Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

U.S. interest rates are at historic lows. The U.S. economy appears to be gaining strength. The Federal Reserve is determined to raise rates. Many investors think that’s a cocktail for higher interest rates and trouble for U.S. bonds.

There’s no shortage of purported solutions for worried bond investors. High-dividend stocks and liquid alternatives are two commonly cited cures for the rate-hike blues. Charles Schwab recently nodded to another remedy: Swap those boring government bonds for corporate ones.

It’s an appealing idea in theory. Bond investors are basically paid to take two risks: Interest rate risk -- the chance that rates will rise and hammer prices -- and credit risk -- the possibility that borrowers won’t be able to pay back their debt.

Investors in government bonds need to worry almost entirely about interest rate risk; there’s little concern that the U.S. government will run out of money. Corporate bonds, on the other hand, carry both risks, which is why yields on corporate bonds are almost always higher than those on government bonds with comparable maturities.

Given their interest rate risk, both government and corporate bonds are in harm’s way when rates climb. But rising rates are often accompanied by a strong economy, and a strong economy usually means that companies are profitable and less likely to default on their debts. It stands to reason, then, that the credit risk in corporate bonds will pay off when interest rates rise and that they will hold up better than government bonds.   

Rising Expectations
Futures traders are anticipating an uptick in inflation
Source: Bloomberg

Despite the strategy’s appeal, Schwab is skeptical that this is a good time to buy corporate bonds “because valuations are on the high end of historical averages.” It’s true that the volume of investment-grade corporate debt has notched a new record in each of the last six years. Companies have been lining up to take advantage of low interest rates and a seemingly endless demand for corporate bonds from yield-starved investors.

Still, it’s not entirely clear that corporate bonds are richly priced. The credit risk premium -- as measured by the difference between the 12-month yield of the Bloomberg Barclays U.S. Long Credit Index and the Bloomberg Barclays U.S. Long Treasury Index -- has averaged 1.3 percent since 1973. As of Jan. 31, that credit risk premium was 1.9 percent, which implies that corporate bonds are cheaper than their historical average.

Cost of Credit
Long-term corporate bonds don't look expensive in historical terms
Source: Morningstar
Note: Corporate bonds are Bloomberg Barclays U.S. Long Credit Index and Treasuries are Bloomberg Barclays U.S. Long Treasury Index.

But it turns out that valuations are hardly the issue. Investors who are tempted to swap their government bonds for corporate ones have a bigger obstacle: Corporate bonds aren’t much help when government bonds stumble.

I compared the historical monthly returns of long-term government bonds with those of long-term corporate bonds since 1926. I counted nine times when the total return from government bonds was negative 10 percent or worse. Those occasions coincided with periods of rising interest rates, as expected. (Interestingly, seven of those occasions have occurred during the celebrated bond bull market of the last three decades.)

Either Way
The total return from government bonds was down 10 percent or more nine times since 1926, and every time corporates were down, too
Source: Morningstar
Note: The dates refer to the drawdowns for government bonds; the dates for corporates do not correspond exactly in every case.

On each of those nine occasions, the total return from corporate bonds was also negative. Corporate bonds generally held up better, but not by much. The return from government bonds was down by an average of 13.1 percent, whereas corporate bonds were down by an average of 10.5 percent.  

There were additional periods of less drastic negative returns since 1926. Here, too, losses for government bonds almost always coincided with losses for corporate bonds, but in this context corporate bonds fared worse on average. Over rolling one-year periods, the total returns from government bonds were negative 28 percent of the time, and the average loss was 4.1 percent. Corporate bonds were negative 24 percent of the time, and the average loss was 4.3 percent.

Before investors anxiously pivot back to high-dividend stocks and liquid alternatives, it’s worth asking whether they ought to react to rising rates at all.

Consider that during eight of the nine occasions when government bonds were down 10 percent or more, investors were back in the black eight months after the bottom on average (the ninth occasion is currently underway, so it’s too early to know). In the worst case, investors had to wait 12 months for losses to reverse. Here again, the same was generally true for corporate bonds.

So even in their worst moments, bonds generally deliver on their reputation for safety. That is, provided investors can hang on for a few months. And if they can’t, corporate bonds are probably the least of their concerns.     

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net