Bogleheads

[larryswedroe]

Returns-Based Style Analysis of High-Yield Bonds
Dale L. Domian; William Reichenstein
THE JOURNAL OF FIXED INCOME
Spring 2008

We present returns-based style analysis of four high-yield (HY) bond indexes and 60 HY bond funds. It is widely accepted that HY bonds are hybrid assets, with returns sensitive to both high-grade bond returns and stock returns. Our findings show they should be viewed as part high-grade bonds, part stocks, and sometimes part cash. Consistent with theory, as the credit rating decreases from BB to B to CCC, the bond component of returns decreases from about 73% to 48%, while the stock component increases from about 22% to 52%. Furthermore, there is a strong small-cap tilt in HY bond index returns. Our results reveal substantial differences among HY bond funds. Differences across funds in style weights are consistent with differences in the funds' holdings and investment styles. Returns of funds that invest more heavily in low-quality debt are more sensitive to stocks than funds that focus on BB or better bonds. There are notable differences in the strength of the small-cap tilts. Separately, some HY bond funds are more sensitive to growth stocks, while others show a value tilt. These findings should help investors better understand their true asset allocations and better manage their portfolios.

[woof755]

Better off taking your risk on the equity side in the first place.
_________________
"By singing in harmony from the same page of the same investing hymnal, the Diehards drown out market noise."

--Jason Zweig, quoted in The Bogleheads' Guide to Investing

[dothemontecarlo]

[larryswedroe]

quick thoughts
For taxable investors with choice of location there is no question (at least IMO) that this asset makes no sense, because of the location issue. You can replicate the exposure by splitting assets into component parts and then avoid the location problem.

For investors with no choice then I still find no compelling reason to own the asset class since there is almost no unique risk and you can accomplish the same thing with more control and lower costs yourself by splitting the assets into components. Also the historical evidence (at least of original issue junk) is lousy.

[larryswedroe]

Finally was able to read the paper and not just the abstract.
Here are some highlights thought would be of interest--draw your own conclusions

[stratton]

Thanks Larry!

I can read this publication online at the library, but only up to one year ago. This looks like a really interesting paper just because they deconstruct current mutual funds.

Time to warm up the backtest spreadsheet.

Paul

[larryswedroe]

Paul
Reichenstein is one of the most respected in this field, Written lots of good papers on things like asset location, after tax allocations, and the need to consider all assets (intellectual capital)

We even coauthored a paper on EIAs for the AAII.

I just happen to have gotten off the phone with him after emailing him about the paper and he confirmed that he agreed with my view that individuals with choice of locations should not own high yield debt as it is inefficient because of the location problem.

[Rick Ferri]

The study relied on attribution analysis to determine the best back-fit of HY bonds and bond funds to only stock and bond indicies. It is a forced fit only between those two asset classes. There was no room allowed for measuring the element of unique risk in high yield.

In the period observe,

The returns on BB-rated bonds are similar to those achievable with a portfolio of 22.3% stocks, 73.2% bonds, and 4.5% Treasury bills. To be more precise, the stock portion consists of 2.9% large-cap value, 7.3% large cap growth, 11.5% small-cap value, and 0.6% small-cap growth stocks, while the bond portion consists of 63.3% corporate, 6.2% long-term government, and 3.7% intermediate-term government bonds.

This statement is fine, but it tells you nothing about the future. It does not state the those same conditions that caused the above regressions will be present over the next 10 or 20 years. I would venture to say that over the next 20 years the same analysis will produce far different attributes.

Based on this report, one cannot conclude that the return of HY is similar to a particular mix of stock and bond styles. One can only conclude that over the period studied, the return of HY was similar to a certain mix of these stock and bond styles

The mix will likely be different in the future. The reason is because these variables are not highly correlated. There are times when HY does perform like a mix of the above equity styles, and times it performs very differently. These varying rolling correlations are illustrated very clearly in my All About Asset Allocation book. Thus, you get a diversification benefit from being in HY.

Rick Ferri

[alec]

[Dale_G]

Location, location, location - sure, it is important if one has adequate space in taxable and tax deferred.

But my guess is that most users of this forum don't have the ability to perfectly locate their investments. Most seem to have the bulk of their assets in tax deferred accounts - and judging by the reported equity percentages held, most users are holding a significant percentage of equities in tax deferred.

As long as equities are an intended asset in tax deferred accounts, junk location is not an issue.

Dale
_________________
first we crawl, then we walk, then we run, later we use any available transportation

[Dale_G]

Deleted - duplicate post
_________________
first we crawl, then we walk, then we run, later we use any available transportation

[Rick Ferri]

I looked a rolling correlation analysis between the HY premium and various equity risk premiums (Beta, BtM, size).

> HY premiums are monthly HY returns less investment grade returns.
> Equity risk premium is monthly market less T-bills
> Value premium is the FF BtM (High - Low) monthly
> Size premium is the FF US Size (Small-Large) monthly

I used 12 month, 26 month, 60 month and 120 month correlations to compare many different time periods to see if there were consistent 'causes' for the HY premium (a cause has statistical significance).

None of these variable have statistical significance. The rolling correlations varied tremendously in all time periods. Thus, no one can say that equity premium 'caused' the high yield premium, or that the value 'premium' caused the the high yield premium, or that small stocks did it. If it did 'cause' it, the correlation would be consistently high. Although, I concur with the above study that small stock premiums were more consistently correlated with HY premiums, but not conclusively so.

When I have time, I am going to publish a report on this with all the charts and all the data. Perhaps I'll have time in the fall.

Rick Ferri

PS> Many academic studies fall far short of usable information, and the report above is one. The researchers draw one best fit linear line through mountains of past data then infer very general conclusions about that line. While all of that is scientifically accurate, it yields little to no information unless one can conclude (and prove) that the future line will fit the past line. If that cannot be done, then you may have interesting data, but not usable information. That is why it is so important for advisors who use these studies to crunch their own data and do their own research to see the flaws in the conclusions that other people make.

Rick Ferri

[0brian0]

It should be said also that high yield bonds only make sense some of the time. When the credit spread for high yield bonds is low, stay away. When the credit spread is high, the argument for high yield bonds is stronger. Anyone who judges high yield bonds as part of a static asset allocation is missing the point.

Moreover, Ferri's point about over-reliance on past data can't be emphasized enough - especially on this forum. The future is never the same! This time and every time it's different. Financial returns are not stable statistical processes, making most statistical arguments built on them dubious at best.

Moreover, as the Bayesians will happily explain, even if you choose to rely on historical data, you should not discard information about current market conditions in the process. Instead, you should use historical data to adjust your views of markets, which can be derived from past performance, current market conditions, analytical reasoning, etc.

JMHO FWIW
_________________
Failure to explain is caused by failure to describe.

[dumbmoney]

[dothemontecarlo]

[dumbmoney]

[larryswedroe]

Obrian
All the academic studies are clear. There is only a very small amount of unique risk in junk bonds. The rest is equity like risks and high quality bond risks. If the spreads are wide all that is saying is the market says risks are high (high expected defaults for example or a higher liquidity premium). That is the same thing as saying the equity risks are high--the small cap premium probably up too. Buying when spreads are wide is like saying buy stocks when P/Es are low, nothing more.

[larryswedroe]

Everyone agrees that junk is a hybrid instrument, with some equity component and some high quality bond component

We can then draw IMO the following conclusions

That means for those individuals with asset location choices you have some of the risk in the wrong location. This is not an issue for institutional investors but that is reason for individuals to not own high yield. Those that have choice of location are better served by splitting the allocations and placing them in the right location.

Second point, let's assume that you don't know what the exact percentages of exposure to equities to bonds are, that they drift. All that means is not that you get a diversification benefit, but you lose control of the asset allocation decision. There is no diversification benefit, or at least only a tiny one, because the returns are still explained by those two factors basically and you don't know how much stocks and bonds you have. Losing control of the AA is a reason to avoid junk

Third, as the article and I have stated, we see plans allocating say 10% to junk as part of a say 60/40 portfolio and count the 10% as BOND exposure when we know that is not true. Depending on the type of bonds held the allocation might be 65/55 or 63/57 or whatever. In all my experiences dealing with institutional type investors I have never seen one split it out, taking into account the reality that they have equity exposure. We can only wonder how many advisors that advise to buy junk explain to clients that part of their bond exposure is really stock exposure. IMO this was an important part of that paper.

Fourth, since you must use a fund manager to gain access to junk to get the needed diversification, but you don't need a fund manager to buy Treasuries you can save the OER of the fund manager.

[0brian0]

Larry, the academic studies paint with a crude (frequentist) statistical brush which misses useful nuances. If, for example, junk bonds were a simple blend of equity and debt, then distressed debt arbitrage would be impossible.

In my opinion, timing the junk bond market is closer to timing the Treasuries versus TIPS market - perhaps not everyone's cup of tea, but certainly not impossible or even particularly difficult.

The comparison with buying low P/E stocks is a bit loose, since there is quite a bit more noise in equity markets due to the much higher valuation uncertainty. Having said that, it seems quite reasonable to buy stocks when P/E ratios are low. Unlike you, I don't conclude that "equity risks are high" just because the P/E ratio is low. Just the opposite. To paraphrase Freud, sometimes a market is just a market.
_________________
Failure to explain is caused by failure to describe.

[Rick Ferri]

[larryswedroe]

Obrian
I dont think that what is called distressed debt arbitrage is really that, meaning there is no risk. Most players there just buy distressed debt making bets or taking lots of risk.

Now on occassion we have seen anomalies between prices of debt and stocks, like during the tech boom, where you had crazy p/es yet distressed debt. Hard to make living though waiting around 20 years os so for the next bubble.

[0brian0]

[larryswedroe]

obrian
First, I know the term arbitraged is used but it is an oxymoron in this and many other cases as arbitrage implies no risk, two transactions simultaneously done with no net risk.

The type of transactions you suggest do come with great risks, first often very expensive to short stocks and second you can be right in long term but dead in short term due to market movements (markets can remain irrational longer than you can remain insolvent)

One problem is that many hedge funds (like those that engage in this type strategy) use improper benchmarks to compare performance and thus show phony alphas.

Having said that I fully agree that the evidence shows that if there is a discrepancy in prices between equities and bonds the bond price is usually right (probably because bonds are more the arena of the professionals and less subject then to bubbles).

[Laren]

I have a (possibly very basic!) question about high yield bonds and TIPS. Rick Ferri states above:
"Thus, HY provides significant diversification in a fixed income portfolio that hold TIPS."

But what's the advantage of including TIPS+HY versus just holding a total bond market fund? TIPS & HY may offset each other, but what advantage does holding the combination bring to the table?

Is it just that they throw off more income, so if I'm not looking particularly for income I should pass? Is it that TIPS bring a good advantage (of what) over just a total bond market fund, and then you would bring in HY because it diversifies the TIPS?

And a related question - should either TIPS or HY even be considered for a taxable account?

I feel like I'm really missing the boat here, but I'm trying to get my head around it so any help is welcome!

[larryswedroe]

Laren
I dont accept that argument at all, you can the same diversification benefits by allocating the hybrid exposure of junk into the separate components, and you don't have the location problem which nevers gets addressed by those that recommend high yield
High yield highly tax inefficient, and thus have to hold in tax advantaged account meaning you hold the part that is equity risk in the wrong location, losing the benefits of loss harvesting, stepped up basis, ability to donate appreciated shares to charity.
And of course you have the I lose I lose nature which people seem to forget about---you don't have the two way game as you do with equities. The upside is limited since the issuer will call in the debt if things improve or rates fall. So again you lose the benefits of the equity exposure being taken in form of interest payments