The Credit Risk Premium: Should Investors Overweight Credit, When, and By How Much?

Abstract

The authors revisit the case for maintaining a strategic overweight to corporate bonds in fixed income portfolios based on the notion of the credit risk premium. Using a series of excess returns to investment-grade corporate bonds going back to 1926, the authors find evidence of a positive risk premium of corporate bonds over Treasuries. However, investors who rely on a passive structural overweight should be aware of the substantial additional tracking error and the long payoff periods required. Second, they examine the behavior of credit excess returns through many cycles, using the OECD Composite Leading Index to divide economic activity into four re-occurring phases. At the margin, the results are useful in guiding portfolio managers and asset owners in their tactical decisions with regard to the magnitude of the credit tilt.

TOPICS: Fixed-income portfolio management, mutual funds/passive investing/indexing, analysis of individual factors/risk premia