Grok’s Tip #14: Avoid long-term corporate bonds

grokGrok’s Tip #14: Avoid long-term corporate bonds

It’s a tough fixed income investing environment out there, no question. Bond yields are brutally low with the 10 year treasury yield under 2% and t-bills yielding 0%. There has been a lot of talk about corporate bonds, and in particular some may think that long-term corporate bonds, with yields of around 4.5%, might be worth a look. Apple for example recently sold 30 year corporate bonds at a yield of 3.88% which was a spread over treasuries of 100 bps. Investors were so excited about the offering that it was 3 times oversubscribed.

http://www.fool.com/retirement/general/ … stors.aspx

Vanguard introduced a long term corporate bond ETF in late 2009 and the returns have been very good, averaging 12% annual return since inception. So should you dive in?

My advice: stay away!

To understand why, let’s look at the long term returns. Over the past 40 years, the average annual return since inception of the Barclays long term corporate bond index was 8.88%.  Not too shabby. But wait- what was the return over the same period of the long-term treasury index? You guessed it, almost exactly the same, it clocked in at 8.78%. And of course you can buy and hold treasuries directly at no cost. Whereas even the ultra-low cost Vanguard ETF charges 12 bps annually- so after costs the corporate bonds lagged by 2bps.

So basically, over this long 40 year period investors received no compensation for bearing all the extra risks of corporate bonds, credit risk, liquidity risk, etc.

So why is investing in long-term corporate bonds a mug’s game? Who knows? My own view is that it may have something to do with the limited life-span of corporations. See this link for example

http://www.innosight.com/innovation-res … al2012.pdf

The chart shows that the average lifespan of a company in the S&P 500 index has declined from around 30 years in the mid ’70s to less than 15 years today. It’s a volatile uncertain world out there and getting more so.

But wait, you say, doesn’t the same argument apply to equity index investing? The difference I think is a fundamental one between stock and bond investing. With stocks you have unlimited upside. So if a few companies fail, that can be more than compensated for by the companies whose value skyrockets like Google, and well, I guess Apple! But on the bond side, your upside is capped. When you are only getting a measly 1% per year over treasuries it only takes one Enron to ruin the return for your whole bond portfolio.

So skip long-term corporate bonds! Take your risk on the equity side!

We don’t own any corporate bonds other than the small amount that is in the Vanguard total bond market fund. And these are certainly not long-term bonds.

As an interesting aside, John Bogle has been espousing the need to hold more corporate bonds. Here is a new interview with John Bogle by Olly Ludwig of ETF.com. It is titled, “Bogle: Tilt To Corporates For More Yield.” This is the introduction:

John Bogle, Vanguard’s founder who built a second career as an author and the conscience of American capitalism, is still vigorous and relevant at the age of 84. As always, Bogle counsels investors to keep their focus on the long term, and to try to look past the near-term distractions in markets.

Total returns will always be the sum of earnings growth and dividend yield, plus whatever yield the bond market is serving up. Regarding the paltry bond yields that still prevail since markets crashed five years ago, Bogle reckons investors would be wise to work around the overweight in government debt that now characterizes the Total Bond Market Index.

He stressed that even ardent indexers like himself should always be focused on improving indexes, and he does that in the bond market by taking on a bit of extra risk and yields by including corporate debt in his retirement account and tax-free municipal debt in his non-retirement account.

Personally, I agree with Grok on this one. Corporate bonds are just so much more risky than treasuries. Their returns have historically been the same, why take on extra risk for no additional reward? And yes, I realize that corporate bonds have been paying a higher yield in the current low-interest environment, but how long will this continue?


2 thoughts on “Grok’s Tip #14: Avoid long-term corporate bonds

  1. Our Simpleton’s portfolio calls for 25% short term, high quality US bonds…which pay less than my savings account these days. It’s a bit aggravating, but that’s the point of this part of our portfolio. It’s the safe part. Though I have to wonder if I’d be better off just holding cash these days…

    1. Hi Done by Forty. You and I and everyone else are wondering about bonds. My trouble with changing from bonds to cash (using CDs or some such) is that all of our bonds are in tax sheltered accounts, and CDs would be in taxable accounts. If I were to shift things about in a substantial way, I’d be selling a lot of equities in our taxable account, for which we’d have to pay a lot of capital gains. I’d prefer not to do that when we could pay zero taxes on capital gains after we retire (and are hopefully in the 15% income tax bracket). Nothing is easy.

      Thanks for stopping by and commenting.

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