Date: 12/7/2010
Author: John Radtke

An Optimal Mix for Corporate Bonds

Advisers meeting with clients on year-end strategies may be discussing a fixed income portfolio which sufficiently diversifies credit risk. A recent study conducted by BondDesk Group makes the case that the number of bonds needed for adequate diversification may be lower than many advisers assume.

The BondDesk study suggests that a high grade fixed income portfolio of 10-15 bonds offers nearly as much credit risk diversification as 40-50 bonds. A major finding of the study is that ‘for an investment-grade portfolio of corporate securities, as few as 10 bonds provide enough diversity to prevent extreme default loss'.1

The default risk associated with investment grade corporate bonds was apparent during the late 2008 and early 2009 credit crisis. As a result, portfolios constructed to avoid a drastic loss are very much on the minds of both investors and advisers.

The methodology of the study utilized Monte Carlo simulation to quantify two values: tail risk and black swan risk. Tail risk measures the probability of incurring a loss of a particular level (i.e. 20%) within an entire portfolio. Black swan risk measures hypothetical portfolio loss during a catastrophic market event. An example of such a loss would be a 50%+ market meltdown, which is assigned a much lower probability.

While no analysis can encompass all the relevant variables, the study calculated the tail risk and black swan risk for 49 distinct portfolios – 2 bonds, 3 bonds, 4 bonds…up to 50 bonds. The combination of the two variables was used to determine which bonds in the portfolio would default and which would survive.

In the BondDesk study, the simulation engine pulled a random variable representing the state of the macro-economy and a second random variable representing the economic health of each specific firm. Repeating the simulations over 10 million times per portfolio, a two-dimensional loss distribution was computed.

The study observed substantial reductions in tail risk as portfolio sizes were increased from two to 10 bonds and diminishing reductions with 11 bonds or more. Similarly for black swan risk, the point of diminishing returns was approximately 11 bonds.

Assuming the study's premises and methodology are valid, the marginal benefit of holding more than a dozen investment grade corporate bonds would be minimal compared to the cost of managing and owning the additional portfolio positions.

The study points to four conclusions and implications for financial advisers:

1. The analysis challenges the concept that individual bonds should be the domain of only high net worth clients. With many corporate bonds now offered on platforms where trades of $10,000 par value are common, a portfolio of $100,000 or more may be enough for sufficient diversification.

2. For baby boomers approaching the withdrawal phase, portfolios of individual bonds allow for predictable cash flow streams. A portfolio with 12 semi-annual pay bonds means 24 coupons per year. A staggered payment schedule could provide two ‘paychecks' per month.

3. A third implication is that credit quality may be more important than individual security selection. The study concludes that ‘a diversified portfolio of at least 10 investment-grade bonds should carry sufficient protection from extreme default loss.'

4. The study also notes that a portfolio of 10 bonds is large and flexible enough to accommodate most fixed income investment strategies. A 10 bond five year ladder could cover five years with two bonds maturing each year, while a 10 year ladder would mean one bond maturing per year. Alternatively, a barbell could be created with five bonds maturing in the first 2-3 years, and the balance in the 7-10 year range.

While a 10-15 bond portfolio may not be optimal for all investors, this study does merit the serious attention of the investment community. For fixed income allocations, individual bonds deserve consideration for unique advantages such as known maturities, predictable cash flows, tax efficiency and customization. An investment grade bond portfolio diversified by credit, industry, and structures (e.g. callable, non-callable, step-up, market-linked notes) can be utilized by a wide range of investors.

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