Bridge over ocean
1 July 1987 Financial Analysts Journal Volume 43, Issue 4

Lower-Grade Bonds: Their Risks and Returns

  1. Marshall E. Blume
  2. Donald B. Keim

To reflect as realistically as possible the risks and returns of lower-grade bonds, the authors constructed an index from actual average returns used in the compilation of the Salomon Brothers and Drexel Burnham Lambert lower-grade indexes, supplementing these with month-end prices prior to 1982 from the S&P Bond Guide. The authors’ index is adjusted to avoid any bias due to dropping a bond before it actually defaults.

Over the 10-year period from January 1977 through December 1986, the realized returns on a portfolio of lower-grade bonds exceeded those on high-grade bonds. Furthermore, the risk of lower-grade bonds was no greater than the risk of higher-grade bonds.

The covariances between lower-grade bonds and other risky assets indicate that lower-grade bonds can provide diversification when included in a portfolio of high-grade bonds or equities. Comparison of the returns on the lower-grade bond index with the returns of the common stock of the bonds’ issuers also reveals that the bonds are not close substitutes for the equity; thus a diversified portfolio may contain both the debt and equity of the issuing companies.

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