Swensen on corporate paper

I've been reading though _Unconventional Success_ by David Swensen. Swensen discusses how bonds can be useful for the personal investor, some of which are: - low correlation with equities - defense against deflation - hedge against inflation (TIPS)

but corporate and municipal bonds fail the above tests. Most have call options that can be used if interest rates fall. Investment grade bonds can have credit ratings decreased, meaning you're holding a riskier bond that's now valued less. The issuer can default on the debt; this tends to occur exactly when you need bonds most, during a recession when stocks are doing poorly. And for all this, you get a meager point spread over government bond. Mortgage based securities, including GNMAs, can have similar problems - all resulting in lower returns.

He recommends holding Treasuries instead. They very rarely have call options, don't get riskier, don't default, and tend to be in demand during a downturn in the economy.

But many bond funds, including Vanguard's Total Bond Market Index, seem to include corporate paper and/or mortgage-based securities. Is there another side to these bonds? Why would any personal investor want medium-to-long term corporate paper? Perhaps for the additional yield if you expect the economy to remain on an even keel - no interest rate changes, no recession?

If you hold a bond fund, there is a degree of diversification. Not all the bonds will be called if interest rates fall. Although in the case of mortgage-backed, it is possible that a very large proporation of them will, to the point where as an investor you might lose money.

Accordingly, you get a higher return, in return for taking on a higher risk. In a bond fund the risk of an individual issue is normally diversified away for the bond fund unit holder.

*however* there are issues about credit risk:

- high yield ('junk') bonds are best thought of as a form of small cap equity investing. They don't have enough bond like characteristics

- even A rated companies or better (Moody's, S&P bond ratings) are often the subject of leveraged buyouts (LBOs), which lead to sharp reductions in bond creditworthiness- -bond holders get hosed, typically, in such situations (unless they have incorporated protective covenants in the original bond issue)

Perhaps for the additional yield

The yield difference between corporate bonds and treasuries moves up and down over time. Typically when it is very low relative to historic spreads it is because the economy is strong, and you are not really being paid as a bondholder to take on the extra risk. When the spreads are above historic averages, you are getting paid for that risk.

My own view is that an individual investor can afford to hold a percentage of her wealth in a broadly diversified bond index fund (ie including corporate bonds and mortgage backed)-- perhaps as much as half of his or her total exposure to bond funds.

However a medium term bond fund (say 5 year average maturity) really plays the role of a cash substitute in a portfolio. Because interest rates normally increase with the time to maturity (upward sloping yield curve), consistently holding a medium term bond fund in place of most of the cash in your portfolio is likely, over the long run, to give you higher returns.

I am not a big fan of long bonds (10+ years maturity say) unless it is to meet a specific, fixed liability in the future. I don't feel you are being adequately compensated, normally, for the risks of inflation (relative to a 5 year bond which typically yields as much).

For reasons Swensen explains, individual mortgage backed or corporate issues are probably inappropriate for most individual investors.