Treasury Bonds vs. Corporate Bonds – The Showdown

Bonds are usually held in a portfolio with equities to reduce volatility and to offer downside protection against black swan events. Let’s dive right into comparing treasury bonds vs. corporate bonds.

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In a hurry? Here are the highlights:

• Corporate bonds are more volatile than treasury bonds.
• Interest from treasury bonds is exempt from state and local taxes, while interest from corporate debt is not.
• Treasury bonds offer a reliably lower correlation to equities than corporate bonds.
• Compared to corporate bonds, a traditional 60/40 portfolio using treasury bonds has historically resulted in higher returns, lower volatility, higher risk-adjusted returns (Sharpe), and smaller drawdowns.
• Many investors incidentally hold corporate bonds simply because of the convenience, popularity, and availability of total bond market funds that contain some allocation of corporate bonds.
• Treasury bonds should be preferable to corporate bonds in a long-term diversified portfolio, and have the added benefits of allowing you to avoid state and local taxes, credit risk, and liquidity risk that accompany corporate debt.

Introduction and Assumptions

Let’s start with some basic assumptions for the foundation of this discussion:

• Stocks tend to have higher returns than bonds.
• Bonds are used as a diversifier, held alongside stocks to reduce volatility and protect against black swan events.
• Investors should be attempting to optimize the portfolio as a whole (specifically CAGR, volatility, max drawdown, and risk-adjusted return as measured by Sharpe), not assets held in isolation.
• Classes of bonds include government debt and corporate debt (among others), each with its own unique correlation to equities.

Corporate bonds have historically delivered ever-so-slightly higher pre-tax returns (on paper) than treasury bonds. It’s been theorized that this is due to a “tax premium” to compensate for state and local taxes, a liquidity premium due to their comparatively lower trading volume, and a risk premium considering corporate issues are riskier than U.S. government debt.

One would think it would follow that higher portfolio returns can be achieved by pairing stocks with corporate bonds, but that’s actually not the case. The reason for this lies in asset correlations.

Correlations, Liquidity Risk, and Credit Risk

Recall from high school math class that the bivariate correlation coefficient (aka the Pearson correlation coefficient or “Pearson’s r”) is a measure of the linear correlation between two variables, with possible values between -1 and 1. A correlation coefficient of -1 means perfect negative correlation. A correlation coefficient of 1 means perfect positive correlation. A correlation coefficient of zero means no correlation, or uncorrelation.

The reason bonds tend to reduce volatility within a portfolio alongside equities is precisely because of their possessing negative correlation – or at least uncorrelation – to equities. Over the past 30 years or so, long-term treasury bonds have had a fairly reliable negative correlation to stocks of approximately -0.5 on average, compared to 0.1 for corporate bonds.

It has been noted that this negative correlation of treasury bonds is even amplified during times of market turmoil, which researchers referred to as crisis alpha. From 1926 to 2015, US long-term treasury bonds had a monthly correlation to US equities of 0.09, compared to 0.19 for US long-term corporate bonds. In months when US stocks generated a negative return, these correlations were 0.00 and 0.36, respectively.

This is due to the famous “flight to safety” behavioral effect wherein investors flock to bonds – specifically treasury bonds – when stocks are falling, thereby bidding up the price of treasuries. A portfolio using treasury bonds should reliably outperform a portfolio using corporate bonds in times of market turmoil.

Moreover, the 2008 financial crisis showed us that corporate bonds do indeed present significant liquidity risk during periods of market turmoil, for which investors are not adequately compensated. This illustrated that equity risk and credit risk are related, and that corporate bonds do not do their job at the precise time you need them to (when stocks are crashing). Just as with stocks, corporate bonds seem to possess significant tail risk. The credit risk for treasuries is essentially zero.

Keep in mind too that the potential outperformance in isolation of corporate bonds comes at the cost of greater volatility. The whole point of bonds in a diversified portfolio is usually to reduce volatility. A common Bogleheads reference is to “take the risk on the equities side.”

These differences are amplified in a taxable environment, as interest from treasury bonds is tax-free at the state and local levels, while interest from corporate debt is not.

Treasury Bonds vs. Corporate Bonds – Performance Backtest

Here’s a backtest going back to 1978 using a traditional 60/40 portfolio, one using long-term treasury bonds and one using long-term corporate bonds. The portfolio with treasury bonds (in blue below) comes out with a higher return, lower volatility, higher risk-adjusted return (Sharpe), and considerably smaller max drawdown (from the Subprime Mortgage Crisis of 2008):

Why Do People Hold Corporate Bonds?

Due to the inherent higher volatility of corporate debt, it has been shown that, pre-tax, holding corporate bonds over government debt is basically the same as an additional 2 percent weighting to equities. I’ve been saying this for years – I view corporate bonds as somewhat of a halfway point between stocks and treasuries. A portfolio containing stocks and bonds invariably requires a higher corporate bond allocation (compared to treasuries) for the same degree of volatility reduction and downside protection.

So why does anyone hold corporate bonds?

I can think of a few reasons why they might:

• For some reason, the entire portfolio may be 100% bonds and the investor wants more risk/reward within those bonds.
• The investor is using bond interest as income and is utilizing a high-yield corporate bond fund.
• Probably the most likely, the investor is invested in a total bond market fund within a lazy portfolio, such as Vanguard’s BND. Investors simply may not know – or may not care – that total bond market funds usually contain about 25-30% corporate debt. This case is likely simply borne of the convenience, popularity, and availability of total bond market funds, especially considering investors may not want to or may not know how to choose the appropriate maturity and duration of their bond allocation. Recent products like the iShares U.S. Treasury Bond ETF (GOVT) remedy this.

Conclusion

In conclusion, utilizing treasury bonds should be preferable to corporate bonds due to their superior volatility reduction and black swan protection in a long-term diversified portfolio, and have the added benefits of allowing you to avoid state and local taxes, credit risk, and liquidity risk that accompany corporate debt.

References

Swedroe, Larry. 2014. “Swedroe: Fixed Income’s Low Risk Anomaly.” ETF.com, posted April 23 at etf.com/sections/index-investor-corner/21862.html?nopaging=1.

Swedroe, Larry. 2016. “Swedroe: Reconsidering Corporate Bonds.” ETF.com, posted July 15 at etf.com/sections/index-investor-corner/swedroe-reconsidering-corporate-bonds?nopaging=1.

Stivers, Chris, and Licheng Sun. 2002. “Stock Market Uncertainty and the Relation Between Stock and Bond Returns.” Federal Reserve Bank of Atlanta working paper 2002-3, available at https://www.optimizedportfolio.com/wp-content/uploads/2020/10/10.1.1.197.4328.pdf.

Philips, Christopher B., David J. Walker, and Francis M. Kinniry Jr. 2012. “Dynamic Correlations: The Implications for Portfolio Construction.” Vanguard research paper available at https://www.optimizedportfolio.com/wp-content/uploads/2020/10/dynamic-correlations.pdf.

Fama, Eugene F., and Kenneth R. French. 1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics 33 (1): 3–56.

Connolly, Robert, Chris Stivers, and Licheng Sun. 2005. “Stock Market Uncertainty and the Stock-Bond Return Relation.” The Journal of Financial and Quantitative Analysis 40 (1): 161–194.

Disclaimer:  While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.