02 2017 CORPORATE BONDS IN A MULTI-ASSET PORTFOLIO DISCUSSION NOTE

02 2017 CORPORATE BONDS IN A MULTI-ASSET PORTFOLIO DISCUSSION NOTE

Introduction
In this note, we evaluate the risk and return characteristics of corporate 
bonds, and discuss their role in a multi-asset portfolio consisting of equities 
and Treasuries in addition to corporates. This note is a follow-up to DN 
2-2016 “Risk and return of different asset allocations”, where we focus on the 
interaction between equity and interest rate risk in portfolios with different 
combinations of the two risk factors. 
Introducing credit risk into the analysis allows us to assess whether corporate 
bonds add any value over and beyond Treasuries in an equity-bond portfolio. 
Along the same lines as in DN 2-2016, the objective of this note is to shed 
light on the risk-return characteristics of corporate bonds as well as the asset 
class’s co-movement properties against equities and government bonds. We 
pay particular attention to how the role of corporate bonds might vary with 
the size of the equity allocation. 
We find that corporate bonds have historically enhanced multi-asset portfolio 
returns, although whether the enhancement is statistically and economically 
significant is highly sample-dependent. Of critical importance for the 
portfolio properties of corporate bonds, we find that corporate bond excess 
returns have historically been positively correlated to equity excess returns, 
while moving counter to excess returns on Treasuries. The multi-asset 
portfolio properties of corporate bonds therefore depend crucially on the 
initial equity-Treasury mix. 
The upshot of this is that credit risk acts as a diversifier in a portfolio 
dominated by interest rate risk, while an allocation to corporate bonds has 
historically increased the overall volatility of multi-asset portfolios dominated 
by equity risk. 
Drivers of credit returns
For an investor who has decided on a non-zero corporate bond allocation, 
the focus should be on the drivers of the yield difference, or spread, between 
corporate and government bonds. A large literature in academic finance, 
covering both theory and empirics, attempts to account for the variation in 
credit spreads. The literature points to a tight link between credit returns and 
drivers of returns in equity and Treasury markets. 
A well-documented observation from this literature is that credit spreads 
have historically compensated for more than the expected loss from default 
using traditional credit models. The reason for this excess spread – termed 
the credit spread puzzle – must either be misspecification in the traditional 
models or that additional factors drive observed credit spreads. 
The focus on credit spreads can be misleading, however. As Ilmanen 
(2012) points out, ex-post corporate bond excess returns are found to be 
meaningfully lower than implied by ex-ante credit spreads. Using Barclays 
data covering the period 1973–2009, Ilmanen finds average realised excess 
returns of roughly 30 basis points. Contrasting this number with the average 

option-adjusted credit spread of 120 basis points over the same period yields 
a significant residual. 
Ilmanen (2012) attributes the difference to a host of factors, including the 
downgrading bias
, the fallen-angel effect
, differences in realised and 
expected defaults, and repricing effects that occur over multi-decade data 
samples. The upshot of this is that one should be careful to distinguish 
between ex-ante credit spreads and ex-post excess returns. Still, the key to 
understanding realised corporate bond returns arguably lies in the drivers of 
corporate bond prices and the yield spread over government bonds. 
The literature dealing with the valuation of corporate debt starts with the 
seminal work of Merton (1974), who applies the option-pricing theory 
developed by Black and Scholes (1973) to the modelling of a firm’s value and, 
crucially, to pricing corporate bonds. In a nutshell, Merton (1974) lays out 
a simple framework where a firm, with a total value V, issues a single zero-

coupon bond with a face value F, and equity is the residual claim on the firm 
value. Default occurs at maturity T whenever the firm’s liabilities exceed its 
assets (V < F). 
The payoff to holders of equity and debt will naturally differ, depending on 
whether the firm defaults or not. Starting with the bond holder, the payoff 
can either be 1) face value F at maturity whenever V > F, or 2) firm value V 
whenever V < F and the firm defaults. On the flipside, this leaves the equity 
holder with zero whenever the firm defaults, and V – F otherwise. Merton 
(1974) recognises that the payoff to equity holders – max(0, V – F) – is 
equivalent to that of a call option on the assets of the firm. 
The critical insight from Merton (1974) is perhaps better understood when 
applying the put-call parity of Stoll (1969). The put-call parity is a no-arbitrage 
condition, which simply states that the market value V of a given underlying 
asset must equate to the sum of a call option C with strike price K written on 
the asset, a put option P (also with strike K) on the same underlying asset, 
and the present value of a risk-free bond B with a face value equal to the 
strike price (V = C + P + B). 
The risky corporate bond in the Merton framework is therefore equivalent to 
a combination of a risk-free bond and a short position in a put option written 
on the assets of the firm. This insight allows us to think of the credit spread 
– the spread between the risky corporate bond and a comparable risk-free 
bond – as a short put option on the firm. While still being a subject of great 
controversy in the financial literature, the Merton model clearly establishes a 
(positive) link between risk premiums in equity and corporate bond markets.

02 2017 CORPORATE BONDS IN A MULTI-ASSET PORTFOLIO DISCUSSION NOTE