How does the investment risk profile of a corporatebond and that of the common stock of thesame company affect the investment philosophyin managing a corporate bond portfolio?

What will be an ideal response?

The risk–return profile for an investor in the common stock of a company versus the corporate bonds of the same company is substantially different and has implications for the investment philosophy of the management of a corporate bond portfolio.The implication for the management of corporate bond portfolios is to avoid "losers," and this is far more important than for equity portfolios. Equity portfolio management for long-only investors involves identifying "winners."For corporate bond portfolios it is particularly important to obtain diversification in managing a corporate bond portfolio given that a corporate bond index may have far more issues than a manager may be able to purchase for a typical portfolio. More details are given below.

The risk–return distribution faced by an equity investor is quite different from that of an investor in the bonds issued by the same company. The upside for corporate bond investors is the coupon payments, if the bond is purchased at par and held to maturity. For bonds purchased at a discount and held to maturity, it is the capital gain realized plus the coupon payments. For a corporate bond sold prior to maturity and that is not a distressed bond selling at extremely low prices, there is market price appreciation. However, the price appreciation is limited. For an equity investor, the upside is potentially unlimited. The doubling, tripling, or even greater increase over a short period of time is not unusual. As for the downside, for a corporate bond investor both the principal and the interest payments can be lost, partially offset by some possible recovery value. For an equity investor, the entire investment can be lost.

An interesting exercise performed by Zan Li and Jing Zhang of Moody's Analytics highlights the difference in the return distributions for investors in corporate bonds versus those of equity investors. The exercise has important implications for investing in corporate bonds. Using the Merrill Lynch Investment Grade Index, Li and Zhang eliminated the 10% best-performing and 10% worst-performing issues over the period from July 1999 to July 2009 . Panel A of Exhibit 26-1 shows the cumulative total return over the period for both the original index and for the truncated index (i.e., the index after removing the 10% best and 10% worst performers). As can be seen, the truncated index outperforms that of the original index. When the same analysis was done for the Merrill Lynch High-Yield Index, the truncated index's outperformance was far greater (see panel B of Exhibit 26-1). Finally, Li and Zhang did the same exercise using the Dow Jones 30 equity index. The result, is different from what was found for the two corporate bond indices. The cumulated return for the truncated stock index is considerably less than the original index.

What are the implications of this exercise in establishing an investment philosophy for managing corporate bond portfolios? We can see that for credit portfolios, avoiding "losers" is far more important for credit portfolios of corporate bonds than for equity portfolios. Equity portfolio management for long-only investors involves identifying "winners."Moreover, it is particularly important to obtain diversification in managing a corporate bond portfolio. If the benchmark is a corporate bond index with 3,000-plus bond issues, it will not be practical to hold more than 150 or so issues. This means that there will be considerable idiosyncratic risk. This risk cannot be avoided but it can be minimized using traditional credit analysis and/or credit risk models.