada Government Bond Index) over the past 27 years, the data has shown corporate bonds have: (1) provided a better yield than government bonds; (2) shown better capital protection qualities than government bonds; and (3) been able to generate more efficient portfolios when combined with stocks.
(1) Better Yield
The chart below shows the historical yield advantage of corporate bonds over government bonds from the year 1992 to the year 2019. A traditional minimum yield that investors would accept is the rate of inflation, which the Bank of Canada targets at 2%. The yield on government bonds moved below 2% in 2011, and has stayed below that level to this day (only briefly moving above 2% in 2018). The average yield premium on corporate bonds over the same period was 1.4%, which is significant because it was the difference between investors earning a positive or negative yield after-inflation.
(2) Better Capital Protection
The perception that government bonds have better capital protection (drawdown) characteristics than corporate bonds can be linked to the fact that government bonds are labeled as “risk-free”. However, this label only pertains to credit risk, or default risk, and doesn’t mean that government bonds cannot lose investors’ money. There are a variety of risks that investors in government bonds and corporate bonds alike must be aware of, one of the most important risks being interest rate risk, which was discussed in a previous paper: “Beware of Falling Interest Rates: Your Bonds May Be Riskier Than You Think!”.
As the chart below illustrates, government bonds are not necessarily more resistant to drawdowns compared to corporate bonds. In fact, on average the opposite has been true. Over the past 27 years, the average maximum drawdown for government bonds and corporate bonds was 1.6% and 1.3%, respectively, and the average length of the drawdown period was 6.8 months and 5.6 months, respectively. In other words, corporate bonds on average have had smaller maximum drawdowns and shorter drawdown periods than government bonds!
(3) More Efficient Portfolios
Modern Portfolio Theory teaches us that investors shouldn’t focus on investments that generate the highest absolute returns irrespective of risk, rather the focus should be on generating “efficient portfolios” – allocating to a fixed set of investments in a way that generate the highest returns at a given level of risk, where risk is defined as the standard deviation of returns. Plotting all of the efficient portfolios at different risk levels gives what is known as the “efficient frontier”. Any portfolio plotted below the efficient frontier is known as an inefficient portfolio because a greater return could be achieved with the same set of investments at the same level of risk.
The chart below shows the efficient frontier for the following investment set: S&P/TSX Total Return Index, ICE BAML Canada Corporate Bond Index and ICE BAML Canada Government Index. The only portfolio on the efficient frontier with even a partial allocation to government bonds is the “Minimum Variance Portfolio” – the portfolio that generates the lowest absolute level of risk. All other points on the efficient frontier were generated using some combination of the S&P/TSX Total Return Index and ICE BAML Canada Corporate Bond Index without the need for government bonds. The chart also illustrates how a portfolio comprised of 60% S&P/TSX Total Return Index and 40% ICE BAML Canada Government Bond Index is an inefficient portfolio, as it is plotted below the efficient frontier, and a higher return could be achieved at a similar level of risk by pairing the S&P/TSX Total Return Index with the ICE BAML Canada Corporate Bond Index instead of with the ICE BAML Canada Government Bond Index.
Government bonds, despite being categorized as “risk-free” from a default risk perspective, are not risk-free from a capital loss perspective. Based on historical data, investment grade corporate bonds have been the clear choice for investors looking to improve yield, improve capital protection and create more efficient portfolios.
This publication is intended for use by investment professionals only. This publication has been prepared by Lysander Funds Limited and has been prepared solely for information purposes. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Lysander Funds Limited does not make any warranty or representation regarding the information herein. Information in this publication is subject to change without notice. Lysander Funds Limited does not assume any duty to update any information herein.
Certain information in this document has been derived or obtained from sources believed to be trustworthy and/or reliable. Lysander Funds Limited does not assume responsibility for the accuracy, currency, reliability or correctness of any such information. Nothing in this publication should be considered a recommendation to buy, sell or short a particular security.
This document may contain forward-looking statements. Statements concerning a fund’s or entity’s objectives, goals, strategies, intentions, plans, beliefs, expectations and estimates, and the business, operations, financial performance and condition are forward-looking statements. The words “believe”, “expect”, “anticipate”, “estimate”, “intend”, “aims”, “may”, “will”, “would” and similar expressions and the negative of such expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. These forward- looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from current expectations. Readers are cautioned not to place undue reliance on these forward-looking statements. While Lysander Funds Limited considers these risks and uncertainties to be reasonable based on information currently available, they may prove to be incorrect. ®Lysander Funds is a registered trademark of Lysander Funds Limited.
Any unauthorized use or disclosure is prohibited. Nothing herein should in any way be deemed to alter the legal rights and obligations contained in agreements between any ICE Data Services entity (“ICE”) and their clients relating to any of the Indices or products or services described herein. The information provided by ICE and contained herein is subject to change without notice and does not constitute any form of representation or undertaking. ICE and its affiliates make no warranties whatsoever either express or implied as to merchantability fitness for a particular purpose or any other matter in connection with the information provided. Without limiting the foregoing ICE and its affiliates makes no representation or warranty that any information provided hereunder are complete or free from errors omissions or defects. All information provided by ICE is owned by or licensed to ICE. ICE retains exclusive ownership of the ICE Indices including the ICE BofAML Indexes and the analytics used to create this analysis ICE may in its absolute discretion and without prior notice revise or terminate the ICE information Indices and analytics at any time. The information in this analysis is for internal use only and redistribution of this information to third parties is expressly prohibited.
Neither the analysis nor the information contained therein constitutes investment advice or an offer or an invitation to make an offer to buy or sell any securities or any options, futures or other derivatives related to such securities. The information and calculations contained in this analysis have been obtained from a variety of sources including those other than ICE and ICE does not guarantee their accuracy. Prior to relying on any ICE information and/or the execution of a security trade.