hidden risk in high yield bonds

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hidden risk in high yield bonds

Postby larryswedroe » Wed Dec 19, 2012 2:29 pm

http://www.cbsnews.com/8301-505123_162-57559838/a-hidden-risk-in-high-yield-bonds/

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Re: hidden risk in high yield bonds

Postby garlandwhizzer » Wed Dec 19, 2012 4:38 pm

I respectfully disagree with Larry's assertion that there is no place for HYB in a portfolio, specifically VWEHX (the Vanguard fund which holds both intermediate and low quality corporate bonds, a lower risk profile than most junk bond funds). I have held the Vanguard HYB fund for more than a decade and done quite well. Like stock funds that tank in bad markets like 2008, you have to have the stomach not to panic and hold on to HYB when things get bad. If you don't have a stock market stomach, it's best to stay away from HYB because at some points you'll be tempted to sell them when they're down, the same temptation you feel with stocks in a big bear market decline. Like stocks, however, if you hold on to them through the storm, you'll do quite well when the weather again turns sunny. Since the bottom of the 2008 market collapse they have quite dramatically outperformed high quality bonds of all types, rewarding those who held on.

Outperformed so much that I have some concerns about HYB now based on the fact that investors in a mad search for yield have rushed into this asset class in such huge numbers that I believe the risk/reward tradeoff is not so attractive anymore. When any asset that I hold gets too popular and has such a big run-up, too overbought and hence undervalued, I start looking for the exit. HYB may now in my opinion be overvalued relative to their risks. I have trimmed my position already and I am now seriously considering closing it out completely, taking the gains in a non-taxable account and not returning to HYB until the herd rushes elsewhere.

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Re: hidden risk in high yield bonds

Postby magician » Wed Dec 19, 2012 6:27 pm

garlandwhizzer wrote:When any asset that I hold gets too popular and has such a big run-up, too overbought and hence undervalued . . . .

I trust that you meant overvalued.
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Re: hidden risk in high yield bonds

Postby magician » Wed Dec 19, 2012 6:33 pm

I wonder why the author of the article thinks that low liquidity is a hidden risk. It seems to be pretty out-in-the-open to me. If his point is that many (maybe most) investors wouldn't think of it or wouldn't take it into account, that sounds to me more like you-didn't-know-what-you-were-doing risk than liquidity risk. And that's a hard risk to overcome, even with articles such as this one.
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Re: hidden risk in high yield bonds

Postby larryswedroe » Wed Dec 19, 2012 6:38 pm

few thoughts
magician
I used the term hidden because investors might look at the return of the index, like they could with say the S&P 500 or Treasury bonds and assume they can replicate that return, minus the low costs of an index fund. That is clearly not the case with high yield.

Garland
To evaluate high yield you need to do two things, run regressions to see what the risks are like and also not look at returns in isolation.
Once you do those two things, as I have shown in my book, the data shows HY has not added, but subtracted, value relative to alternative strategies that use only investment grade or Treasuries. I have given examples of that here and in my books. The problem is most people don't know how to evaluate the strategy against alternatives

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Postby maddyken » Wed Dec 19, 2012 6:57 pm

I have a small amount of HY, my fund managers see value (for now) and I don't second guess them.

I personally wouldn't own HY if I managed my portfolio because the misleading long term correlations don't hold during crises. I've come to the conclusion downside protection is paramount, as opposed to return or risk-adjusted return. While I haven't conducted any studies, obviously, I think your high quality advice is sound.
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Re: hidden risk in high yield bonds

Postby magician » Wed Dec 19, 2012 8:27 pm

larryswedroe wrote:I used the term hidden because investors might look at the return of the index, like they could with say the S&P 500 or Treasury bonds and assume they can replicate that return, minus the low costs of an index fund. That is clearly not the case with high yield.

I see what you mean, but it still seems like a they-don't-know-what-they're-doing risk to me.
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Re: hidden risk in high yield bonds

Postby nisiprius » Wed Dec 19, 2012 9:49 pm

I think it would be a better world if someone could try to set a fashion for calling them "non-investment-grade bonds."

Understandably, the people who are actually selling them want to make them sound good, but why do the rest of us have to do their marketing for them?
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Re: hidden risk in high yield bonds

Postby rmelvey » Thu Dec 20, 2012 12:03 am

I think they should call them "I Can't Believe It's Not Equities!"

I like HY yield debt. People trash the asset class because they don't want ignorant investors to get fooled into thinking they are safe. If you use them intelligently and carve them mostly out of your equity position I think they make a ton of sense in a tax deferred account.

So when talking to an investing noob, yes trash high yield. If setting up your own portfolio, just approach them critically seeing them for what they are.
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Re: hidden risk in high yield bonds

Postby magician » Thu Dec 20, 2012 12:17 am

nisiprius wrote:I think it would be a better world if someone could try to set a fashion for calling them "non-investment-grade bonds."

I believe that "below-investment-grade" is employed occasionally. Perhaps not with the public at large.
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Re: hidden risk in high yield bonds

Postby johnep » Thu Dec 20, 2012 7:55 am

I posted this reply in an earlier thread on HY:

"I am a long time investor in HY corporate bonds. I do not disagree with most of what has been posted. People need to understand the added risk of HY before investing. Also need to understand there is a variety of HY funds. Some invest heavily in very risky bonds and others like VWEAX invest in the less risky of HY. There is a big difference in the quality of bonds in different HY funds.

I did a quick comparison using M* data of returns of VITSX (total stock index) versus VWEAX (HY corporate) from 2002 thru 11/30/12. This covered 2 bear markets, 2002 and 2008. VITSX had gain of 68% and VWEAX had gain of 121%. This was pretty good performance for a fund type that gets maligned a lot on this forum. Hopefully my math was correct but I am sure someone will check it."

Larry responded with some good points, one being that in addition to credit default risk, there is the risk of downgrades which also devalues the HY bonds and the fund. That makes sense to me. However, I have to assume those issues occurred in 2002 and 2008 and VWEAX still had a far better return than VITSX over the past 10 years. Some may choose to put all of their risk in equity which is fine. However, those that have accepted the risk of VWEAX have been rewarded handsomely the past 10 years.

Some other experts recommend a small allocation to HY. I agree with that and would caution against a large allocation to HY. Also, others have mentioned that a lot of "hot" money has chased HY recently, so now is probably not the best time to invest more in HY.
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Re: hidden risk in high yield bonds

Postby bikeguyken » Thu Dec 20, 2012 8:23 am

I've also been invested in Vanguard High Yield for 10 years plus and been very pleased. And yes it does have an equity type component so I use a 25% equity factor and slide my total equity holding % down accordingly (high yield is 10% of my bond holdings which are at 72% to match my age). I'm sure both Larry and Rick would be comfortable with this approach--there are many roads to Dublin!

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Re: hidden risk in high yield bonds

Postby larryswedroe » Thu Dec 20, 2012 9:36 am

ken
Few thoughts,
First, that's good that you account for the equity risk in them. The issue you should be aware of is that's the AVERAGE equity risk. In crises it might jump to to say 60 or 70% and in other periods will go towards zero. In other words, you don't control your AA as effectively
Second, you still have the call risk which isn't only related to interest rate risk (reinvestment risk in this case), it's asymmetric equity risk. If things go well the credit rating can rise and then they call in the bonds even if rates haven't fallen so they can issue cheaper debt or they issue equity. So you don't have the same upside you have with stocks but you have the same type downside.
And third, as I noted not only higher ER but higher internal trading costs which you don't see--especially if you get fund redemptions in bear market when liquidity is king.

Given the small diversification benefit I just don't see the reason for adding them in the face of the negatives and we haven't even addressed the location issue

But to each his own

Bikeguy, too many people get fooled by shorter term returns, and 10 years isn't that much. And certainly the risks showed up in 2008. I looked at the total history of the fund and including it instead of treasuries meant less efficient portfolio and you can certainly do better than Treasuries with no risks by using CDs. I haven't seen any evidence in any of the literature to show a reason to buy with the one exception being buying the fallen angels, the once investment grade that gets knocked down. There the reason is you basically eliminate or greatly reduce the call risk and also you now have gained the liquidity premium and importantly are buying after the pension plans have dumped the stock as required (many by charter can only hold investment grade) so the stocks get dumped--it's buying when there's blood on the street. At very least IMO you should do account for the equity risk you have there.

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Re: hidden risk in high yield bonds

Postby Valuethinker » Thu Dec 20, 2012 9:40 am

Nisi

sub investment grade bonds is the normal title, I think.

We used to call them 'junk' and now, in a fit of Political Correctness, we call them 'High Yield'.

William Bernstein makes a case there are times to buy HY bonds-- when the yield spread blows out.

Right *now* is surely not that time.


In a repeat of the follies of 2006-07, we are seeing:

- PIK bonds - that pay interest in more bonds, rather than in cash

- HY bond issues so that the issuers can pay dividends to their private equity/ leveraged buy out owners out of the proceeds (but leaving the companies more indebted)

that, plus low spreads, means that surely *this* is not the time to be exposed to this asset class.

One small positive:

- higher coupon means lower sensitivity to changes in interest rates, so if the Fed does raise rates (and I believe the US economy will be a lot stronger than pundits predict, and the rise in interest rates will be visible by end of 2013) then in theory, at least, HY bonds don't get hit so hard

- if I am right about US economy then default rates should fall, not rise

I should add I retain my general disdain for the asset class-- equity risk, but not equity returns.
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Re: hidden risk in high yield bonds

Postby garlandwhizzer » Thu Dec 20, 2012 12:11 pm

magician wrote:
garlandwhizzer wrote:
When any asset that I hold gets too popular and has such a big run-up, too overbought and hence undervalued . . . .

I trust that you meant overvalued.


Sorry, thanks for the correction.

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Re: hidden risk in high yield bonds

Postby neurosphere » Thu Dec 20, 2012 12:31 pm

I have 3% of my total portfolio in Vanguard's high yield fund. I also aim for a 70/30 equities/bonds ratio.

Does it really matter if I count it as equities (which I do), so I have 67/30/3 stocks/bonds/junk? Or if I count is at bonds, so that perhaps I can consider my portfolio 70/27/3? What will be the difference long term between those two portfolios?

My point is, does it really matter if you only hold a small amount of high-yield? Call it either stocks or bonds and it should make little difference.

I guess the counter argument to that is, if only holds a small amount, why hold ANY, since it's not going to make a big difference? :D
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Re: hidden risk in high yield bonds

Postby garlandwhizzer » Thu Dec 20, 2012 12:58 pm

Larry wrote:
Garland
To evaluate high yield you need to do two things, run regressions to see what the risks are like and also not look at returns in isolation.
Once you do those two things, as I have shown in my book, the data shows HY has not added, but subtracted, value relative to alternative strategies that use only investment grade or Treasuries. I have given examples of that here and in my books. The problem is most people don't know how to evaluate the strategy against alternatives

Best wishes
Larry


Actually, it seems to me that Larry's argument hinges on the fact that HYB have equity like characteristics, more risks and volatility, and that by using higher quality bonds, Treasuries for example, one reduce bond holdings and control volatility and therefore increase equity holdings in the asset allocation model. Hence, improve long term returns, since equities tend to outperform bonds in the long term.

The only problem with that analysis is that in the last 10 years (which seems like long term to me), the Vanguard HYB fund has outperformed Vanguard's primary diversified equity funds, both TSM and S&P500, and it has also handily outperformed all Vanguard bond fund options. There is no combination of Vanguard US bond funds and US equity funds over that 10 year period that could possibly have outperformed its HYB fund. In short regardless of what your "regressions" show, those who followed your advice and avoided them for other Vanguard options have lost money for a decade. Personally, I prefer a decade of money in my pocket to the mathematics of your regression models based on past economic history and I don't personally believe that models of returns whether it be SCV versus TSM or Treasuries versus HYB can be counted on with certainty going forward. Certainly it hasn't held up in the last decade in the case of HYB and there is no assurance that it will hold up in the next decade either. Models are sophisticated attempts to explain past reality but they do not reliably forecast the future reality with certainty. Humility rather than the certainty of model "regressions" seems the appropriate attitude when forecasting what the future of market returns is going to be.

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Re: hidden risk in high yield bonds

Postby larryswedroe » Thu Dec 20, 2012 1:18 pm

Garland
The only problem is you're taking a short period, one that began with high yield at high spreads and drawing a conclusion. The right way is to look at the longest data available and when you do that you find the result I showed.
Also I would note that typically, though not always, HY are value stocks, stocks of distressed companies. So you have to look at it from that perspective
But remember you can also diversify the equity exposure and so one could look at a more diversified portfolio, one not solely in S&P and would have had much better results
Like many IMO your making the mistakes of recency and putting way too much weight on short term data.
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Correction

Postby Taylor Larimore » Thu Dec 20, 2012 1:37 pm

There is no combination of Vanguard US bond funds and US equity funds over that 10 year period that could possibly have outperformed its HYB fund.


Vanguard 10-year returns (11/30/2012):

8.12% Vanguard Hi-Yield Corporate (VHEHX)
8.38% Vanguard Long Term Bond Index (VBLTX)
14.78% Vanguard Energy (VGENX)

Past returns do not guarantee future returns.

Best wishes.
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Re: hidden risk in high yield bonds

Postby garlandwhizzer » Thu Dec 20, 2012 5:19 pm

Taylor Larimore wrote:
Vanguard 10-year returns (11/30/2012):

8.12% Vanguard Hi-Yield Corporate (VHEHX)
8.38% Vanguard Long Term Bond Index (VBLTX)
14.78% Vanguard Energy (VGENX)


I misspoke. I meant to say Vanguard DIVERSIFIED BOND and DIVERSIFIED STOCK funds for the comparison. The point is that HYB detractors, and there are many of those on this forum, state that HYB have both equity-like and bond-like characteristics that make them unacceptable for inclusion into a bond portfolio, that you should hold only highest quality bonds which allows you to hold less in bonds and increase diversified equity holdings to get better long term results without increasing volatility. By equity I don't mean VGENX and by high quality bonds I don't mean VBLTX, both of which are sector plays. If it is true that HYB are in fact part equity-part bond, one would expect HYB to perform somewhere between TSM and TBM over significant periods of time. My point is that over the last 10 years which seems to me a long period of time, HYB returns have not been anywhere between TSM and TBM but in fact superior to both. Hence it cannot be a hybrid of the two. HYB are a unique asset class which dances to its own tune.

Having said that, I don't recommend them for everyone and I limit them to never more than 20% of my bond allocation. Clearly they have risk. Furthermore, I am less than enthusiastic about their prospects going forward after such a huge run-up (as I am, by the way, for Treasuries at present). The point that I am making is simply that for some people at some times the Vanguard HYB fund makes sense as a modest percentage of a bond portfolio. That, at least, is how I see it.

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Re: hidden risk in high yield bonds

Postby larryswedroe » Thu Dec 20, 2012 6:39 pm

garland
Your problem IMO is not understanding that 10 years is a very short and pretty meaningless period for any asset class. Just think 90s for growth stocks. Or how about last 10 years for gold, pretty long time so we should all load up on gold right? Or how about 69-08 when stocks underperformed Lt Treasuries, for 40 years, Also note that HY started period when spreads were wide and now they are narrow. So you have to understand that and how that impacts the data.
Any analysis really should look at the longest data we have, and it shows what I said. Now if you wish to ignore that fine.
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Re: hidden risk in high yield bonds

Postby fl_retiree » Thu Dec 20, 2012 7:31 pm

larryswedroe wrote:Also note that HY started period when spreads were wide and now they are narrow. So you have to understand that and how that impacts the data.


Not that its relevant, I've had 2% of total assets in HY since 2001 and have been very happy. Granted 11 years is a statistically unimportant time frame. A question, if I may.

It seems that HY doesn't behave quite like anything else - part equity-like, part bond-like, but there isn't a combination of equity & bond funds I can buy that replicates HY's performance. It seems to me, that this provides an opportunity for better returns from rebalancing -- I'll be buying HY when it is out-of-favor/undervalued and selling HY when it is hot/overvalued. Is the logic flawed and if not is such an opportunity enough to counterbalance the negatives you see in HY?
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Re: hidden risk in high yield bonds

Postby larryswedroe » Thu Dec 20, 2012 9:06 pm

fl+retiree
First the research shows that HY is really just a combination of stocks and bonds and there are papers that show that, including one by Reichenstein. If interested in the literature on the subject you can find the chapter in my book on alternative investments, or in my bond book. But what you need to know is that the relationships drift over time so the relationship is just an average. So of course over any particular period you can get different results. And note that if your buying high yield when it's distressed that is also when the stocks of those companies are also distressed (they are even riskier than the bonds of course), and investors seem to ignore that fact.

Second, sure if you buy any asset class when it's out of favor, valuations are low and expected returns high, you are likely to do better than investors that do the reverse, which is what most do.

I don't know why people ignore the evidence which is clear that over its lifetime using the Vanguard HY did produce lower portfolio returns than five year Treasuries and one can easily do better than that by simply buying CDs instead. That's the facts. Ignoring it doesn't change it.

And it ignores the location issue, the loss of control of your AA (as high yield shifts its exposure), and it takes on call risks which has not been rewarded. Other than that it's great

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Re: hidden risk in high yield bonds

Postby Grt2bOutdoors » Thu Dec 20, 2012 9:54 pm

Take Larry's advice - use equities if you must take risk. My idea of safety does not conjure up thoughts of high yield bonds.
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Re: hidden risk in high yield bonds

Postby Rick Ferri » Thu Dec 20, 2012 10:04 pm

First the research shows that HY is really just a combination of stocks and bonds and there are papers that show that


Then the papers are wrong. If HY was simply a combination of stocks and bonds, then the returns would also be a combination of stocks and bonds. In fact, the Vanguard High-Yield Corporate Admiral Shares performed 8.2% over the past 10 years while the Total Stock Market earned 7.2% and the Total Bond Market earned 5.4%. A combination of stocks and bonds earned only 6.3%. So,where did the other 1.9% come from?

Larry's idea that high yield has no reason to exist is getting very old. We've been arguing about it for 10 years, and for 10 years he has been wrong. Give it up, already! :wink:

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Re: hidden risk in high yield bonds

Postby Valuethinker » Fri Dec 21, 2012 8:24 am

garlandwhizzer wrote:I misspoke. I meant to say Vanguard DIVERSIFIED BOND and DIVERSIFIED STOCK funds for the comparison. The point is that HYB detractors, and there are many of those on this forum, state that HYB have both equity-like and bond-like characteristics that make them unacceptable for inclusion into a bond portfolio, that you should hold only highest quality bonds which allows you to hold less in bonds and increase diversified equity holdings to get better long term results without increasing volatility. By equity I don't mean VGENX and by high quality bonds I don't mean VBLTX, both of which are sector plays. If it is true that HYB are in fact part equity-part bond, one would expect HYB to perform somewhere between TSM and TBM over significant periods of time. My point is that over the last 10 years which seems to me a long period of time, HYB returns have not been anywhere between TSM and TBM but in fact superior to both. Hence it cannot be a hybrid of the two. HYB are a unique asset class which dances to its own tune.


Martin S Fridson is the Wall Street guy you want to read.

With HY last 10 years you have to strip out the interest rate effect (which has benefited US Treasuries, first and foremost) from the credit spread effect (credit spreads over AAA Treasuries or investment grade corporate bonds are now the lowest they have ever been, almost).

Run the data back to the 1980s-- you will see the time to buy HY is when 'the sky is falling' and the time to sell is just about now, when forecasts of default rates are bottoming and you start to see low grade issues creep back in (piece in NYT about that, last few months).

Examples of low grade issues:

- bonds to refinance LBO/ PE stakes in companies - so bonds to buy back shares or pay dividends or for 'general purposes', unstated vs. capex or (some) acquisitions
- bonds with PIK features, or just 'cov lite'
- bonds from perenially bankrupt sectors (see Altman's data at NYU site) such as airlines
- call provisions become more embedded - eg if call if upgraded to IG, etc.

CLO funds, btw, are looking a lot more interesting. We may have missed the boat, but Financial Times, today, re CLO funds.
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Re: hidden risk in high yield bonds

Postby Valuethinker » Fri Dec 21, 2012 8:26 am

I must admit given what is happening in general background (economy, politics) if I were USian I would be taking a look at municipal bonds.

That tax exemption could turn out to be increasingly valuable.

Downside in Robert Merton's comment, that to free themselves from pension liabilities municipalities will have to go Chapter 11 route, but I think that will be long drawn out, bloody and selective.

California is lurching towards a budgetary *surplus*. CA, basket case number one for state financing.

Tells you something.
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Re: hidden risk in high yield bonds

Postby Valuethinker » Fri Dec 21, 2012 8:47 am

Grt2bOutdoors wrote:Take Larry's advice - use equities if you must take risk. My idea of safety does not conjure up thoughts of high yield bonds.


The roller coaster ride 2007-2009 was vertiginous.

Arguing that it 'came out alright in the end' ignores, I think, what might have happened.

Yes there was a buying opportunity in early 09 (and you can find my posts cautioning against it ;-)). But really, this sort of thing happens once in a decade or even more infrequently than that.

When 60% of your portfolio is in the tank, you want the other 40% to be at least close to stable.
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Re: hidden risk in high yield bonds

Postby Sidney » Fri Dec 21, 2012 9:03 am

Valuethinker wrote:That tax exemption could turn out to be increasingly valuable.

Unless it goes away.
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Re: hidden risk in high yield bonds

Postby larryswedroe » Fri Dec 21, 2012 9:21 am

That's right all the literature is wrong. If it was wrong there certainly would be contrary papers out there as academics like nothing better than to show another is wrong. What's wrong is taking a short period and concluding it's wrong. Obviously there is some unique risk in high yields, but it isn't much and certainly not worth negatives I've listed as the long term data shows, which doesn't even include the location issue.
The point being that correlations (or relationships) drift over time. So we can only estimate that high yield is say 25% equity. We also know that the risks show up at the wrong time and it becomes say 75% equity. Remember it's not only how much risk you have in an asset, but when the risks tend to show up that matter. There really is nothing to like about high yield, just an illusion.
Sure if you can time the asset you might get some benefit because the asset class doesn't move exactly in sync with equities (in rallies I think HY tends to lead by a bit), but good luck with and it certainly isn't a Boglehead strategy.

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Re: hidden risk in high yield bonds

Postby bengal22 » Fri Dec 21, 2012 9:35 am

Valuethinker wrote:
Grt2bOutdoors wrote:Take Larry's advice - use equities if you must take risk. My idea of safety does not conjure up thoughts of high yield bonds.


The roller coaster ride 2007-2009 was vertiginous.

Arguing that it 'came out alright in the end' ignores, I think, what might have happened.

Yes there was a buying opportunity in early 09 (and you can find my posts cautioning against it ;-)). But really, this sort of thing happens once in a decade or even more infrequently than that.

When 60% of your portfolio is in the tank, you want the other 40% to be at least close to stable.


Its always a great day when you learn a new word - VERTIGINOUS! Now to use it in a conversation for 28 days and it will be a habit. Thank You Valuethinker.
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Re: hidden risk in high yield bonds

Postby Rick Ferri » Fri Dec 21, 2012 9:41 am

Larry,

High yield is large and growing part of capital creation in the country and is included the total-total bond market. For various, many years ago you chose to exclude this asset class from your portfolio. That's fine. No one said a Boglehead strategy must include all asset classes. But let's not go down that road of saying that not including HY is "the" Boglehead strategy because that's not correct..

Boglehead philosophy and individual strategy are quite different concepts.

The Boglehead philosophy is to not market-time, to invest in low-cost and widely diversified mutual funds or ETFs, avoid illiquid investments, use index fund if available and feasible, be tax efficient, etc.

Strategy is how each person implements this philosophy. It is highly personal and specific to each investor. This is where the question of high yield comes in. You chose not to use HY in your portfolio, I chose to use it in mine. You chose to use commodities, I chose not to. Some people use TIPS, some people use iBonds, some people chose not to have any inflation adjusted bonds in a portfolio.

Including or not including high yield has nothing to do with philosophy, it has everything to do with personal strategy. There is only one Boglehead philosophy, but there are as many Boglehead strategies as there are Bogleheads.

Rick Ferri

.
Last edited by Rick Ferri on Fri Dec 21, 2012 10:15 am, edited 3 times in total.
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Two of my favorite quotes.

Postby Taylor Larimore » Fri Dec 21, 2012 10:03 am

Larry & Rick:

Thank you for your interesting and civil debate on the subject of Hi-Yield Bond Funds.

Two of my favorite quotes:
When experts disagree it is often because it does not make much difference.

There is more than one road to Dublin.

Best wishes and Merry Christmas!!

Taylor
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Re: hidden risk in high yield bonds

Postby larryswedroe » Fri Dec 21, 2012 10:23 am

But let's not go down that road of saying that not including HY is "the" Boglehead strategy because that's not correct..


Rick, I did not say that. I was referring to trying to time the market using HY. Obviously the data shows that if you made it an allocation, using Vanguard fund, that it has underperformed in a portfolio over even 5 year Treasuries, let alone CDs which would have produced even better results. So the only way it would have added value in the long term is if you were able to successfully time entry and exit. That is not a Boglehead philosophy.

Hope that clarifies the issue

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Re: hidden risk in high yield bonds

Postby Valuethinker » Fri Dec 21, 2012 10:28 am

Sidney wrote:
Valuethinker wrote:That tax exemption could turn out to be increasingly valuable.

Unless it goes away.


Fair point.

I don't want to be seen to be speculating on policy but ending a major channel for US municipal finance would be impossible. There'd have to be a replacement specified at the same time ('Build America' bonds?). That would impact new bonds, but not old bonds?

However tax deductions for munis could, no doubt, be curtailed-- particularly for higher tax brackets.
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Re: hidden risk in high yield bonds

Postby Rick Ferri » Fri Dec 21, 2012 11:15 am

larry wrote:The only way (HY) it would have added value in the long term is if you were able to successfully time entry and exit. That is not a Boglehead philosophy.


I disagree for many reasons, and here is one. The data to support your argument is period specific to a falling interest rate environment (1980 to 2012). The gigantic drop that occurred in interest rates over the study period is not adequately addressed yet is a huge factor in HY returns due to early calls and refinancing opportunities. Had there been good data on high yield going back 100 years or so, which there is not because it only goes back to the 1980s, then we would be able to estimate how HY acts in all interest rate environments and perhaps you could make a better case that this asset class only "works" with successful market timing.

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Re: hidden risk in high yield bonds

Postby garlandwhizzer » Fri Dec 21, 2012 11:21 am

Rick wrote:
Larry,

High yield is large and growing part of capital creation in the country and is included the total-total bond market. For various, many years ago you chose to exclude this asset class from your portfolio. That's fine. No one said a Boglehead strategy must include all asset classes. But let's not go down that road of saying that not including HY is "the" Boglehead strategy because that's not correct..

Boglehead philosophy and individual strategy are quite different concepts.

The Boglehead philosophy is to not market-time, to invest in low-cost and widely diversified mutual funds or ETFs, avoid illiquid investments, use index fund if available and feasible, be tax efficient, etc.

Strategy is how each person implements this philosophy. It is highly personal and specific to each investor. This is where the question of high yield comes in. You chose not to use HY in your portfolio, I chose to use it in mine. You chose to use commodities, I chose not to. Some people use TIPS, some people use iBonds, some people chose not to have any inflation adjusted bonds in a portfolio.

Including or not including high yield has nothing to do with philosophy, it has everything to do with personal strategy. There is only one Boglehead philosophy, but there are as many Boglehead strategies as there are Bogleheads.

Rick Ferri



1+ Well put, Rick.

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Re: hidden risk in high yield bonds

Postby larryswedroe » Fri Dec 21, 2012 12:02 pm

Rick, that is a fair point, and does point out the risks in high yield. Having said that there were also periods of rising rates in bonds, almost as many years where rates were rising as falling if my memory serves.
But remember with junk it's not interest rates falling that is only call risk. It's risk of credit improving. Then company can issue cheaper debt or even equity perhaps.
And as I said, at very least one should account for the equity like risk, treating it the same as safe Treasuries or Investment grade is just plain kidding yourself
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Re: hidden risk in high yield bonds

Postby CaveatEmptor » Sat Dec 22, 2012 3:41 am

You can find here http://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2 an interesting chart of how the spread (over Treasuries) of High-Yield (aka Junk) has evolved since 1997. Note that it stands now at 5.19%, not bargain-territory but also nothing like the exalted 2.5% of 1997-1998 and just before the unpleasantness of 2007-2009.
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Re: L

Postby mpt follower » Sat Dec 22, 2012 7:07 am

maddyken wrote:I have a small amount of HY, my fund managers see value (for now) and I don't second guess them.

I personally wouldn't own HY if I managed my portfolio because the misleading long term correlations don't hold during crises. I've come to the conclusion downside protection is paramount, as opposed to return or risk-adjusted return. While I haven't conducted any studies, obviously, I think your high quality advice is sound.


Nothing provides downside protection in the very short term. See what happened in 2008 with most asset classes.
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Re: hidden risk in high yield bonds

Postby larryswedroe » Sat Dec 22, 2012 10:00 am

The Telltale chart (to use Bogle's term)
The chart Erwin provided is a key to understanding the issue I raised about the recent returns to high yield. You have to be very careful to look at valuations at start and end points of data, especially when looking at relatively short periods. So we began the recent 10 year period with spreads extremely high, well above long term average. And now of course spreads are much lower. So of course you are going to see relatively high returns. That's no different than looking say at stock returns and using your starting point April 2009 when valuations reached their lows. It's also like saying the small premium disappeared after 83. Well we had just had a bubble in small stocks with period of unrealistically high returns from 75-83 when small stocks returned over 30%, roughly twice what the S&P returned. Thus the high valuations at the time doomed them to low returns going forward. (Virtually identical returns to S&P 500 and small stocks 84-11). Without knowing your history and valuations looking only at returns one can draw some very foolish conclusions.

Hope that is helpful

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Re: hidden risk in high yield bonds

Postby Valuethinker » Sat Dec 22, 2012 10:47 am

mpt follower wrote:
maddyken wrote:I have a small amount of HY, my fund managers see value (for now) and I don't second guess them.

I personally wouldn't own HY if I managed my portfolio because the misleading long term correlations don't hold during crises. I've come to the conclusion downside protection is paramount, as opposed to return or risk-adjusted return. While I haven't conducted any studies, obviously, I think your high quality advice is sound.


Nothing provides downside protection in the very short term. See what happened in 2008 with most asset classes.


with most asset classes

Consider:

Ibonds

US government 'G' Fund? (if you have access to that)

Stable Value Funds (eventually they would unwind in a bad smash, the insurers would have to renege on their commitments)

cash and US Treasury Short Term securities ie T Bills

As I recall, Treasury Bond funds did pretty well 08-09?
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Re: hidden risk in high yield bonds

Postby Valuethinker » Sat Dec 22, 2012 10:49 am

CaveatEmptor wrote:You can find here http://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2 an interesting chart of how the spread (over Treasuries) of High-Yield (aka Junk) has evolved since 1997. Note that it stands now at 5.19%, not bargain-territory but also nothing like the exalted 2.5% of 1997-1998 and just before the unpleasantness of 2007-2009.



Good stuff.

The composition of that index must have changed *a lot* over time-- it includes international corporate bonds (from investment grade countries) of sub investment grade, it also appears to include Mortgage Backed Securities (but would not include US Treasury backed ones ie Freddie Fannie Ginnie).
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Re: hidden risk in high yield bonds

Postby louis c » Sat Dec 22, 2012 10:52 am

CaveatEmptor wrote:You can find here http://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2 an interesting chart of how the spread (over Treasuries) of High-Yield (aka Junk) has evolved since 1997. Note that it stands now at 5.19%, not bargain-territory but also nothing like the exalted 2.5% of 1997-1998 and just before the unpleasantness of 2007-2009.


Great chart - thanks for sharing it.

While there is a strong argument against HY bonds based on the claim of poor risk-adjusted returns, and a strong argument for HY bonds based on the claim for a correlation benefit from a distinctly different-performing asset class, why would agreement with both these arguments rule out choosing to hold HY bonds?

If I were instead to choose a "safer" alternative - say 70% treasuries and 30% TSM, then I just reduced the asset diversification of my portfolio (since I already hold treasuries and TSM) and removed a positive real return asset class. While that is ostensibly to gain a better risk-adjusted return, how "poor" does the risk-adjusted return have to be to negate the portfolio-level diversification benefit?

We cannot predict future returns, and future correlations are not predictable either, but the fundamentals of an asset class can be evaluated to determine if they are intrinsically different, and in extreme cases even whether they are overvalued. Based on the above chart they are not cheap, but they are not in nosebleed territory either. The point is HY bonds perform distinctively different from both stocks and bonds, and the fact that HY has at times reached equity levels of risk does not in itself mean to me it is an unworthy asset to own. I do think it is reasonable to adjust the equity allocation if you own HY - not because HY risk can increase substantially "at just the wrong time" - but because asset allocation decisions are to determine portfolio-level risk, not make a comparative risk judgment between just one asset class and another one. I think the point of asset allocation is to not make a judgment on the relative merits of a single asset class other than to determine whether it generates positive real returns over the long term. I have not yet heard a successful argument against HY using that rationale.
Last edited by louis c on Sat Dec 22, 2012 11:07 am, edited 1 time in total.
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Re: hidden risk in high yield bonds

Postby richard » Sat Dec 22, 2012 11:07 am

Rick Ferri wrote:High yield is large and growing part of capital creation in the country and is included the total-total bond market.

Do you (or does anyone) know what percentage high yield is of the total bond market? It's not included in Vanguard's total bond market fund, which is only investment grade.

Here's a broader breakdown
Code: Select all
Category         Amount    Percentage
Government        9.2          28
Municipal         2.9           9
Agency            2.4           7
Corporate         7.7          24
Mortgage related  8.3          26
Asset Backed      1.9           6
Total            32.3         100

http://en.wikipedia.org/wiki/Bond_marke ... arket_size
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Re: hidden risk in high yield bonds

Postby louis c » Sat Dec 22, 2012 11:17 am

richard wrote:
Rick Ferri wrote:High yield is large and growing part of capital creation in the country and is included the total-total bond market.

Do you (or does anyone) know what percentage high yield is of the total bond market? It's not included in Vanguard's total bond market fund, which is only investment grade.

Here's a broader breakdown
Code: Select all
Category         Amount    Percentage
Government        9.2          28
Municipal         2.9           9
Agency            2.4           7
Corporate         7.7          24
Mortgage related  8.3          26
Asset Backed      1.9           6
Total            32.3         100

http://en.wikipedia.org/wiki/Bond_marke ... arket_size


If you add HY, which is $1.3T, that is about 3.6% of the combined total for the US bond market.

Category Amount Percentage
Government 9.2 27.4%
Municipal 2.9 8.6%
Agency 2.4 7.1%
Corporate 7.7 22.9%
Mortgage related 8.3 24.7%
Asset Backed 1.9 5.7%
High Yield 1.2 3.6%
Total 33.6 100
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Re: hidden risk in high yield bonds

Postby Bill Bernstein » Sat Dec 22, 2012 12:12 pm

A bit of a food fight, I see.

I think there are excellent arguments on both sides of this, though I tend to side more with Larry overall: stay away. Long-term, I think that uninformed investors are attracted to hi-yield because of its . . . high yield, and don't take into account the poor return/risk characteristics. (And, as long as we're tossing the literature around, the sweetest spot may in fact be B-BB bonds, since investors ignore them because they fall the gap between IG and HY, which may also be why VWEHX has done so well.) I'm not as impressed with VWEHX's 10-year returns as I am by the fact that the average historical junk-T spread is around 300-400 bp, and the loss rate is probably slightly higher than that. Factor in the higher risk, and HY just doesn't make much sense as a long-term holding.

Having said that, though, I think that there are times when HY can be particularly attractive, even after taking its small/value stock regression stats into account. A perfect example was in early '09, when junk recovered nicely throughout the first quarter, while stocks bottomed out in particularly sickening fashion.

I'll give Taylor the final word on this: when distinguished observers like Larry and Rick disagree about a subject, it can't matter that much.

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Re: hidden risk in high yield bonds

Postby richard » Sat Dec 22, 2012 12:56 pm

louis c wrote:
richard wrote:
Rick Ferri wrote:High yield is large and growing part of capital creation in the country and is included the total-total bond market.

Do you (or does anyone) know what percentage high yield is of the total bond market? It's not included in Vanguard's total bond market fund, which is only investment grade. [snip]
http://en.wikipedia.org/wiki/Bond_marke ... arket_size

If you add HY, which is $1.3T, that is about 3.6% of the combined total for the US bond market.[snip]

HY might already be included in other categories, such as corporate, which would push it to 4%.

In either event, it's a small percentage of the market, which may be reason enough to avoid it. I'd have said hold it in market proportions for diversification, but there's a limit to how much diversification benefit you get from something that would be well under 5% of your total portfolio (and a limit to how much harm such a small percentage would be likely to cause).

Do you have a source for $1.3T?
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Re: hidden risk in high yield bonds

Postby winguy » Sat Dec 22, 2012 10:47 pm

Hi, I'm not from the US.

Should HY bonds entail currency risk? Eg USD HY bonds for me.
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Re: hidden risk in high yield bonds

Postby magician » Sun Dec 23, 2012 12:20 am

winguy wrote:Hi, I'm not from the US.

Should HY bonds entail currency risk? Eg USD HY bonds for me.

Any investment denominated in a currency other than your home currency will have currency (i.e., exchange rate) risk.
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