Ready for this week’s retirement investing pop quiz?
In what kind of bonds should you invest the fixed income portion of your portfolio if you thought that a huge economic downturn was just around the corner—U.S. Treasurys or High-Grade Corporate Bonds?
The standard answer from most financial planners is the former. Their theory, which certainly is plausible, is that during economic crashes investors dump all risky assets—including corporate bonds—in favor of the safety of U.S. Treasurys. But few, if any, of these financial planners have actually analyzed the historical record with sufficient detail to verify this theory.
Edward McQuarrie has just done this work for all of us. He is a professor emeritus at the Leavey School of Business at Santa Clara University who has spent years reconstructing U.S. stock and bond market history back to 1793. In a 200+ page study he just posted on the Social Science Network, he corrected for errors that previous researchers have made in calculating bonds’ returns over the last two centuries.
One of the fascinating insights he got from his research was the surprisingly strong relative performance of high-grade corporate bonds during the Great Depression and the Great Financial Crisis. “I found that a corporate [bond] portfolio launched in January 1929, or in January 2008, outperformed a portfolio of long Treasury bonds if held until after the crisis passed,” McQuarrie told me in an email.
Note that the two dates to which McQuarrie refers come just months before huge economic downturns. Presumably those occasions would be when you would want to avoid corporate bonds at all costs. And, yet, they came out ahead if held for only several years.
Consider first how you would have fared had you invested your fixed income portfolio in long-term high-grade corporate bonds in January 1929. Your total return over the next eight years would have been 5.9% annualized, according to McQuarrie’s data. If you had instead invested in long-term U.S. Treasurys your comparable return would have been 4.9% annualized.
By the way, McQuarrie’s data takes into account the losses corporate bonds suffered because of ratings downgrades and other adverse developments. In fact, his data series shows corporate bonds produced a lower return in some years during the 1930s than previously reported by sources such as the famous Stock, Bonds, Bills and Inflation yearbook made famous by Ibbotson (now part of Morningstar). Still, even after making these corrections, McQuarrie finds that long-term high-grade corporate bonds outperformed long-term Treasurys during the Great Depression.
High-grade corporate bonds’ margin over long-term Treasurys was almost as large over the period beginning in January 2008, just as the Great Financial Crisis was gathering steam. From then until January 2015, according to Morningstar data, long-term corporate bonds beat long-term Treasurys by an annualized margin of 9.3% to 8.5%.
McQuarrie’s research should be reassuring news to retirees who are hoping to capture corporate bonds’ higher yields. Currently, for example, the Vanguard Long-Term Corporate Bond ETF
sports a 30-day SEC yield of 2.80%, 1.31 percentage points more than the 1.49% yield of the Vanguard Long-Term Treasury ETF
Corporate bonds’ higher yields are not entirely a free lunch, since they are likely to suffer more than Treasurys in the early phases of any future economic downturn. This happened during both the Great Depression and the Great Financial Crisis. But, assuming the future is like the past, corporate bonds will in a couple of years recover enough to overcome their initial losses.
In the meantime, so long as that inevitable downturn keeps getting postponed, you will be earning a greater yield with corporates.
Finally, bear in mind that McQuarrie’s research was conducted on investment-grade corporate bonds. He did not focus on high-yield, or junk, bonds. So don’t conclude from his research that, in your quest for higher yields, you now can safely go all the way to the junk-bond end of the risk spectrum that extends from very conservative (Treasurys) to very risky (high-yield).
In effect, the message of his research is that you can take a few steps along that spectrum, but probably no more than that.