Adding other government and corporate bonds
The main focus of this book has been on creating a simple, yet powerful and robust portfolio for the rational investor. The message is hopefully clear: if you want no risk, pick the minimal risk asset; if you want a lot of risk, pick a broad-based equity portfolio. If you want a risk profile in between the two, you allocate between the two. And do this in a cheap and tax-efficient way. Simple. If you do this and read no further, in my view you are already doing better than the vast majority of investors, private or institutional.
If you ignore this chapter and stick with the simple minimum risk/world equity portfolio you are still doing very well. Only add other government and corporate bonds if you are comfortable with extra complexity of the portfolio – the benefits may not be worth it otherwise.
This chapter slightly muddies the waters for those investors who are willing to accept a bit more complexity, namely the addition of return-generating government and corporate bonds. The addition of these asset classes further adds diversification to your portfolio and therefore potentially further enhances the already attractive risk/return profile of the rational portfolio.
Importantly to the rational investor, adding government bonds and corporate bonds does not suggest that you can beat the market in these asset classes. We add these asset classes because we think the asset class as a whole adds to the risk/return characteristic of the portfolio – not because we would have to pick and choose which securities within that asset class are attractive. Much like with equities where we accepted that we can’t beat the market by picking individual stocks, we don’t think we are able to pick only the winners among the other government or corporate bonds either.
So what is the difference between the minimal risk bonds and the other government bonds we are now looking to add? Think of your minimal risk bonds as the core of your portfolio. This is not where you are looking to make money, but where you are looking to take a minimal risk. I am then adding all other government bonds, other than the minimal risk bonds that are already in your portfolio. So if your minimal risk bonds are UK government bonds, then the other government bonds you should consider adding are all but UK government bonds.
Adjusting the rational portfolio
Adding other bonds to the portfolio gives additional diversification benefits to the portfolio, but does so at the expense of more complexity. When deciding on what portion of your portfolio you should allocate to bonds, start by going back to your premise as a rational investor. We assumed each dollar invested in the world markets is equally well informed, and as a result we should try to replicate the exposures of all markets and securities when we add a new asset class.
In aggregate there is over $100 trillion in combined value of world equities, and world government and corporate bonds. But I believe you should only include government bonds that add returns to your portfolio above that of your minimal risk asset. Since the world’s biggest issuers of government bonds are also highly rated (such as US, Japan, Germany, UK, etc.), excluding them reduces the portfolio’s exposure to government bonds compared to the ‘buy the world’ strategy, and is a departure from portfolio theory. According to portfolio theory you should add all the world’s investable assets in proportion to their values, and combine those investments with the risk-free asset to get to your desired risk level. Here I’m suggesting that you should only add government bonds that have a positive real expected return higher than your minimal risk government bonds, as you are otherwise adding currency risk without adding real expected returns.1 As an example, if your minimal risk asset was UK government bonds and you added German government bonds to the portfolio then the low yield of the German bonds would not add returns to your portfolio, but would add GBP/EUR foreign exchange risk.
Unlike for the government bond portion of the portfolio, for corporate bonds we are trying to add a representative investment of the whole asset class across the broadest range of maturities, sectors, geographies, currencies and credit qualities.2
In order to not muddle the simple message of this book, the reasoning and details behind adding government bonds and corporate bonds are in separate appendices. If you are inclined to accept adding additional asset classes to your portfolio, please have a read – it could be well worth it.
After adjusting the portfolio to exclude the minimal risk bonds and other highly rated and low-yielding government bonds – so all the AAA/AA-rated ones – the split among asset classes looks like Figure 7.1.
Figure 7.2 The updated portfolio
Using this mix of assets as a rough guide to our portfolio allocation we could allocate our risky investments as follows:
| World equity markets | 75% |
| Sub-AA government debt | 10% |
| Corporate debt | 15% |
If you combine your investment in the minimal risk asset with investments in equities, risky government bonds and corporate bonds in those proportions you are doing well. You will have allocated your investments roughly in the same proportions as the aggregate market participants who have been choosing between a wide array of investable assets in search of the best risk/return. If you now do so in a cost- and tax-efficient manner, while thinking about your risk levels, you will have created a very strong portfolio. Graphically this updated portfolio is illustrated as point T in Figure 7.2 (see Appendix on portfolio theory for better understanding of graph).
If your risk preference is lower than point T, you combine the ‘T’ portfolio (as in Figure 7.2) with the minimal risk asset to get the desired portfolio risk.
The rational portfolio allocations
So, now we have a rational portfolio as shown in Figure 7.3. Incorporating the points above about the relative proportions of risky government and corporate bonds relative to equities, the rational portfolio could look like that in Table 7.1.
Table 7.1 The rational portfolio at different risk preferences (percentages)
The allocations shown in the table are the best because they are based on the proportions of values that the market already ascribes to them, with the caveat that I have excluded non-return generating, highly rated government bonds. So apart from those highly rated bonds, the ratio of equities, government and corporate bonds is in line with the market value proportions in the world today. And if we allocate along the same lines as the efficient markets we will achieve maximum diversification and the best risk/return profile.
We need to take a combination of equities and other government and corporate bonds and combine that with our ‘safety asset’, the minimal risk asset. How much risk we want is then determined by how much of the minimal risk asset, and how much of the combination of the other asset classes, we want. Construct your portfolio in this way and you will have an outstanding portfolio for the long run.
In implementing the portfolios outlined above look for products that, as closely as possible, represent the various asset classes:
| Asset class | Description |
| Minimal risk asset | UK, US, German, etc. government bonds (or equivalent credit quality) with maturity matching investor’s time horizon. |
| Equities | World equity index or as broad an exposure as possible. |
| Other government bonds | Diversified, real return-generating government bonds of varying maturities, countries and currencies; we have used those rated sub-AA as a good indicator. |
| Corporate bonds | Broad range of corporate bonds of varying maturities, credit risk, currency, issuer and geographic area. |
In the appendices ‘Adding Other Government Bonds’ and ‘Adding Corporate Bonds’ are some specific thoughts and tools to practically gaining this exposure in your portfolio. See Chapter 12 for details about how to implement the minimal risk asset and world equity index tracker exposure.
If the strategy for investing above seems simple, that is because it is. As a rational investor who is willing to add a bit of complexity to the minimal risk/equity mix from earlier, we are simply adding real return-generating bonds in the proportions that they exist in the world. We think that the normal functioning of the market has caused the prices of the many debt and equity securities to be such that they reflect the risk/return characteristic of that security.
Of course not every investment in the world is perfectly efficiently priced. If this was the case, and everybody believed it, then there would be no trading. Everyone would accept that the prices reflected all information and the security’s risk/return contribution. But that is not the point. The point is that we do not think that we are in a position to know better than the prices set by the market and as a result should not try to reallocate our portfolio to get better returns.
Return expectations of the rational portfolio
Below are some estimates for returns of the various asset classes we have discussed so far in this book. Based on a mix of academic research, historical returns, a study of the financial markets and my own judgement I have outlined what I would consider reasonable expected returns for each asset class, above the rate of inflation as follows:
| Annual real return expectations | ||
| Minimal risk asset | 0.50% | (UK, US, German government debt or similar) |
| ‘Risky’ government bonds | 2.00% | (sub-AA-rated countries) |
| Corporate bonds | 3.00% | (mix of maturities, countries and credit quality) |
| World equities | 5.00% | (4.5% equity risk premium) |
In later sections, we look at individual attitudes towards risk. We have good data to gain some meaningful insights about the risk of investing in equity markets, whereas it’s harder to be exact about the overall portfolio risk. While we can try to quantify the risk of government and corporate bonds, it is harder to predict how those move relative to each other and to equities (correlation) with any accuracy, and therefore what the aggregate portfolio risk is.
Extrapolating an understanding of equity market risk to the overall portfolio you need to bear the following in mind:
- Try to understand the risks you are taking with an investment in the world equity markets.
- Realise that your minimal risk asset is not entirely without risk, but has a far lower risk than the equity markets. Longer-maturity bonds will fluctuate more in value than shorter-term ones.
- Other government and corporate bonds will typically have a risk level between equities and the minimal risk bonds. The riskier the bonds, the more they will be like equities and perhaps move in price more like equities if markets drop, but it is hard to be exact about that. As a very rough rule of thumb, assume that the other government and corporate bonds have slightly less than half the risk of equities, but will move more like equities in terrible markets than when markets are stable.
Although you have added diversification to your portfolio by adding risky government and corporate bonds, adding bonds is not always guaranteed beneficial. The correlation between those assets and the rest of your portfolio is likely to be higher during duress than in a steady state, even as some higher-rated bonds may increase in value as a safe haven during a storm.
Special case: if you want a lot of risk
Theory and practice collide in the case where an investor’s risk preference is higher than point T in Figure 7.2. Theory suggests that the investor should borrow money and use that borrowed money to buy more of the ‘T’ portfolio.3 In reality many investors either don’t ever want to borrow to invest or simply can’t find the money to do so. Particularly post-2008, when geared investors got burned badly as loans got called at the worst possible time, investing with borrowed money is often not a real or desired alternative.
For investors with a higher risk preference than point T, I would suggest buying more of the world equity portfolio and fewer bonds (instead of borrowing money to buy more of the mix of equities and bonds) – see Figure 7.4.
If you want even more risk than being 100% invested in world equities there are leveraged ETFs. Simplistically, the way they work is that the provider takes your $50 and uses that as collateral to borrow another $50, and then invests the $100 (in the case of a 50% leverage product). You will then have the exposure to the market of $100 despite only having invested $50. This obviously works well if markets are going up, but will quickly hurt badly in declining markets.
Figure 7.4 Higher risk-preference investors
Typical criticisms of adding bonds to a portfolio
Compared to equities there are fewer good bond indices and they are not as well known
True. Many investors don’t even know they exist. But what we care about is the availability of products that represent a broad range of bonds, both geographically and by type. Although this sector is still not up to the level of equities it is improving.
You will tend to overweight the debt of indebted countries and companies (they have more debt outstanding as a fraction of company value or GDP)
True. But the prices should reflect the higher indebtedness. In the future there could be government bond indices driven by the GDP of a country, but those that exist are still not that widespread. That said, if you find one country or issuer dominating your additional government or corporate bond portfolio it would make sense to reduce that exposure.
In certain countries the trading of bonds is very expensive, rendering them a bad risk/return prospect
The key thing to figure out is if you are at a cost disadvantage compared to other market participants. If you are, it may make sense to stay away. If costs are just high for everyone, the higher costs should be reflected in the price and not affect the bond’s risk/return profile.
The income from bond coupon payments renders them tax inefficient
Important point. If you are unable to find tax-efficient products (ETFs, etc.) you may consider tax-advantageous bonds in your geographic area, such as municipal bonds in the US. A tax disadvantage can easily eliminate any investment advantage.
Bond products only represent a portion of the total bonds outstanding
It would be impractical and/or impossible to buy a small portion of all outstanding bonds in the world. Indices try to ensure that they can be practically implemented and thus avoid small and illiquid bonds; as with equity markets (to a lesser degree) this is a simplification we have to live with.
Bonds are mainly dollar denominated. This is an issue for non-US investors
Yes, a large portion is in dollars. This is because of the US’s dominance of government and corporate bonds, but also because many that issue bonds in currencies other than their home currency do so in dollars. You can partly alleviate this problem if your minimal risk asset is not US government bonds and thus exclude them from your other government bond allocation. Also, don’t ignore the large and increasing number of international corporate bonds.
It is expensive to trade bonds and hard to get the exposure right
Unless you are a big institution you should buy products like ETFs, bond index funds or even cheap managed bond funds that acquire the bonds for you. With the exception of buying government bonds directly from the treasury, you can typically only buy bonds in larger ticket sizes and by buying aggregating products like ETFs or index funds scale and cost advantages are gained that are hard for the individual investor to match. (This is also discussed later in Chapter 12). I agree that it is hard to find the kind of broad and cheap exposure like the world equity index tracker, and it is a good reason for many people to stay away from adding these extra asset classes. Many of the choices are quite expensive and give a fairly narrow exposure which is not in the interest of the rational investor.
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1 See Chapter 4 on minimal risk assets for the cases where buying highly rated government bonds from different countries in various currencies may make sense for you if either you want to diversify the very low risk of a highly rated country defaulting, or you consider your base currency a mix of several currencies.
2 Note that the argument of only adding bonds that add returns above your minimal risk asset also applies to corporate bonds. But in reality there are very few corporate bonds with higher rating than your minimal risk asset, so for simplicity I have ignored this slight inconsistency.
3 The straight line between minimal risk, point T, and up to the right assumes that the investor can borrow at the same rate as the minimal risk bond. In reality the borrowing rate for the investor would be higher and the curve to the right of point T would be flatter to reflect the lower expected return (higher borrowing costs) as risk increases.