Swiss corporate bonds: a winning balance of yield and protection

The practice of combining equities with fixed income to build a diversified portfolio is well established. But how exactly do bonds contribute to overall portfolio performance? In this insight, we examine the specific attributes of Swiss government and corporate bonds, and explain why a higher corporate allocation may make sense right now.

Why include Swiss bonds in a mixed portfolio?

The role of Swiss bonds in a mixed portfolio is generally defined less by their return potential and more by their risk characteristics. They are largely meant to provide diversification, offering regular and predictable income with typically lower volatility than equities.

Swiss bonds are expected to provide a protective effect by contributing stable, positive returns, particularly during equity market downturns. Compared to other diversifying asset classes, Swiss bonds are also usually more liquid, making them better suited for managing asset allocation.

Protection driven by interest rate exposure and low credit risk

As Swiss bonds are generally associated with very high credit quality and low default risk,  most of their price fluctuations are driven by interest rate risk. This is precisely what underpins their protective function in a mixed portfolio: in an equity market crisis, central banks typically respond by cutting rates, which in turn should support bond prices.

In contrast, credit risk premiums typically rise in equity downturns. While corporate bonds still benefit from falling interest rates, this is often offset by widening credit spreads. To maximise protection in a mixed portfolio, the allocation to Swiss bonds should minimise exposure to credit risk.

An ideal protective solution would be a portfolio of Swiss government bonds; however, these offer very low yields. At longer maturities, they can also exhibit price volatility almost comparable to equities. By comparison, corporate bonds typically carry shorter duration risk, while generating higher carry income due to the additional credit risk premium.

Ultimately, the key question is: how much protection is lost as a result of taking on additional credit risk?

Read also: Prudent Swiss central bank focuses on the franc amid uncertainty

The key to protection: negative correlation with equities

In financial markets, the protective function is often quantified by analysing the correlation between two asset classes. Positive correlation means both assets tend to rise and fall in tandem, while negative correlation means one asset gains when the other declines. An effective protective function therefore ideally requires a negative correlation.

The protective role of Swiss bonds in a mixed portfolio is most important during equity market slumps. In practice, the focus is therefore primarily on the correlation between Swiss bonds and equities during major stock declines.

Figure 1 shows the correlation of various Swiss bond segments with the blue-chip Swiss Market Index (SMI) including dividends, and with the broader Swiss Performance Index (SPI). The analysis is based on monthly data, assessing correlations exclusively in months when the SMI declined by more than 3%.

FIG 1. Correlation of Swiss Bond segments with Swiss Equity Indices under market stress¹

Comparing levels of protection between bond types

Unsurprisingly, Swiss government bond indices appear to offer the strongest protective function. The Swiss Bond Index (SBI) AAA-BBB Index – which includes both government and investment-grade corporate bonds and is often used as a reference to represent the ‘Swiss bonds’ asset class – performs only slightly worse. This suggests that the SBI AAA-BBB Index is primarily driven by interest rate sensitivity and contains very little credit risk.

By comparison, the credit-focused benchmark– the SBI A-BBB Index – shows a slightly positive correlation with equities, but still seems to provide a certain degree of protection.

Quantifying the value of credit risk exposure

Given that credit portfolios should generate higher long-term returns with lower volatility, it is worth evaluating whether Swiss bond allocation should incorporate increased credit risk through a somewhat higher share of corporate bonds (see Figure 2).

FIG 2. Comparison of returns and drawdowns for Swiss bonds and equity indices²

As you can see, the SBI A-BBB index has not demonstrated higher returns than the Swiss government bond index since 2008. However, it should be noted that the longer duration of Swiss government bonds means they have benefited significantly from the marked decline in interest rates over the past 18 years. As a result, the index of Swiss government bonds with maturities of more than 15 years has delivered by far the highest return among all bond segments (although it has also exhibited volatility comparable to that of equities).

Favouring corporate bonds to balance protection and yield

The yield to maturity of the longest-dated Swiss government bond is currently only around 0.5%. It is also legitimate to question how much potential remains to cut interest rates – and thus how much protection long-duration Swiss government bonds can still offer.

The evidence therefore suggests that adding moderate exposure to Swiss corporate bonds does not significantly reduce protection benefits. In today’s low-yield environment, a somewhat higher allocation to corporate bonds may offer a better balance between protection and return.