Retail Investors Are Making Simple — Yet Costly — Mistakes When Trading Corporate Bonds

Not all AAA-rated debt is the same. And credit ratings are not comprehensive indicators of risk.

August 29, 2023

| by Seb Murray
Illustration of a businessman riding a crashing stock line.

Retail investors could have saved over $1 billion in 2019 if they’d stuck with corporate bond index funds. | iStock/dickcraft

Over the past year, several retail investment platforms, including Vanguard, Hargreaves Lansdown, Invesco, and Janus Henderson, have introduced corporate bond funds in response to a surge in demand from individual investors. This trend comes in tandem with a growing appetite for fixed-income debt, particularly corporate bonds, as interest rates rise.

A recent study coauthored by Ed deHaan, an accounting professor at Stanford Graduate School of Business, suggests that bond mutual funds and ETFs are less risky and have higher net returns than trading individual bonds. With Jiacui Li, PhD ’19, of Eccles School of Business, and Edward Watts, PhD ’20, of Yale School of Management, deHaan finds that retail investors who pick their own corporate bonds often base their trades on untimely or incomplete information, leading to poorer outcomes.

Retail investors hold 28% of all U.S. corporate bonds. Exploring an extensive dataset of U.S. corporate bond trades from 2002 to 2019, the researchers found that these investors often treat credit ratings as comprehensive indicators of credit risk. They trade as if bonds within the same rating, like AAA, are similar, inadvertently overlooking that the financial health of firms with the same rating can vary widely.

Additionally, these investors tend to disregard the well-known fact that unusually high bond yields signal heightened risk. Yet they aim to maximize their potential profits by buying bonds with high yields and selling those with lower interest rates.

These behavioral patterns correlate with significant underperformance. The study concludes that had retail investors opted for index funds rather than hand-picking corporate bonds, they could have collectively saved over $1 billion in 2019 alone.

This phenomenon can be attributed, in part, to the vastness of the corporate bond market coupled with the high costs associated with conducting independent risk assessments. For unsophisticated investors, credit ratings are a more affordable and convenient metric. “They’re comparison shopping,” deHaan explains. “Not a lot of us have detailed financial knowledge or education, so we use all sorts of summary statistics to simplify our lives because thinking very carefully about every transaction is just not possible — we would stress ourselves to death.”

Look Beyond the Ratings

While credit-rating agencies revise their ratings periodically, these updates occur at a slower pace than changes in market dynamics or companies’ financial health. Other research indicates that a firm’s financial reports and the prices of its stocks or bonds provide quicker insights into investment risk. “Credit ratings overall have plenty of flaws,” deHaan says. “Market prices move within minutes or even seconds, even in the fairly illiquid bond market. Retail investors fail to appreciate that.”

You should not invest in single-name corporate bonds. You should invest in a well-diversified, low-cost index fund. It will avoid this pattern of systematically buying and selling the wrong bonds.
Ed deHaan

While bond yields and prices move in opposite directions, yields are often the standout factor when it comes to selecting bonds. As the famed investor Warren Buffett once noted, “Reaching for yield is really stupid. But it is very human.” Notably, major retail trading platforms are designed to make it easy to arrange bonds based on their yields, particularly within specific rating tiers.

The study also illuminates a counterintuitive aspect: Although retail investors generally prefer safer-rated bonds, they tend to choose riskier ones within each safety rating. This underscores a strategy focused on generating profits that may not fully account for risk, deHaan says.

Furthermore, retail investors often act counter to important news about a company, even when such information suggests they should take a different course of action. For instance, if news signals improvements in a company’s performance or share price, these investors trade in the opposite direction. This behavior isn’t a deliberate choice, deHaan notes; rather, it is likely driven by the allure of bonds issued by poorly performing companies offering higher yields as compensation for the risk of potential defaults.

Bonds offering the highest yields are more prone to future ratings downgrades. The study finds that if retail investors purchase more of a particular bond, there is a small yet significant rise in the likelihood that its rating will decline in the following month. This, in turn, also increases the probability of future bond defaults. These findings highlight the potential for retail investors to underperform, even with long-term investments.

Indeed, deHaan’s research shows that bonds bought most heavily by retail investors underperform by 51.4 basis points per month versus heavily sold bonds. To put this into context, the average bond generates a return of 60.5 basis points per month. This discrepancy indicates that retail investors could have made more money by diversifying their investments across various bonds rather than picking specific bonds, the researchers say.

Interestingly, these findings are particularly evident for the retail trades valued below $50,000, which are likely driven by less experienced and sophisticated investors. In conclusion, deHaan and his colleagues recommend that ordinary investors explore simpler strategies, such as investing in low-cost index funds, which distribute capital across a range of bonds, potentially generating substantial savings.

“You should not invest in single-name corporate bonds,” deHaan says. “You should invest in a well-diversified, low-cost index fund. It will avoid this pattern of systematically buying and selling the wrong bonds. And it will lower the transaction costs on each bond.”

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