Investment Grade Bonds

In addition to market risk, investors in fixed income instruments may also take on credit risk (that is, the risk that the issuer of the bond will default, and you will lose your capital value). To help investors judge this risk, most bonds are rated by a credit rating agency. Typically, bonds receiving the top four ratings (e.g., AAA, AA, A, and BBB) are considered "investment grade", while those with lower ratings are politely called "high yield", and less politely called "junk bonds." Theoretically, the only bonds that don’t have any credit risk are those issued by governments, since governments don’t go bankrupt. However, history has proven that some governments do go out of business (reluctantly, and usually with a lot of bloodshed), which, from a bondholder’s perspective, is the same thing. So, to be more accurate, the lack of credit risk associated with government bonds is only guaranteed for the time horizon over which you believe you can predict potentially disastrous political events.

Broadly speaking, there are three types of investment grade bonds. The first are issued by governments. The second are issued by corporations, but not secured by any assets (technically, these are known as debentures). The third are bonds secured against assets, the most common of which are mortgage bonds (though the volume of other "asset-backed bonds" secured against things like credit card receivables has been growing in recent years).

As previously noted, investment grade bonds are particularly attractive during deflationary periods, which increases the real value of both the interest and principal payments received by bondholders (assuming said gains aren’t offset by increasing defaults brought on by deflation). During inflationary periods, the real value of bond interest (assuming fixed payments) and principal declines, and bondholders sometimes earn negative real returns (particularly if they hold long term instruments). In normal periods, with low inflation and steady GDP growth, bondholders generally earn total returns that lag behind those on other asset classes.

The following table clearly illustrates these differences. It shows the geometric average real returns earned by bondholders in different currencies during three very different decades of time. The seventies were a period of high inflation, the eighties moderate inflation, and the nineties low inflation (including deflation in Japan). The final two columns show the real returns earned over two very troubled quarters: the fourth quarter of 1987, which included the global equity market crash, and the third quarter of 1998, which included the global liquidity crisis associated with the collapse of the Long Term Capital Management hedge fund.

Real Domestic Investment Grade Bond Returns Under Different Conditions
Geometric Annual Returns for Decades, Quarterly Returns for Quarters

	1970s	1980s	1990s	4Q 1987 (1)	3Q 1998 (2)
A$	(5.5%)	2.4%	8.8%	.3%	3.6%
C$	(1.6%)	6.4%	9.3%	5.6%	3.7%
DM/Euro	1.9%	4.7%	5.1%	3.9%	4.5%
Yen	(2.3%)	6.7%	5.4%	7.4%	4.4%
GB £	(4.4%)	7.5%	8.9%	5.4%	7.4%
US $	(1.7%)	7.2%	6.7%	4.6%	3.4%

Sources: Triumph of the Optimists (Dimson, Marsh, Staunton), and Retired Investor calculations
1Global equity crash; 2Global liquidity crisis (Long Term Capital Management)

This table demonstrates two of the great truisms in the bond business: first, falling rates are your friend. For example, in the United States, the nominal yield on ten year Treasury Bonds has fallen from 15.32% in September, 1981 to 3.96% at the end of April, 2003, creating a bull market in bonds that has lasted longer than its equity market counterpart. The second truism is that investment grade bonds (and especially government bonds) tend to benefit when things hit the fan, and investors move their funds into low risk assets (also known as a "flight to quality").

It is equally informative to look at the distribution of real returns on different domestic bond indexes over the entire 1971 to 2002 period. The following table shows arithmetic average annual returns, standard deviations, skewness and kurtosis for these indexes:

Real Domestic Bond Returns 1971 to 2002

	Average Annual Return	Standard Deviation	Skewness	Kurtosis
A$	3.94%	9.85%	(.22%)	2.38
C$	4.28%	7.64%	.32	4.15
DM/Euro	4.62%	5.06%	(.30)	1.06
Yen	3.58%	5.56%	(.44)	3.22
GB£	4.13%	9.70%	.26	1.53
US$	3.82%	5.40%	.41	4.20

This table is interesting for a number of reasons. First, it shows that the real average annual return on investment grade domestic bonds over the past thirty-two years has been roughly the same across six major markets. At the very least, this suggests that those markets operate quite efficiently. Second, the fact that Australia and the UK experienced higher levels of inflation in the seventies and eighties than the other two areas shows up clearly in the higher standard deviations for these two currencies. Finally, the table helps to illustrate our earlier point about risk being a concept that is hard to capture using a single statistic. The standard deviations of returns are about the same for DM/Euro and Yen bonds. If that was the only statistic you had available, you might say they were equally risky. You wouldn't say this, however, if you could also examine their skewness and kurtosis.

As you can see, Yen bonds were more likely to have returns below their average, and these were more likely to be bigger than was the case for DM/Euro bonds. In short, after examining all three statistics, it becomes clear that the Yen bonds were riskier to hold over the 1971-2002 period.

If you assume that the lowest risk asset in any market is a real return bond issued by the government, you can estimate the future return on other domestic fixed income assets by adding a spread to the real return bonds that reflects the increased riskiness of the asset whose future return you are estimating. In this case, to estimate the future real annual return on domestic investment grade bonds, we have added 1.50% to the estimated future return on real return bonds. This yields an estimated real return of 4.00% per year. For the standard deviations, we will use the data from 1971-2002, as this period contains a fairly wide mix of different market conditions.

So, to summarize the pros and cons of investing in this asset class:

Market Condition	Normal	Inflation	Deflation
Reasons to Invest in Domestic Investment Grade Bonds	Relatively low return volatility Relatively low correlation of returns with other asset classes Potentially high short term (e.g. quarterly) returns in times of crisis that trigger "flight to quality"	Hard to think of one.	Both interest payments and capital values increase in real terms
Reasons Not to Invest in Domestic Investment Grade Bonds	Other asset classes provide higher returns	Avoid declines in the real value of interest and principal payments	Credit quality may be adversely affected (stick to government bonds.)