Does corporate credit risk add value

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larryswedroe
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Does corporate credit risk add value

Post by larryswedroe »

Second in the series on taking credit risk and is it well rewarded

http://seekingalpha.com/article/2296895 ... 1404312450

Hope it's helpful

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Re: Does corporate credit risk add value

Post by Rodc »

Anyway to read this without registering?
Second in the series on taking credit risk and is it well rewarded
Did you mean that as written? It seems at odds with the summary bullets that I can read.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: Does corporate credit risk add value

Post by larryswedroe »

says IS IT well rewarded, not that it is well rewarded
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Re: Does corporate credit risk add value

Post by Rodc »

larryswedroe wrote:says IS IT well rewarded, not that it is well rewarded
Larry
:oops:
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: Does corporate credit risk add value

Post by acegolfer »

Without reading the article, doesn't any risk decrease the value, and increase the expected return, ceteris paribus?

Or does the article analyze the return/risk ratio?
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Re: Does corporate credit risk add value

Post by kramer »

Excellent and relevant article.

Larry, you mention the Barclay's Capital Treasury Bond index in the article.

If I understand correctly, that is the index listed here as "US Treasury" with no particular range of years like the others listed, and currently has a duration of 5.26 years:

https://indices.barcap.com/show?url=Ben ... nd_Indices

So are you saying a duration range that long is OK for most investors or was that just to make a proper comparison to the non-Treasury indices used in the article?
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Re: Does corporate credit risk add value

Post by Professor Emeritus »

As I read it (and frankly agree with) "bond" per se is not a meaningful category for an investment portfolio. All bonds carry what the article calls risk ( and what I think is properly uncertainty) the key statement is


The lower a bond’s credit rating, the higher it’s correlation with equities. It’s essentially equity risk in disguise.

I would only add that it is not it is not in disguise at all. It's obvious to everyone but the "spreadsheet Zombies" who insist that if it is called a bond it goes in a single category of bonds and then can be put on the spreadsheet for allocation. But bonds have default and call risks that are difficult to analyze. People rely on bond raters who have conflicts of interest.

This is why indexing of bonds is different from indexing of stocks. Can "bond Managers" actually out guess the bond raters in terms of the risk of bonds?

I have long hypothesized that Wellington and Wellesley can and do do this.

Good article
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Re: Does corporate credit risk add value

Post by acegolfer »

Professor Emeritus wrote:As I read it (and frankly agree with) "bond" per se is not a meaningful category for an investment portfolio. All bonds carry what the article calls risk ( and what I think is properly uncertainty) the key statement is


The lower a bond’s credit rating, the higher it’s correlation with equities. It’s essentially equity risk in disguise.

I would only add that it is not it is not in disguise at all. It's obvious to everyone but the "spreadsheet Zombies" who insist that if it is called a bond it goes in a single category of bonds and then can be put on the spreadsheet for allocation. But bonds have default and call risks that are difficult to analyze. People rely on bond raters who have conflicts of interest.

This is why indexing of bonds is different from indexing of stocks. Can "bond Managers" actually out guess the bond raters in terms of the risk of bonds?

I have long hypothesized that Wellington and Wellesley can and do do this.

Good article
Agreed. The financial asset classification (equity, debt, derivative) is just a simplification. The line between equity and debt can be ambiguous. Two examples are high yield bonds and preferred stocks because these have both equity and debt characteristics.

However, having some classes (even if it's controversial) is better than none for analysis purpose. One just needs to know its limitations.
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Re: Does corporate credit risk add value

Post by Longtimelurker »

Thanks Larry for this and the series on muni's. Unlike equities, where I have no problem staying the course, I have struggled to find conviction with my bond allocation for years now. It is incredibly painful to take on credit and interest rate risk with SEC yields under inflation. But through experience and study I have become more disciplined, shed my need to market-time the yield curve or go into higher yield bonds. These articles have helped. Thank you!
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Re: Does corporate credit risk add value

Post by larryswedroe »

kramer
Yes to make comparison relevant
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Re: Does corporate credit risk add value

Post by Professor Emeritus »

acegolfer wrote:However, having some classes (even if it's controversial) is better than none for analysis purpose. One just needs to know its limitations.
I teach and argue academically that this is not true, at least in the areas I deal in.
You cannot start with defective classes and get anywhere. E.g. Do Weapons of Mass destruction include 767s? Buildings? etc.

As a further example Large thick skinned Vegetarians were all called Pachyderms. But Rhinos hippos and elephants are not closely related at all.

(Nb I agree that if the purpose of classification is making hunting rifles, Pachyderm is a class)

You have to show a priori that for the purpose of the analysis , the class makes more sense than not.
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Re: Does corporate credit risk add value

Post by acegolfer »

Professor Emeritus wrote: I teach and argue academically that this is not true, at least in the areas I deal in.
You cannot start with defective classes and get anywhere. E.g. Do Weapons of Mass destruction include 767s? Buildings? etc.

As a further example Large thick skinned Vegetarians were all called Pachyderms. But Rhinos hippos and elephants are not closely related at all.

(Nb I agree that if the purpose of classification is making hunting rifles, Pachyderm is a class)

You have to show a priori that for the purpose of the analysis , the class makes more sense than not.
Great to know that we have an academia. If you teach Investments, do you think the financial asset classification in textbooks is meaningless? (or, why do they classify the financial assets?)

If yes, can you explain academically why "this is not true?" You used examples rather than academic explanations. In addition, can you elaborate your last statement?

Final note: I like to challenge academically especially to those who are in academia. However, if you think I'm asking unreasonable questions, I'll stop asking.
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Re: Does corporate credit risk add value

Post by longinvest »

Here's the fundamental law of investor returns:

Gross returns in the financial markets minus the costs of financial intermediation equal the net returns actually delivered to investors. See: http://www.vanguard.com/bogle_site/sp20060101.htm and http://www.stanford.edu/~wfsharpe/art/active/active.htm.

Therefore, one could get lucky and select a strategy that makes more than the overall market, but that means that someone else has to select another strategy that makes less than the market.

Note that this argument does apply to the investment-grade nominal bond market.

Vanguard's Total Market Bond Index Fund contains 6579 distinct bonds spawning across a wide range of maturities and low levels of credit risk. I guess that an investor that decides to only invest in a small subset of these bonds (short and intermediate treasuries) must really feel lucky!
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Re: Does corporate credit risk add value

Post by larryswedroe »

longinvest
One doesn't have to get lucky to do better than market, just follow the (academic) research. There's plenty of evidence of persistent anomalies caused by bad individual investor behavior and limits/costs of arbitrage.
Among them are avoiding all stocks with lottery like characteristics which individuals overweight and institutions underweight (they know better)
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Re: Does corporate credit risk add value

Post by mptfan »

longinvest wrote: Vanguard's Total Market Bond Index Fund contains 6579 distinct bonds spawning across a wide range of maturities and low levels of credit risk. I guess that an investor that decides to only invest in a small subset of these bonds (short and intermediate treasuries) must really feel lucky!
Or and investor could invest in bonds that are not included in Vanguard's Total Bond Market index, including high yield corporate bonds, TIPS, international bonds, or emerging market bonds.
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Re: Does corporate credit risk add value

Post by longinvest »

Larry,

If academics were unanimous about it, it would be a better argument. Unfortunately, they're not.

On the other hand, both academics and non-academics agree on the fundamentals that Investor Returns are equal to gross market returns minus fees.

Investing in total market indices, as long as it is done in funds with low fees and good execution, will guarantee market returns (minus the low fee and small tracking error). Doing anything else does require the investor to believe that he has found a winning formula and that some other investors are dumb, and will remain dumb by adopting, in aggregate, the reverse non-market strategy.

So, you are free to believe that you and some academics have found a free lunch.

I will, personally, remain satisfied if I simply gather my fair part of market returns without having to make any bet or leap of faith based on non-unanimous academic arguments.

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Re: Does corporate credit risk add value

Post by nisiprius »

This is my current simple-minded understanding of why higher credit risk is equity risk... not even really in disguise. Please correct me where I've got it wrong. I believe that:

A bond has to be paid like any other bill. A healthy corporation has a thick margin of safety that enable it to pay its bills in both good years and bad. It doesn't need to get a smash hit every year just to keep the lights on. The credit rating is basically an assessment of that margin of safety. If the margin of safety is thick, as in a high-grade bond, the safety and value of the bond are almost decoupled from the company's business success. The investor doesn't get more when the business has a good year, and doesn't get less when it has a bad year--unless it folds completely.

The value of a company's stock fluctuates together with the health of the company's business.

A low-grade bond means that there isn't much cushion, and that the company's ability to pay its bills depends on the health of its business. Investors know that, and therefore the value of its bonds fluctuates with the fluctuating health of the business--as does the value of its equity. They are really one and the same thing; they are correlated.
Last edited by nisiprius on Fri Jul 04, 2014 1:44 pm, edited 1 time in total.
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Re: Does corporate credit risk add value

Post by longinvest »

mptfan wrote:
longinvest wrote: Vanguard's Total Market Bond Index Fund contains 6579 distinct bonds spawning across a wide range of maturities and low levels of credit risk. I guess that an investor that decides to only invest in a small subset of these bonds (short and intermediate treasuries) must really feel lucky!
Or and investor could invest in bonds that are not included in Vanguard's Total Bond Market index, including high yield corporate bonds, TIPS, international bonds, or emerging market bonds.
Yes, they could. Note that I was specifically arguing about the (U.S.) investment-grade nominal bond market.

Of course, the investor returns argument can be applied to any market. That's the beauty of it.
Last edited by longinvest on Fri Jul 04, 2014 2:29 pm, edited 2 times in total.
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Re: Does corporate credit risk add value

Post by mptfan »

nisiprius wrote:They are really one and the same thing; they are correlated.
These are different statements....they can be different and correlated.
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Re: Does corporate credit risk add value

Post by Johno »

I'd add a few things:
-the return of investment grade corporate bond funds is significantly affected by the mechanics of indexing. That is, bonds are kicked out of the index and thus the fund if the rating goes below BBB-/Baa3, with losses in almost all cases, the bulk of 'credit' losses such a fund will suffer (default directly from an investment grade rating, without being downgraded to junk first, is relatively rare). The spread on the bond which must be sold has widened if it started out in the index/fund at any rating much above the threshold, and that's magnified by the fact that so many institutional holders of bonds, funds and other, are strictly required to dump bonds which go below investment grade. Of course there is a buyer for every seller, but the rigid requirement to sell bonds which go below the threshold results in a larger number of sellers when the rating crosses the threshold, and a larger price concession to generate enough buyers to accommodate them, than would be the case if such a rigid requirement didn't exist. However it must exist so a fund or other institutional portfolio can be presented as 100% investment grade, not 'formerly 100% investment grade except for these things here, and those things there'.
This factor has historically robbed corporate bond index fund of a significant % of the excess they'd apparently earn over treasuries if you just considered the starting spread and subtracted the historical default loss rate. IOW a portfolio of bonds which *starts* as all investment grade but is held to maturity will have higher return, more risk (as some bonds will be 'ridden down' from investment grade to junk to default), but better risk/return characteristics than a portfolio constantly maintained at investment grade by dumping bonds which drop below the threshold.

-in part due to the same phenomenon, BB (BB+/Ba1>BB-/Ba3) corporate issues historically give the best risk/return performance of any credit rating as regards losses due to default.

-at the CCC level or below, risk/return performance deteriorates substantially, probably due to 'lottery ticket' effect. Investors unable to efficiently use leverage become more predominant at very poor ratings, seeking the big win when an issuer manages to pay back a distressed issue selling at 10's of % discount to par. More sophisticated investors seeking more return can instead leverage up their exposure to better risky credits if the risk/return is superior.

So I'm willing to accept that most investors gain little by diversifying from US treasury/govt backed risk to US corporate investment grade in funds. I'm not as convinced though that junk investing has no separate place in a portfolio. As an outright replacement for 'riskless' bonds? certainly not. But for some diversifying niche in the portfolio it's really not the same *exact* thing as stocks plus treasuries. It's a different position in the capital structure of typically different companies (the TSM is dominated by stocks of investment grade issuers) with performance that can differ in parts of the economic or stock market cycle. And corporate credit is manifestly not a completely efficient market as in the points above. I would accept though as for most other things it's not likely to make a *huge* difference whether or not one has a junk allocation. Should one have international stocks? I think so. Is it likely to make a huge difference if you don't? arguably not. Same here, and the prudent allocation to junk would be a lot smaller than a typical one for international stocks.
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Re: Does corporate credit risk add value

Post by cowboysFan »

If investment grade bonds and high yield bonds had characteristics that weren't quite a stock/treasury bond combination, then wouldn't it make sense to look at a portfolio that had all four asset classes in the optimization problem instead of restricting yourself to two of the four?
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Re: Does corporate credit risk add value

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longinvest wrote:Therefore, one could get lucky and select a strategy that makes more than the overall market, but that means that someone else has to select another strategy that makes less than the market.
You're completely missing the point of the article. Larry is looking at the effect of credit risk on the entire portfolio not just the FI portion. In his example he holds the return constant and looks at the difference in a risk factor as the FI portion takes on more credit risk. In order for your "can't beat the market" theory to be applicable you would have to make all investors have the same AA which of course they don't. Bond traders for example usually do not have a lot of equities in their piggy bank and life insurance companies with relatively well defined future cash flow needs may be restricted to buying FI type instruments.

Until interest rates fell through the bottom we rarely saw these threads about the risk/return aspects of FI by itself. Rather many of the threads were concerned with the efficiency frontier and what people's AA needed to be as they progressed through their investment lifetime. Low interest rates did not change the basic risk/return aspect of our portfolios. It only means that we need to save more for the same overall risk. Larry's article demonstrates that increasing the credit risk is not a substitute for saving more.
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Re: Does corporate credit risk add value

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larryswedroe wrote:One doesn't have to get lucky to do better than market, just follow the (academic) research...
Larry
I guess all we need to do is to have someone tell us what research to follow, then we will all be rich. It is amazing that most active managers haven't figured this out yet, otherwise they would be beating the pants off of the index funds.

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Re: Does corporate credit risk add value

Post by larryswedroe »

Dale
Another view, just follow the research that appears in the leading academic/peer reviewed journals that is also persistent and pervasive. And btw-that's what the best active managers have done, and in fact it's their behavior/returns that often motivates the research (like the paper Buffett's Alpha), and then vehicles are created to "take advantage" of that research.
Note the value premium was well known by such as Graham and Dodd for decades before the academics "discovered" it
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Re: Does corporate credit risk add value

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Dale_G wrote:
larryswedroe wrote:One doesn't have to get lucky to do better than market, just follow the (academic) research...
Larry
I guess all we need to do is to have someone tell us what research to follow, then we will all be rich. It is amazing that most active managers haven't figured this out yet, otherwise they would be beating the pants off of the index funds.

Dale
I know he's viewed as a blow-hard by most here, but I just read a Ken Fisher article with a similar view (stated in his blow-hard way):
Ken Fisher wrote: http://www.forbes.com/sites/kenfisher/2 ... -counting/
...Looking back, 1984 seems remote. [...] Originally, I thought small stocks best. Academics “proved” it. Now I view that as a liquidity trap for fools–and that most leading academics spend too much time counting angels on pinheads to fathom reality. All equity categories, correctly calculated, create near identical lifelong returns. They just get there via wildly differing paths. Believing otherwise disbelieves capitalism and markets – do so at your mortal soul’s peril. Over time I’ve come evermore to believe in capitalism and less in most else...
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Re: Does corporate credit risk add value

Post by nisiprius »

JoMoney wrote:
Ken Fisher wrote:All equity categories, correctly calculated, create near identical lifelong returns. They just get there via wildly differing paths. Believing otherwise disbelieves capitalism and markets – do so at your mortal soul’s peril. Over time I’ve come evermore to believe in capitalism and less in most else...
Your mortal soul's peril? Really? Your mortal soul? Doesn't that seem a little...
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Re: Does corporate credit risk add value

Post by larryswedroe »

JoMoney
It's one thing to be blow hard but to get facts way wrong is another
All equity categories, correctly calculated, create near identical lifelong returns
This isn't even remotely close to being true--just look at the returns of small growth versus small value stocks for example. You see difference in compound returns of almost 5% 9.05 vs. 13.80

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Re: Does corporate credit risk add value

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I think part of the problem with high yield or lower credit quality bonds is their design. You take on the risk of equities but you are capped in terms of return. Why would you not buy the equity versus the high yield bond of a company? Another observation is high yield returns are very cyclical similar to stock returns. I think that there is no difference between stock risk and corporate credit risk. They are all coming from the same cash flows just a matter of how uncertain the levels will be to pay the bond cash flows. That is why I think some types of cash flows that have bond like characteristics (in terms of risk and coverage) can be purchased for nice premiums because they are not labeled as bonds but as another asset class. These types of securities appear to provide reward for risk between equities and bonds. The specific examples I give are NNN REITs and pipeline MLPs. If you look at the performance of NNN REITs (even in 2008) you see they perform better than high-yield and equities yet do not have the downside of either. This is in part due to their structure a lease obligations to unlevered or lightly levered firms. Despite this characteristic, the still yield from 5 to 7%? Pipeline MLPs are similar.

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Re: Does corporate credit risk add value

Post by Munir »

From the Vanguard web site:

Yield YTD 1 year 5 years 10 years

Inter-Term Invest-Gr (Adm) 2.67% 4.07% 6.34% 7.94% 5.88%

Inter-Term Treasury (Adm) 1.67% 2.11% 2.18% 4.19% 5.03%
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Re: Does corporate credit risk add value

Post by larryswedroe »

Munir
If you look at say Vanguard's high yield vs Treasury you'll find same thing, higher returns over long term. But when you put in portfolio that advantage disappears due to higher correlations and risks showing up at wrong time. Making mistake of looking at things in isolation
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Re: Does corporate credit risk add value

Post by packer16 »

If the subject portfolio has a long term focus (no monetary need for 5 years) does the risk showing up at the wrong time cause any problem beyond a behavioral one (i.e. you will sell when the portfolio is down despite the fact that you will not need the money for 5 years)? Therefore, one can obtain the higher return if they stay the course and will lose it if they will not.

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Re: Does corporate credit risk add value

Post by Munir »

larryswedroe wrote:Munir
If you look at say Vanguard's high yield vs Treasury you'll find same thing, higher returns over long term. But when you put in portfolio that advantage disappears due to higher correlations and risks showing up at wrong time. Making mistake of looking at things in isolation
Larry
Got it. Thanks, Larry. Since 70% of my portfolio is fixed income, I am yield-greedy and need the income. As you had mentioned previously, it may be acceptable to use investment grade corps if one acknowledges their equity-type risk and includes that in the overall portfolio risk. BTW, my FI is a mix of bond funds, SPIAs, and cash.
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Re: Does corporate credit risk add value

Post by Doc »

packer16 wrote:If the subject portfolio has a long term focus (no monetary need for 5 years) does the risk showing up at the wrong time cause any problem beyond a behavioral one (i.e. you will sell when the portfolio is down despite the fact that you will not need the money for 5 years)? Therefore, one can obtain the higher return if they stay the course and will lose it if they will not.

Packer
If you don't need the money for five years and the stock market doesn't crash or even correct in those five years and if you never rebalance into equities no matter what and you have zero faith in modern portfolio theory and CAPM then go ahead and take on more credit risk in your FI portfolio. Oh if the stock market does crash then some of those companies might default on their debt obligations but so what you don't need the money until late anyway. Oh, when you do need it those defaulted bonded will have a value of what?

Just a few post up thread
larryswedroe wrote:Making mistake of looking at things in isolation
If the risk of low credit bonds doesn't materialized you will get more return except if bond traders knew for certain that the risk would never materialize their wouldn't be a risk factor in the low credit bonds return in the first place. Catch 22.
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Re: Does corporate credit risk add value

Post by larryswedroe »

Munir
Glad to help but what I've tried to show is that YIELD isn't what should drive your decisions at all. IT's total portfolio return and the most efficient way to get the return you need. And it's not by taking credit risk---don't confuse yield and return.
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Re: Does corporate credit risk add value

Post by packer16 »

Doc wrote:
packer16 wrote:If the subject portfolio has a long term focus (no monetary need for 5 years) does the risk showing up at the wrong time cause any problem beyond a behavioral one (i.e. you will sell when the portfolio is down despite the fact that you will not need the money for 5 years)? Therefore, one can obtain the higher return if they stay the course and will lose it if they will not.

Packer
If you don't need the money for five years and the stock market doesn't crash or even correct in those five years and if you never rebalance into equities no matter what and you have zero faith in modern portfolio theory and CAPM then go ahead and take on more credit risk in your FI portfolio. Oh if the stock market does crash then some of those companies might default on their debt obligations but so what you don't need the money until late anyway. Oh, when you do need it those defaulted bonded will have a value of what?

Just a few post up thread
larryswedroe wrote:Making mistake of looking at things in isolation
If the risk of low credit bonds doesn't materialized you will get more return except if bond traders knew for certain that the risk would never materialize their wouldn't be a risk factor in the low credit bonds return in the first place. Catch 22.
I agree that taking on more credit risk makes little sense since you are not getting rewarded for it. Your upside is par and you have a large amount of call risk for the situations that turn out favorable. At least with equities you will get rewarded for taking risk. I have no high yield in my portfolio for that reason. Also when HY does look favorable, stocks look more so. My comment was in more generic sense that about the risks showing up at the wrong time and historically if you have held through the decline within 5 years you would have to recovered. You bring up a good point about rebalancing to ensure at the current and future times this pool of money has a 5 year period of time to recover.

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Re: Does corporate credit risk add value

Post by Munir »

larryswedroe wrote:Munir
Glad to help but what I've tried to show is that YIELD isn't what should drive your decisions at all. IT's total portfolio return and the most efficient way to get the return you need. And it's not by taking credit risk---don't confuse yield and return.
Larry
I was under the impression from reading conversations on this forum that yield is the best indicator of future returns for a bond fund while acknowledging that higher yields mean higher risk. It also sounds like a contradiction in terms when I think about it. I probably need to do more reading.
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Re: Does corporate credit risk add value

Post by larryswedroe »

Yes higher yield does indicate higher risk, but that doesn't always lead to higher returns, the credit default premium for example has only been about 30bp over the long term, far less than the yield differential.
Again, if spreads are wide that shows equity risks are high as well--and better off taking the risk in stocks than bonds for variety of reasons
Larry
acegolfer
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Re: Does corporate credit risk add value

Post by acegolfer »

Munir wrote:
I was under the impression from reading conversations on this forum that yield is the best indicator of future returns for a bond fund while acknowledging that higher yields mean higher risk. It also sounds like a contradiction in terms when I think about it. I probably need to do more reading.
Another example, where ppl think yield to maturity = expected return. To be precise, it's the expected (not the actual) return, if one holds the bond till maturity.
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Re: Does corporate credit risk add value

Post by larryswedroe »

acegolfer/muni
To get the expected return for corporate bonds you have to subtract from the yield the EXPECTED losses from defaults, which isn't zero.
Larry
acegolfer
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Re: Does corporate credit risk add value

Post by acegolfer »

larryswedroe wrote:acegolfer/muni
To get the expected return for corporate bonds you have to subtract from the yield the EXPECTED losses from defaults, which isn't zero.
Larry
Why didn't you subtract the yield from the EXPECTED losses from being called? From the investor's perspective, callable clause is a prepayment risk.

You missed my "hold till maturity" part. If one holds the corporate bond till maturity, there was no default and not called.
Sagenick48
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Re: Does corporate credit risk add value

Post by Sagenick48 »

I believe that it is possible to beat the market. It involves either "inside" information or the ability to control a company.

The ability to control a company, is what the private equity folks do. It is "provable" by the so called control premium that the investment folks talk about. It is not available to us ordinary folks.

Inside information, the legal kind, is available to all of us. We know what we think is a better pharmacy, Walgreens or CVS. The difficulty is that our inside information may not have value because we are the odd ball who prefers one when 90% prefer the other, or because what we value as important, the market doesn't.

From the time I started working I banked at Norwest, now Wells Fargo, at the time they treated me best. I invested in Norwest. I still hold Wells stock. My split adjusted basis is under a $1 a share.

And that is where experience comes in. Knowing what is important. Companies that have capable management and are honest.

I am "lucky" because as a "business" lawyer I see what the management of some NYSE companies do. I see how their land acquisition folks act when they buy land for a store or the lease folks act when they lease a store. I see how they treat their franchisees. That give me legally available inside information about them.

For example, my investment club three years ago bought Cliffs over my objection. I told them that in all of the times I had met Cliffs management I concluded they didn't know what they were doing. The investment club bought and regretted it.

This same experience applies in evaluating debt as in evaluating equity. If you hear from a friend that a particular big company is starting to slow down the payment of payables, or drag out starting a new capital project, and there is no good explanation, it is time to question whether they can pay their bonds on time.

Since I am retiring, I wouldn't any longer have that same kind of access to inside information, so I am gradually converting to treasuries and index funds.
The market goes up, the market goes down.
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Re: Does corporate credit risk add value

Post by larryswedroe »

acegolfer
That too is correct --should subtract expected losses from called. And if hold to maturity that doesn't guarantee no losses from default (:-))
Larry
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Re: Does corporate credit risk add value

Post by larryswedroe »

sagenick
Few problems with your post
First, what you THINK is inside information may very well be known by many others.
Second, your example of Norwest is anecdotal, nothing more. If you had worked at say Enron you might have thought the same thing, as thousands did. That's only great example of confusing what behavioral economists call the familiar with the safe
Third, there is no evidence that private equity outperforms similar risky public equities, even with the 30% control discount (because that goes to the PE firm, not the investor in form of fees)
Larry
Sagenick48
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Re: Does corporate credit risk add value

Post by Sagenick48 »

In response Larry,

1. Isn't my observation the same thing that Peter Lynch said?
2. We all may go to McDonald's or buy an IPhone but do we act on the information?
3. I can give you pages of antidotes since just about every individual investment I have made is based on them. The difference is that I am not trying to manage a large portfolio, or trying to produce quarterly or annual results to impress my investors.
4. This is what active management of a mutual fund says that it does, that it interviews people in the industry, talks to management etc. I have attended some of those management calls and was not impressed with the so called professionals, who seemed to be 2 or 3 years out of biz school. How can you truly know 100 or so companies, as well as evaluate new ones, all the while having a turnover of 10 to 20%?
5. As to private equity, I have just posted a post about my experience. Your argument that private equity does not "beat" the market is ignoring the fees which you argue causes the returns of private equity to be no better than public stocks because the 30% control premium goes to the private equity firm. My point was that the one way to beat the market is to capture the control premium. Some people do that, Warren Buffett comes to mind. So if by some weird and bizarre twist a private equity firm existed that was run like Vanguard, it should "beat" the market.
6. Let's discuss for a moment the idea of actively managed versus passive funds. The passive funds match the market and have low fees. So maybe the academics can answer this question, assume for a moment that all actively managed funds were no front or back end loads and had fees like a Vanguard or Fidelity index fund. Then what % of actively managed funds would beat the market? Would it be close to 50%? That is my point, an individual investor can beat the market because that investor is not charging the fees of an actively managed fund, but is actively managing their funds, and as a buy and hold investor has low transaction fees and can control taxes in a manner superior to a mutual fund. Admittedly, there are few people who have the interest and the aptitude to do this, and for the rest of us, there are index funds.
7. As a final note, what I can tell you is that I am very wary about buying a publicly traded stock in a company that has two classes of voting stock, or a large controlling shareholder, because in my experience as an investor holding the non-voting or lesser voting stock, it seemed that the owners of the voting stock always came out ahead. So there is value in control, even if all it does is create a minority discount.
The market goes up, the market goes down.
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Re: Does corporate credit risk add value

Post by Johno »

larryswedroe wrote:acegolfer/muni
To get the expected return for corporate bonds you have to subtract from the yield the EXPECTED losses from defaults, which isn't zero.
Larry
That's true if you're going to hold the bonds to maturity. But I'd reiterate, the fact that investment grade corporate bond funds have to sell any issue that gets downgraded below investment grade makes their return the combination of, approximately:

1) the yield, for the majority of issues which remain investment grade to maturity and don't default
2) the yield while investment grade minus the mark to market loss from selling the relatively significant % (v. outright defaults) downgraded to junk before maturity.
3) the yield prior to default plus the loss due to default for the rare cases of investment grade bonds which default without having been downgraded to junk first.

In a perfect world that would come out the same as yield minus expected default losses, but in reality it makes a difference because that one threshold of BBB-/Baa3 applies to such a large universe of bond holders, requiring a relatively large price concession, risk premium compared to expected loss, to those willing to hold below investment grade bonds to digest all the bonds falling through the investment grade barrier, especially in unsettled times. It noticeably reduces the return of corporate index funds below yield minus expected default losses. And on the other side of the barrier it's a contributing factor to the credit rating 'sweet spot' in the BB range for risk v return. I'm not talking about a dramatic get rich/poor quick difference here, which almost never exists for anything, but it's enough of a real effect to cement my vote in agreement with you that investment grade corp investing isn't worth it for most investors* v treasuries. I think junk OTOH can have a place in its proper limited role.

*who can't get narrow enough bid-offer on corporate bonds to build and maintain the credit diversification they'd need to construct a portfolio of individual issues, even aside from the extra effort.
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Re: Does corporate credit risk add value

Post by larryswedroe »

Sagenick
1. Unfortunately just because Peter Lynch said something doesn't make it right, in fact IMO one of the dumbest things he ever said, causing real damage IMO, is to "buy what you know". That confuses the familiar with the safe, among other things (like others don't know what you know, meaning it isn't value relevant information). Even Bogle has been wrong on few major issues, like his telltale chart and no need to invest international arguments.

2. No idea what your point is.

3. and your point is? It's all anecdotes with your individual investments, nothing more. I have cited what the literature shows from studies on subject. And I would add they UNDERPERFORM more similarly risk SV stocks. Even with their liquidity premium.

4. So? The same thing is true about some of the best run fund companies in world and they haven't generally added value either.

5. As to private equity, it isn't beating market on apples to apples basis--it's simply a liquidity premium---that's it.

6. Re individuals, possible to beat market of course, on risk adjusted basis, but not very likely. And one reason is that most stocks underperform (mean above median). So the fewer stocks you own the less likely you are to beat the market. The more you own the more likely you are to be near the mean. Now that assumes they aren't subject to the biases individuals tend to be subject, like preference for lottery tickets, which causes underperformance.


Larry
Quincy
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Re: Does corporate credit risk add value

Post by Quincy »

Larry,

I enjoy your articles and posts and have read all of your books. I agree with you on alot of things, but I feel like you may have brainwashed yourself into an absolute belief of the small value premium and its future persistence. Calling Bogle flat out wrong about his telltale chart is going too far. Contrary to popular belief there are lots of reasons to question the small value premium. It is future persistence is most definitely not certain. It could underperform the broad market for decades as it did in the past. It could be arbitraged away or it could persist. Noone knows. Torturing the data is a classic finance mistake. In my opinion Bogle is spot on with all of his investment advice. We just love to make simple things complicated.
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Re: Does corporate credit risk add value

Post by larryswedroe »

Quincy
First, there is no doubt that Bogle was wrong as he measured the WRONG THING---he did not measure the performance of growth stocks and value stocks and compare them. So he clearly was wrong. He measured the performance of ACTIVE value and ACTIVE growth managers to draw his conclusion.

Second, I certainly admit that there is possibility that SV stocks will underperform, just as stocks might underperform. In fact the evidence is that the SV premium has been just as persistent as has the ERP.
BTW-there is no very long period when SV underperformed while there are very long periods when stocks underperformed.
This is clearly not a case of torturing the data as the SV premium persisted AFTER Fama and French published their famous paper. And they went back and created the data to examine it in the earlier period (pre 63) and found it existed, and all test in international and EM markets find the same thing. Given that SV premiums exists in virtually every country the odds that these are all "lucky" or random outcomes are asymptotically close to zero.

Not a guarantee that it will persist as RISKS can show up--but all you need is simple cost of capital story to believe that it will LIKELY persist. No other theories are necessary

Best wishes
Larry
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Re: Does corporate credit risk add value

Post by acegolfer »

larryswedroe wrote: Not a guarantee that it will persist as RISKS can show up--but all you need is simple cost of capital story to believe that it will LIKELY persist. No other theories are necessary

Best wishes
Larry
I haven't read any of your books or all of your posts, so I could be totally wrong about you.

Does your statement above imply that SMB and HML are risk factors based on cost of capital story?
Quincy
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Re: Does corporate credit risk add value

Post by Quincy »

TANSTAAFL.
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