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This article originally appeared on ETF.COM here.
In another article, we looked at the size and volatility of the three equity premiums of beta, size and value. Today we turn our attention to the two premiums that help explain the performance of bond portfolios: term and credit.
Unlike the case with the value premium, there’s no debate about these two factors being risk premiums rather than anomalies created by behavioral errors. The data covers the same 91-year period, 1927-2017, that we used in looking at the equity premiums.
Term premium
The term premium is defined as the difference in returns between long-term government bonds (20 years) and one-month Treasury bills. For the period 1927-2017, the average annual term premium has been 2.55%. The annual standard deviation of that premium has been 9.84%, or almost 4.0 times the size of the premium itself.
The term premium was negative 40 of the years, or 44% of the 91 years. The largest term premium was in 1982 at 29.82%, an almost-three-standard-deviation event. The most negative premium, 15.18%, occurred just two years earlier in 1980. Thus, the gap between the largest and most negative premium was more than 45%, or about 18 times the size of the premium itself. Clearly, there is risk in the term premium.
It’s also important to examine how term risk mixes with equity risk. Over the period, the annual correlation of the term and equity premiums was zero. That’s a positive from a portfolio perspective.
Default premium
The default premium is defined as the difference in returns between long-term corporate bonds (20 years) and long-term government bonds (20 years). For the period 1927-2017, the average annual default premium was just 0.41%. The annual standard deviation of that premium has been 4.5%, or more than 11 times the size of the premium itself.
The default premium was negative 36 of the years, or 38.5% of the 91 years. In contrast, the equity premium was only negative in 27 years, or 30% of the years. The largest negative default premium was in 2008, when it was -17.09%. The largest positive default premium occurred just one year later at 17.92%. Thus, the gap between the largest and most negative premium was more than 35%, or about 86 times the size of the premium itself. Clearly, there’s risk in the default premium.
Read the full article here by Larry Swedroe, Advisor Perspectives
