How to Get the Most Out of Your Bond Investments

Ivanna Hampton: Many investors are trying to figure out what’s next for bonds, and how they fit in their portfolios. Morningstar research shows that there may be a better way to build bond portfolios. The team investigated how the Sharpe ratio can help investors balance risk and reward. The data goes back more than 20 years. Maciej Kowara and Alec Lucas from Morningstar Research Services are here to explain what they found. Maciej is a strategist for fixed-income strategies, and Alec is a director of manager research.

Typical Bond Portfolio

Thanks for being here, Alec and Maciej. What does a typical bond portfolio look like? Can you give us an example, Alec?

Alec Lucas: Sure. So, three of the five biggest bond funds out there track a different version, a slightly different version, of the U.S. investment-grade bond index. There’s about $700 billion in assets in those three funds. So, they’re pretty heavy in Treasuries, 40% to 45% or so, and corporate bonds, these are investment-grade bonds and mortgage-backed securities. And the key thing to keep in mind is that the typical bond portfolio, if you take those as typical, it doesn’t have any high yield, it doesn’t have any leveraged loans. Some active managers will invest in those asset classes, and they’ll vary their allocations a bit, but they tend to track the investment-grade bond index pretty closely. They’ll vary their interest-rate risk or duration. They’ll vary their high-yield allocation. But more or less, it’s pretty similar. And bond funds can be a wonderful source of ballast in a portfolio relative to equities. But the investment-grade bond market has had a tough time lately. If you take out a rally in late 2023, the investment-grade bond market was on track for its third losing year in a row. So, it lost 13.0% in 2022, and 1.7% in 2021. And we wrote this paper because we think investors can do better.

How to Create a Portfolio Optimized for Best Risk-Adjusted Returns

Hampton: Maciej, how would you create a portfolio if optimized for best risk-adjusted returns?

Maciej Kowara: I think there are two aspects to this question. One is what is the maximum risk-adjusted return? And here we defaulted to the standard of the industry, which is the Sharpe ratio. That’s the famous measure by Nobel laureate William Sharpe produced sometime in the 60s, I believe. Basically, it is the ratio of expected excess return of a given portfolio over its standard deviation of excess return. That’s the measure that we are trying to maximize in this exercise. Mechanically, how you do it, it’s not something that you can do on your own or even with an Excel spreadsheet. You need a computer to run an optimizer for you. There are no formulas to calculate those things when you have constraints like all the assets have to be positive and they all have to add up to one and so forth. So, A, Sharpe ratio as the measure; B, optimizer as the tool to get there.

Sharpe-Optimized Portfolio

Hampton: Alec, what asset classes are prominent or more prominent in a Sharpe-optimized portfolio and why?

Lucas: We did our optimizer in a couple of different respects. The first was we had no minimum equity allocation. We just said, “Allocate to asset classes.” The constraint that we used is you had to have an ETF that could represent it. So, it’s something that investors could do. In that case, there ended up being a 5% equity allocation. So, it was primarily bonds. It was 95% bonds. But what was interesting was the allocation in the bond portfolio. We said earlier that corporate bonds are a big part of the market of the typical investment-grade market. They received no representation in our portfolio. Credit risk, or the potential for a borrower not to make timely interest and principal payments, got represented instead by leveraged loans, otherwise referred to as bank loans. They received a 30% weighting in our Sharpe-optimized portfolio. And that’s a more than $1 trillion asset class that’s excluded from the investment-grade bond market and showed up pretty big in what we did.

Bank Loans and Corporate Bonds

Hampton: Maciej, why does the portfolio have so much in bank loans and not corporate bonds?

Kowara: The second one is probably easier to answer quickly. Investment-grade corporate bonds share risk factors with both equities and Treasuries. Investment-grade bonds usually have long durations like Treasuries because they have low coupons, so durations get long. But at the same time, they are exposed to many of the same risks that equities are exposed to. If there is a recession, they will not do that great on the credit front. It doesn’t mean that there is no room for them always, but at least from our experience, looking at the data, it seems like they did not provide a high enough return to be included in that optimal portfolio. The optimizer preferred to look at bank loans and high yield. Bank loans are excluded from interest-rate risk. They do have some credit risk, obviously. And high yield, they have much smaller interest-rate sensitivity than investment-grade bonds. They do share the same credit risk, but their returns have been more compelling. That’s why I think this ended up looking the way it did.

Why Should Investors Trust This Portfolio?

Hampton: Alec, why should an investor trust that this mix would work?

Lucas: Well, it’s based on data, and it’s based on a pretty large dataset. So, we took Morningstar index data dated to 2000, and it’s a more than 23-year period that we looked at. And then we did 15-year samples, and we did multiple samples of that. And we did that because there’s a fair amount of uncertainty and variability in financial markets. It’s going to depend a lot on whether you invest, say, at the beginning of 2008 or if you invest maybe at April 2009; your results are going to be very different depending on starting and endpoints. So, to sort of take out the effect of starting and end points, we did multiple samples, 15-year samples of that more than 23-year data set. And then we basically averaged the optimal results.

And the term optimal just think sort of what’s the best allocation if you’re trying to maximize return relative to volatility or standard deviation. That’s essentially what the Sharpe-optimal portfolio is. And one of the things we did is we had no constraint for allocation to equities, and we also experimented with what if an investor insisted on having a 50% allocation to equities because they felt like 5% would be far too little to meet their needs, what if they insisted on a 60% allocation, what if they insisted on a 70% allocation, and so forth. And then we optimized the bond portion of the portfolio in light of that minimum equity allocation. And what was interesting is the allocations changed. So, corporate bonds had no role in our unconstrained version. When you had an equity allocation, say, at 60%, they had a 1% to 2% weighting. And what was interesting is emerging-markets debt started having a double-digit weighting as you got a higher equity weighting. One of the takeaways from this study is the optimal bond portfolio for an investor is going to depend on how much equity risk you want to take.

Risk-Adjusted Portfolio vs. 60/40 Portfolio

Hampton: Let’s talk more about 60/40. That particular portfolio, my check, why go the risk-adjusted route instead of a typical balanced portfolio like the 60/40?

Kowara: Well, the 60/40 seems to be, it’s a venerable old relic, but it is a little long in the tooth, I would say. Typically, people think of populating that portfolio with some exposure to stocks and on the bond side, either the [Bloomberg] US Aggregate [Bond Index], which has no high yield or bank loans, or alternatively with the US Universal, which has some high yield, no bank loans again. So, I think investors can do better. And my feeling is that nobody has looked at this stuff for quite a long time. A lot of this asset-allocation research has been done before there was enough data available for assets like bank loans, for instance. Now we do have a good sample of data, so we can actually incorporate those. And when you plug those into the optimizer, you get a portfolio that I think you can have a reasonable confidence that it’s going to do as well maybe better than a 60/40.

How Investors Can Use Our Research

Hampton: Alec, how can an investor implement this research into their portfolio?

Lucas: We tried to make that as easy as possible, and we actually wrote the article with that very question in mind. So, there are seven readily available exchange-traded funds that we list in our article in the longer paper on which it’s based that an investor can invest in. They’re free to check out those ETFs and look at the recommended allocations. And what we did is we also showed the real-world results of our portfolios. What we did is we took our portfolios, we assumed that you rebalanced the target allocations once a year, and then we compared the results of all of our portfolios to a passive allocation to Vanguard Total Stock and Vanguard Total Bond. So, for our unconstrained portfolio which had 95% in bonds, the 5% allocation was to Vanguard Total Stock, same thing as the reference portfolio, or the benchmark in this case. And then the bond portfolio was our mix, our Sharpe-optimized mix compared to Vanguard Total Bond. And then we rebalanced that benchmark portfolio, if you will, once a year just like we did the Sharpe-optimized portfolio, and then we compared results over a roughly 12-year period which is the longest period we could find, sort of real-world results.

What are the results? Well, we have them in the article, we have them in the paper. What I can say now though is the 5% equity allocation, 95% bond allocation delivered 48 more basis points, about half a percentage point on an annualized basis with lower volatility, which we took to be good news. And every single portfolio we did on a total-return basis [beat] its corresponding benchmark portfolio. Sometimes by less, sometimes by more. The portfolio got a little less optimal as you increased the equity weighting. But we think the results were compelling and interesting and worth investors’ interest.

Kowara: And I would just add to Alec’s answer that that was not part of the optimization exercise. We did not set out to find something that beat the 60/40 or its equivalents for different allocation ladder portfolios.

Hampton: So, was it like a surprise?

Kowara: It was kind of a little bit of a surprise, yes, that not only did we get good risk-adjusted returns, but the returns themselves looked compelling.

What Could Go Wrong With a Risk-Adjusted Portfolio?

Hampton: And I’m happy to say that a link to your article, both of you guys’ article will be in the show notes for people to check out the research and those ETFs in your list. So, let’s wrap it up. Maciej, all investing strategies come with risk. What could go wrong with this kind of risk-adjusted portfolio?

Kowara: Quite honestly, I think the biggest risk is that the future will look so dramatically different from the last quarter century that we have no idea what it might bring. Otherwise, if the world stays roughly the same, we’ll go through some recessions, some small wars somewhere, or whatever, but the general tenor of the market is not going to change. I think we should be OK.

Lucas: The biggest risk is that an investor would bail on it. So, for example, if you take a 60/40 allocation, you do 60% in stocks and do the 40% bond, optimize the way we suggest, and you have a sizable portion in emerging-markets debt, and emerging-markets debt does really bad and poorly, you could bail on it. So, the biggest risk, I think, is going to be behavioral. Otherwise, I think that the portfolio will hold up well relative to other portfolios, absent a catastrophe. So, let’s hope that doesn’t happen.

Hampton: Well, I want to thank both of you guys for coming on the podcast to explain how to invest better with bonds.

Lucas: Thank you.

Kowara: It’s been a pleasure. Thank you

Hampton: That wraps up this week’s Investing Insights. Thanks to all of you for checking out the podcast. I want to thank senior video producer Jake VanKersen. Subscribe to Morningstar’s YouTube channel to stay up to date on investment ideas and market trends. I’m Ivanna Hampton, a lead multimedia editor at Morningstar. Take care.

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