Bogleheads

[larryswedroe]

1979-2007,
The idea is to create portfolios with the same return and see if we could create more efficient portfolios than ones that included a 10% allocation to the Vanguard high yield fund. The allocations reflect the fact that the Vanguard fund is a hybrid.

Portfolio A: TSM 60%/40% Lehman Intermediate Gov't Bond 30/10% Vanguard Hi-Yield
Portfolio B:61% TSM/39% Lehman Intermediate Gov't
Portfolio C: 56% TSM/44% Lehman Intermediate Credit
Portfolio D: 40% TSM/51% Lehman Intermediate Govt/9% FF small value RETURNS
Portfolio A 11.53%
Portfolio B 11.52%
Portfolio C 11.52%
Portfolio D 11.52%


STANDARD DEVIATIONS
Portfolio A 10.33
Portfolio B 10.07
Portfolio C 9.82
Portfolio D 8.40

Note that all the alternatives were more efficient. What is good is that with B you eliminated all the credit risks and got the same return with lower SD, even though took slightly more equity risk.
With C you eliminated all the junk and only took investment grade risk and even took less equity risk and got lower SD.
With D, you lowered the risk the most as you lowered exposure to BETA quite a bit, and also got rid of the junk risk and added some size and value risk. Another example of how adding tilts and lowering equity allocation has allowed you to lower risk without lowering returns.

I hope you find the above helpful

Like I said, I cannot think of single reason to own this stuff. It ain't called junk without cause ()

[AzRunner]

Larry,

Thanks for the example. In Portfolio D with less equity exposure but tilted to small and value the standard deviation is lower but as you have stated in many posts there are other risks that do not show up in the portfolio's standard deviation.

Depending on the investors personal situation, this tilt may or may not be advantageous. For example, the investor's job may be highly linked to a recession such that he may lose his job at the same time that his value and or small-cap is doing relatively poorly (along with the market as a whole).

Bottom line: the equity in portfolio D in some sense exhibits the same amount of risk as portfolio B, it is just that the portfolio D risk is not fully explained by the standard deviation measure.

What the example seems to suggest is that you can hold a portfolio with less equity exposure (portfolio D) but have the risk more concentrated in this smaller equity holding achieving the same expected return (portfolio A) with less volatility.

I also think the point is well taken when comparing portfolios B and C that if one holds corporate investment grade bonds than they should hold somewhat less equity since they have some equity exposure with their bonds that is not present with US government bonds.

Tangentially, to broaden this discussion, perhaps it is really not appropriate to use standard deviation as a proxy for risk since it assumes a normal distribution of market returns while markets deviate significantly from a normal distribution.

Norm

[larryswedroe]

Norm
I fully agree. Those whose intellectual capital is more highly correlated wth the economic risks of small and value should tilt less to those risk factors, but also tilt less to equities in general.

[bilperk]

Larry or anyone else:

There seems to be a general agreement that HIY has some equity like component, a hybrid.

Realizing that this probably changes over time, and maybe increasing at the wrong time, can you put a % number on the "equity-ness"

We have been told " at least adjust you equities if you are going to own this fund"

This begs the question; How much adjustment?

thanks,
_________________
Bill

[larryswedroe]

The problem is that it matters how deep the credit rating is. The lower the more equity like it is. But as I said you can take a rough estimate by using the academic evidence that for A rated paper about 40% of the yield spread between junk and Treasuries is equity risk. Lower credit rating and that figure will go higher

[Karl]

You've often argued (and I fully agree) that long-term bonds don't yield enough for retail investors since the yield is too low due to high demand by institutions like insurance companies that need a way to fund long-term liabilities.

How do you explain the poor returns (relative to risk) on HY bonds? Is the market irrational here?

[old_dominion]

[larryswedroe]

olddominion
Love to see the evidence on that--as I don't think there is any.
Vanguard fund a great example. Despite the spreads being very wide at times it barely outperformed a Treasury bond index. And much of the outperformance probably came early when there were only fallen angel junk (not original issue junk). As Fridson showed, the returns from fallen angels have been much better.

The problem is that it is a long way from yield to return (especially with junk and credit risk and then add in the call risks)

[Rodc]

[kenschmidt]

[larryswedroe]

Ken
There is a very good explanation which I have pointed out several times--Fridson's paper on Original Issue Hi-Yield Bonds.

[Rick Ferri]

Useless information, Larry.

You suggesting that past performance should be the only gage of future performance. If it were that easy, we would all be rich. Not a very wise way to invest, IMO.

Rick Ferri

[larryswedroe]

Karl

See the paper by Fridson which fully explains why he thinks the "anomaly " exists and why it is likely to persist

In addition, while institutional investors (non profit) have no location issue the problem for individual investors is that they have a location issue to address--and holding any hybrid, if one has choices, leaves one with the wrong risk in the wrong location in one of the cases.

I also find it more than amusing that with about 30 years of data on an asset class and some good academic papers on junk bonds (one by the leading expert in the field) that the data can be called useless. My only explanation for that comment is cognitive dissonance.

[larryswedroe]

some thoughts on anomalies
While I believe markets are highly efficient there is plenty of evidence they are not perfectly efficient. Even FF threw in the towel on that long ago in adopting DFA structured portfolio rules--and they continue to do so

They screen out "anomalies" with low returns like IPOs, very low priced stocks and stocks in bankruptcy. All have "lottery" effect issues IMO--and junk bonds no different

Also DFA will not buy callable bonds--no evidence they have provided appropriate returns

And they added momentum screens-the ultimate anomaly--no risk story there.

Now we have plenty of data on junk bonds and they all show the same thing. But worse for individuals is the location issue which cannot be gotten around if you have location choice.

And as I have pointed out, despite Rick's claims there is almost no unique risk here, as found in academic papers. Less than 10% of the spread is explained by unique risks. Not even less than 10% of the yield, but less than 10% of the spread. And you can get the treasury like return without any costs, just buy them on your own.

[kenschmidt]

Larry -

First off, Fridson's paper only covered 1997–2006. Secondly, he divided the High Yield bonds into Fallen Angels (good companies who had fallen on hard times) and Original Issue (new junk). The Fallen Angels do provide good risk adjusted returns according to him. The OI bonds do not - his explanation didn't seem to solid to me - as best as I understood it, he is stating that high yield provides poor risk adjusted returns because investors want the yield and so ignore the default and other risks.

I don't know - it doesn't sound as clear cut to me as that - I have a period dependancy concern here and I don't think the evidence is as solid as you portray it.

Best regards,
Ken

[Sidney]

[stratton]

[larryswedroe]

Ken
I explained all that in a post long ago on the subject of that paper.

And yes the returns would be explained anyway by the exposure to the various factors--as academic papers show there is very little unique risk here. After the EXPECTED credit losses and the state tax differential 85% of the remaining spread is explained by the three factor model.

And that is one of the reasons I showed the various alternatives--how you could combine equity risk and bond risk without junk risk and get more efficient alternatives--and that eliminates the location problem--and the credit risk altogether!!!!

So maybe if you are an institutional investor without a location problem and you can buy ONLY the fallen angels you might want to add the asset class. Since individuals have location issues and there is no fund that only buys the fallen angels (passive and low cost) I see no good reason to buy junk bonds. And I wonder if you buy only the fallen angels if you can get sufficient diversification. With stocks that is not a problem. I hate uncompensated risk

[larryswedroe]

Ken
I know that paper is also only ten years the data is consistent with the longer data--

The following table presents the results of the study, “Which Risks Have Been Best Rewarded?” The study covers the relatively brief period 1985–2002, so we have to be careful about drawing conclusions that might only be period-specific.
Has Credit Risk Been Rewarded?
Asset Class Mean Return (%) Standard Deviation
7-10 Year Treasuries 9.6 6.5
7-10 Year AAA/AA 9.6 5.7
7-10 Year A/BBB 9.6 5.3
7-10 Year High-Yield 8.8 7.7

The striking result is that, at least for this period, the negative impact of credit risk, calls and clawbacks resulted in a reduction in returns, and they did so while producing greater volatility—not exactly a good combination.

[stratton]

Now if we could just get a fallen angel junk bond fund like this CEF that wasn't so pricy: Highland Distressed Opportunities Inc (HCD) with its 3.62% ER and total expenses of 7.26% (see prospectus (500k pdf)) by the time the borrowing and transaction fees are added. The fees are so high even the extra ~5% fallen angel bonds return over original issue junk you are further in the hole than just buying a normal junk bond fund. This appears to be one of those products designed to be sold and not bought.

Paul