An analysis my colleague did on high yield

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An analysis my colleague did on high yield

Post by larryswedroe » Thu Jun 13, 2013 7:50 pm


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Re: An analysis my colleague did on high yield

Post by Mazz » Thu Jun 13, 2013 7:59 pm

Larry,

I agree. This type of information has been well publicized for years.

However, what about the investor who is merely looking for a higher rate of quarterly income.
Don't you think High Yield has a place for people who 'Need' current income.

If you don't need income above the interest and dividends of a balanced portfolio for a period of 5 years, then a larger allocation to stocks and investment grade bonds is the better portfolio.

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Thu Jun 13, 2013 8:27 pm

MAZZ
IMO the problem is that using a cash flow approach is the wrong way to do things for variety of reasons.
The right way IMO is to use a total return approach.
One simple reason is that you don't live forever.
The other is that when you have "normal" interest rates that generate sufficient cash flow from divs/interest than the total return and cash flow approaches are the same. Now that means in determining your AA you should have taken into account your ability, willingness and need to take risk. So if rates fall that doesn't change your ability or willingness to take risk----but the cash flow approach forces you to take more risk than you determined you should--and that is not a good thing. Forces people to make bad decisions like buying div paying stocks or REITS or preferreds, etc as substitutes for safe FI. That's fine until the risks show up and then can be disastrous, with potential to create problems you cannot recover from

The key IMO is to understand that the role of FI is to dampen the risk of the overall portfolio to an acceptable level, and provide liquidity when it's needed

Larry

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Re: An analysis my colleague did on high yield

Post by Frengo » Thu Jun 13, 2013 9:20 pm

larryswedroe wrote:http://www.multifactorworld.com/Lists/P ... spx?ID=125

Thought would be of interest
Larry
What's the duration of such a security ? ;)

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Re: An analysis my colleague did on high yield

Post by baw703916 » Thu Jun 13, 2013 9:46 pm

Thanks Larry.

One (amusing) typo: "Sharpe Ration"

Of course you could arrive at the absurd conclusion that since HY bonds performs very similarly to equities + bonds, then you could replace the three-fund portfolio with 100% high yield! (well, it does have more volatility). edit: I'm kidding---seriously, don't do this. There are those, including RIck Ferri, who recommend owning some high yield, but only as a small proportion of one's portfolio (10% or so).

Brad
Last edited by baw703916 on Thu Jun 13, 2013 9:56 pm, edited 2 times in total.
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Re: An analysis my colleague did on high yield

Post by LadyGeek » Thu Jun 13, 2013 9:48 pm

Good article, but I think it's missing a basic explanation to new investors - high yield bonds present a very different risk than an equivalent stock / bond (not high yield) portfolio. Then, the article will make sense (along with Brad's previous comment.)

Background material is in this thread: know the data before buying HY bonds. A good summary is in this post (Subject: know the data before buying HY bonds):
Rick Ferri wrote:There are two schools of thought. Larry's school says take risk with equity and invest the rest in "safe" fixed income and leave "riskier" bonds out such as high yield and mortgages. My school is to have a total-total bond market portfolio that includes all asset classes, and then set the portfolio risk based on this portfolio. I believe my strategy is more practical because it doesn't try to pick winners and losers.

That being said, either strategy is fine. We're talking about out portfolio strategies being different, not investment philosophy. We're all Bogleheads', so we all believe in the same basic investment concepts of low-cost, diversification, etc. Yet if there was a polled on strategy, we'd get a thousand different answers.

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Fri Jun 14, 2013 7:36 am

Lady Geek
Sorry to disagree, All of the evidence including from academic papers makes very clear that there is very little unique risk in HY--some but not much and even part of the unique risk is liquidity risk which is also in stocks and particularly small stocks, and that there has been no advantage so far in including them and some serious disadvantages (including higher costs, tax inefficiency and increased tail risks)

Frengo
Don't understand the question--what security are you referring to?
Best
Larry

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Re: An analysis my colleague did on high yield

Post by Bradley » Fri Jun 14, 2013 8:49 am

Below is a snippet from William Bernstein’s opinion published on his Efficient Frontier site. Those who have followed and taken Rick’s advice have been well rewarded and that provides the best evidence there is.


“But high-yield is a remarkable asset class and worth examining..................
Belief in the efficient market theory does not relieve one of the duty to estimate asset-class returns. Because of the term structure of high-yield bonds, returns will tend to mean-revert more quickly, and more surely, than equity. Yes, there is risk. But when their long-term expected returns start approaching 5% over Treasuries (as they did not so long ago), it looks like a risk worth taking with a small corner of one’s portfolio. One caveat: Because most of the return, similar to REITs, accrues as ordinary income, junk bonds are appropriate only for tax-sheltered accounts.
Are we market timing? I suppose. It’s the lesser of two evils—I’d rather violate the efficient market hypothesis than ignore appealing expected returns with a relatively short time horizon
--------------William Bernstein
You can sum up any active fund manager’s presentation at an investor conference in one sentence: “We’re doing well, all things considered.”

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Fri Jun 14, 2013 9:07 am

Those who have followed and taken Rick’s advice have been well rewarded and that provides the best evidence there is.
Why do people make statements that are not true, even after they have been shown that they are false.
I have repeatedly showed, and my colleague Jared Kizer's blog as I posted, that HY has been a poor investment, resulting in lower Sharpe ratios.

Here is just one example of the many I have provided included in my books
http://www.cbsnews.com/8301-505123_162- ... ortfolios/


The credit premium has been by far the worst rewarded of all premiums with only a tiny fraction of the yield premium being realized---and within portfolios because of the much higher volatility and correlations rising
at the wrong times the impact on portfolios has been negative and even worse the tail risks are much higher--very bad for those in withdrawal phase.

http://www.cbsnews.com/8301-505123_162- ... eld-bonds/
recent post on this subject

Note others have posted opinions, but not the factual data--impact on portfolio

Larry

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Re: An analysis my colleague did on high yield

Post by Bradley » Fri Jun 14, 2013 9:22 am

larryswedroe wrote:
Those who have followed and taken Rick’s advice have been well rewarded and that provides the best evidence there is.
Why do people make statements that are not true, even after they have been shown that they are false.
I have repeatedly showed, and my colleague Jared Kizer's blog as I posted, that HY has been a poor investment, resulting in lower Sharpe ratios.

Here is just one example of the many I have provided included in my books
http://www.cbsnews.com/8301-505123_162- ... ortfolios/


Larry

Anyone who was considering a diversifying asset at the time of the great commodity debate which was just over five years ago was richly rewarded if they rejected the argument to include commodities and instead chose VWEAX (HY) as a diversifier. How’s that?


VWEAX has returned 8.8% over the past 5yrs.


PCRIX has lost 7% over the past 5yrs.


15.80% every year over 5yrs is what I call richly rewarded.

If we just look at the past 1yr VWEAX has still outperformed by 8.97%. There is theory and then there is the real world.
You can sum up any active fund manager’s presentation at an investor conference in one sentence: “We’re doing well, all things considered.”

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Fri Jun 14, 2013 10:34 am

VWEAX has returned 8.8% over the past 5yrs.


PCRIX has lost 7% over the past 5yrs.


15.80% every year over 5yrs is what I call richly rewarded.

If we just look at the past 1yr VWEAX has still outperformed by 8.97%. There is theory and then there is the real world.
Perfect example of complete lack of understanding of the issues.
First, one is not a substitute for the other and should not be compared.

Second, it shows things in isolation not in terms of portfolio impact. But that is not even the biggest error--including when adding commodities the ability to extend maturity (and note that the longer the bond the better the returns have been)

Third, and the largest error is that the HY comes from the bond allocation. So one should compare it's returns to an investment grade bond index as the alternative

The HY comes from the bond side of the portfolio, while the CCF comes from the equity allocation--again why they are very different

And this idea of the "great debate" starting at some artificial date---these issues have been discussed for far longer and I wrote about them in my books way before the date chosen

Fourth, the order of returns matters a great deal to those in withdrawal phase and including HY in portfolios in 2008 led to much larger losses for a diversified portfolio while adding CCF did not--and in fact if did add maturity then you gained value by doing so'

Again, just as my colleague Jared showed, HY has led to lower Sharpe ratios, and higher volatility for those that have included them in portfolios
Those are the facts, the data, not opinions

Larry

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Re: An analysis my colleague did on high yield

Post by Bradley » Fri Jun 14, 2013 11:01 am

No one claimed that one was a substitute for another. And there is clearly no mis-understanding of a 15.8% return per year over 5 year period effect on ones portfolio.

There is absolutely no need for either commodities OR high yield in any one’s portfolio.

BUT, if one had chose to add one, as a diversifier, after the great commodity debate, those who rejected commodities and instead added VWEAX were well rewarded. You do not have to be a CFA to understand how these two asset classes have contributed to portfolio performance over the past five years.

Now let’s look at take the allocation from the bond side.

Over the past 5 years the total bond market(BND) has returned 5.61%/year.

Over the past 5 years VWEAX has returned 8.80%/year.

Even using your comparison VWEAX contributed 3.19%/year over the past 5 years to one’s fixed allocation.

I do believe the 15.8%/year over the past 5year better reflects the difference in strategies/opinions. You prefer commodities and some others prefer VWEAX. The next five years is most probably going to have a different result but the past 5 years have been fruitful to the HY vs commodity issue.

Bradley
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Re: An analysis my colleague did on high yield

Post by larryswedroe » Fri Jun 14, 2013 11:41 am

as I noted the above post shows a complete lack of knowledge of the subject at hand, and beyond that it takes very short term data and then confuses strategy with outcome
Not worth wasting more time on this subject
Larry

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Fri Jun 14, 2013 5:03 pm

Thought I would add just this one of many reasons for my above statement--as I explained to one Boglehead who PM'd me on the subject

Five years ago the spread on HY was about it's all time high--so looking at returns from that as your start point is like looking at stock relative to bond returns when stocks are trading at exceptionally low p/es which then revert to their mean. Should look at returns over long cycles---as I have done in both books and blogs and as my colleague did in his post.

Also HY as I have explained is not a bond investment, but a hybrid, including exposure to equity risks as well. So you get a huge stock rally over the last five years and you then should expect HY to outperform as the stock risks did not show up. But if you compare a portfolio with HY to a portfolio with a higher beta (reflecting the beta risk in HY) you would see different answer.

On the other hand with CCF none of the risks you were trying to hedge showed up--neither unexpected inflation nor supply shock. So you would expect that in such a period that a portfolio with CCF would underperform one without it---that's the cutting both tails component of the strategy. But then saying that is a bad outcome is like saying you wasted the premiums for life insurance because the risks did not show up and you would have been wealthier had you not bought the insurance. Since there are no crystal balls, either a strategy is right or wrong before the outcome is known, [rude comment removed by admin LadyGeek].

Hope that is helpful
Larry

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Re: An analysis my colleague did on high yield

Post by LadyGeek » Fri Jun 14, 2013 7:19 pm

First, thanks for correcting my prior post.

I think my error was one of association. You're explanation (above this post) helped greatly clarify that High Yield bonds are corporate bonds, meaning that they have equity (corporate) risks. The inconsistent use of "HY" without "Corporate" was throwing me off. Experienced investors have no trouble with this, but to those with less experience, it's very confusing.

For example, I have no problems to understand:

TIPS - which have "Inflation Protected" built into the acronym
Municipal "muni" bonds - A bond issued by a municipality
Corporate bonds - Issued by a company

Unless it's stated as a "High Yield Corporate" bond, I will associate the term "HY" with a Treasury. The acronym "HY" is used inconsistently in many places, including published blogs and the many threads in the forum. If "HY" does truly mean Corporate bonds, may I suggest to include it, e.g. HY Corporate?

To be clear, I can easily handle high level math. However, you can sometimes get stuck on the simple stuff. This is one of those times and I'd like to explain why. Clarification of acronyms may seem trivial. But, to those without a financial background (like those learning about investing), it's critical to get correct. (If I'm wrong again, feel free to correct.)

CCF = Collateralized Commodity Futures
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Re: An analysis my colleague did on high yield

Post by baw703916 » Fri Jun 14, 2013 7:38 pm

LadyGeek wrote: Unless it's stated as a "High Yield Corporate" bond, I will associate the term "HY" with a Treasury. The acronym "HY" is used inconsistently in many places, including published blogs and the many threads in the forum. If "HY" does truly mean Corporate bonds, may I suggest to include it, e.g. HY Corporate?
LG.
High Yield also can refer to a category of municipal bonds. Those are quite a different animal (at least in terms of Vanguard's fund) than High Yield Corporates.

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Re: An analysis my colleague did on high yield

Post by stlutz » Fri Jun 14, 2013 7:51 pm

Anyone who was considering a diversifying asset at the time of the great commodity debate which was just over five years ago was richly rewarded if they rejected the argument to include commodities and instead chose VWEAX (HY) as a diversifier. How’s that?
If that person had also tilted to small cap growth in their equity holdings over the past 5 years, they they'd really look smart!

(Just being ornery). :mrgreen:

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Re: An analysis my colleague did on high yield

Post by Frengo » Fri Jun 14, 2013 8:16 pm

larryswedroe wrote: Frengo
Don't understand the question--what security are you referring to?
Best
Larry
Your friend's synthetic HY. With 1/3 of stocks in the mix, how do I calculate its duration ? (It is kind of a rhetorical question)
It seems to me it shares many qualities with an HY fund, but there are differences. Those differences tend to disappear because of the investment fund structure, but some are still there.


@ LadyGeek
HY don't include exposure to equity risk because of their corporate issuer, but because of their higher risk of default.
In fact, investment grade corporates have low correlation with the stock market, just like treasuries, because we already know that it doesn't depend on the state of the economy whether their terms will be satisfied or not.
If you think that HY are issued by disreputable issuers, you will have quite clear that they are mostly of corporate origin, with the occasional State/Nation with bad credit rating thrown in.

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Fri Jun 14, 2013 8:21 pm

Lady Geek
First high yield refers to the riskiest credits within a broader asset class like corporates and munis (as pointed out)

Second, while all corporate bonds have their returns to some degree explained by equity returns (that is what is meant by a hybrid security, the returns are explained by the returns of more than one asset class--in this case both stocks and bonds), AAA rated corporates have very little stock risk, very little exposure to beta. The lower the credit rating the more the exposure to beta risk, and it's not a straight line but a geometric type increase. So for example over the long term Vanguard's fund (just below investment grade) has seen about 25% of its return explained by stock risk but a fund that is junk (CCC) has about double that. On the other hand investment grade overall has perhaps 10-15%, with low single digits with AAA and it rising the lower the rating.

I hope that is helpful

Larry

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Re: An analysis my colleague did on high yield

Post by grabiner » Fri Jun 14, 2013 9:18 pm

baw703916 wrote:
LadyGeek wrote: Unless it's stated as a "High Yield Corporate" bond, I will associate the term "HY" with a Treasury. The acronym "HY" is used inconsistently in many places, including published blogs and the many threads in the forum. If "HY" does truly mean Corporate bonds, may I suggest to include it, e.g. HY Corporate?
LG.
High Yield also can refer to a category of municipal bonds. Those are quite a different animal (at least in terms of Vanguard's fund) than High Yield Corporates.
Vanguard High-Yield Tax-Exempt doesn't even hold what most investors consider high-yield (junk) bonds; it holds mostly bonds rated A and BBB, which are medium-quality, but give a relatively high yield with Vanguard's low expenses. Morningstar puts the Vanguard fund in the intermediate-term or long-term general municipal bond category, not the high-yield category.
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Re: An analysis my colleague did on high yield

Post by larryswedroe » Fri Jun 14, 2013 9:54 pm

FWIW
generally there are three categories used
Investment Grade AAA/AA/A/BBB
High Yield BB/B
Junk-all else

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Re: An analysis my colleague did on high yield

Post by Rick Ferri » Fri Jun 14, 2013 11:13 pm

"From this point of view, the basic idea is that you can replicate the performance of most high yield strategies using stocks and high-quality bonds."
So, what Jared is saying is that he can replicate the performance of ANY asset class as long as he knows the highest returning asset and the lowest returning. Everything else eventually falls on the capital markets line in-between the highest and the lowest, and therefore is just a combination of the two.

[Rude comment removed by admin LadyGeek] You believe that since the return of HY falls between stocks and high quality bonds then it must be a hybrid of stocks and high quality bonds. [Rude comment removed by admin LadyGeek]

Well, then explain to me how high yield could have outperformed both stocks AND high quality bonds as it did in the years following the financial crisis? The fact is, this [(removed) --admin LadyGeek] thesis of yours about HY is wrong and has always been wrong.

Rick Ferri
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Re: An analysis my colleague did on high yield

Post by Frengo » Fri Jun 14, 2013 11:33 pm

Rick Ferri wrote: [Rude comment removed by admin LadyGeek] You believe that since the return of HY falls between stocks and high quality bonds then it must be a hybrid of stocks and high quality bonds. [Rude comment removed by admin LadyGeek]
There is much more to it: HY's returns are partially correlated to the stock market's and, guess what, also 1/3 stocks+2/3 treasuries are partially correlated to the stock market and in the same ballpark, around 0.5. In fact, the synthetic HY fund is less correlated.
Of course, the synthetic fund has to rebalance quite often, while the actual HY doesn't have to rebalance at all and that is an added cost.

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Sat Jun 15, 2013 7:08 am

Rick
You might think twice about such comments as not only do I believe that to be true every academic I have discussed this was does and there are peer reviewed papers on the subject. Perhaps you are the one that should think seriously about the issue. As I said, it is not only my thesis, it's you who are out there on the island. We even worked with DFA when they were coming out with their ST extended credit fund to estimate the amount of beta risk in the fund so we could account for the risks for those that use the fund. [Snarky comment removed by admin LadyGeek.]

The way one tells if an asset has exposure to a factor is to run regressions. And when you run regressions against corporate debt you find that the lower the credit rating the more the exposure to beta risk there is, that is what the literature shows and our own analysis shows. Now are you really saying that this is a pure coincidence? [Rude remark removed by admin LadyGeek.]
[See below. --admin LadyGeek]

What we don't know is before the fact exactly what mix will equal the return of a high yield strategy, which is because the correlations drift depending on what risks happen to show up. But in every case I've looked at high yield has not helped a portfolio and there was a more efficient way to get exposure to the risks one is seeking. And making matters worse as I have pointed out is that high yield changes the potential distribution of returns in exactly the wrong way---it increases the tail risk when every investor I know would prefer to see the tail risks cut (only risk lovers should prefer the alternative and almost all investors are risk averse, not risk lovers)


As to the last question, I would have thought you would have known the answer to that question as it is obvious. Valuations matter as you should know. Starting points matter. HY got crushed at exactly the wrong time (increasing the tail risk) and thus had record low valuations (widest spreads ever), so when the risk of the end of the world did not happen we got a reversion to the mean as spread returned to normal. Nothing unusual here as you try to make out. So HY dramatically underperformed in 2008 and then outperformed after. The liquidity premium in HY (similar to liquidity premium in small stocks) rose and then collapsed partly explaining the data. Correlations drift over time (as you point out in your own book) and what matters is both the LONG TERM correlations and WHEN correlations tend to rise and fall (and with HY its in the wrong direction at the wrong time)

Best wishes
Larry

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Re: An analysis my colleague did on high yield

Post by Valuethinker » Sat Jun 15, 2013 7:32 am

The recurrence of this conversation suggests to me it is basically pointless.

A bit like GNMAs. If you like HY you are not going to hear arguments against it.

What I would say about HY is I think the arguments and analysis are rock solid against it for most investors-- risk uncompensated by return.

HOWEVER in early 2009 I sounded a warning against it. A number of people, including Alex Frakt, noted the record spreads over safe bonds and bought in, and made handsome profits.

This is basically William Bernstein's analysis-- there are moments to play in these risky assets, (EM bonds probably fall into the same category), when the credit spreads just get blown out of the reasonable.

THEREFORE there may be a time for these assets. But right now, covenant quality is deteriorating and spreads are at record lows (or were before the last little slump). The optimal timing cannot be now, compared to say early 2009.

And if you don't know instantly what I am talking about, then I submit to you that this is something to be quite careful about vis a vis investing-- investing in something that you don't understand.

Note there is a whole debate Swedroe v. Ferri whether credit risk is compensated for in returns. I need to reread Antii Ilmanen on this, I found his chapter fairly dense.

As with any asset class, I encourage people to look at the chart, look at 1990, look at 2008-09, and make sure you can live with that volatility.

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Sat Jun 15, 2013 8:37 am

Valuethinker
There is a difference here I would point out

First, as you note valuations matter. And high yield debt was at enormous record spreads in 2009, compensating for the enormous risk to the economy. That of course meant high expected returns. But as I have pointed out to Bill Bernstein at the time, that is nothing more than the equity like risk that we saw in say small value stocks which went on to have great returns as well--SV in 2009 was up 70%!! People talking about high yield always seem to ignore that. And of course the call risk in the bonds was gone because they were trading at big discounts--That is the evidence that Fridson showed in his work--it's only the "fallen angels" that have shown risk being rewarded in high yield (bonds trading at discounts are like fallen angels in that the call risk is gone or dramatically reduced). The problem is in normal times the call risk is there and it creates asymmetric risk which has clearly not been rewarded. Anyone interested in HY should read Fridson's work as he is the leading researcher in the field on the subject.

What I have found is that HY tends to be bit of a leading indicator turning a bit before equity markets----bond markets are more dominated by the professional investors while stock markets more impacted by emotional individuals. But the lead time isn't much. And that lead time is part of why the correlations tend to drift,

Second, there are two ideas here. In my case I have presented the factual data including from live funds and the academic evidence from published papers and shown the impact of HY on portfolios. Facts and data should be what matters.

What I would add is that if one were to buy a HY fund they should only buy one that doesn't sell bonds that get downgraded (as I believe Vanguard does)--those are the very fallen angels that have delivered more appropriate risk adjusted returns (with the call risk gone and a big liquidity premium now there and selling pressure from institutions that must sell by their convenants has created "value")

Best wishes
Larry

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Re: An analysis my colleague did on high yield

Post by LadyGeek » Sat Jun 15, 2013 8:54 am

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Re: An analysis my colleague did on high yield

Post by 3247 » Sat Jun 15, 2013 9:29 am

OK, I admit I am a neophyte in understanding bond and 'bond like' funds. I study Bogleheads to learn more about investing (I am 71). I have read this complete thread (including the linked information) and am now more confused about what to do with my VWEAX fund than when I started.

My VWEAX comprises approximately 20% of my Vanguard portfolio and pays me in the neighborhood of $1100 to $1200 per month seemingly regardless of the NAV. But what I take away from this thread is that I should not be invested in VWENX for all the various points made, leading me to conclude that it is not a good long term investment. I only use it for the cash it generates (along with VWENX, VWIAX and stock dividends). I would like to know what other Vanguard fund I would be wiser to invest in than VWEAX that will produce $1100 to $1200 per month like clockwork?

My total investment portfolio (brokerage, Vanguard and local Bank) is 66% in dividend paying small to micro cap stocks, 22% in Bonds (including VWEAX, VWENX, VWIAX), 12% cash and is in the multiple 7 figure range.

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Re: An analysis my colleague did on high yield

Post by baw703916 » Sat Jun 15, 2013 10:17 am

grabiner wrote:
baw703916 wrote:
LadyGeek wrote: Unless it's stated as a "High Yield Corporate" bond, I will associate the term "HY" with a Treasury. The acronym "HY" is used inconsistently in many places, including published blogs and the many threads in the forum. If "HY" does truly mean Corporate bonds, may I suggest to include it, e.g. HY Corporate?
LG.
High Yield also can refer to a category of municipal bonds. Those are quite a different animal (at least in terms of Vanguard's fund) than High Yield Corporates.
Vanguard High-Yield Tax-Exempt doesn't even hold what most investors consider high-yield (junk) bonds; it holds mostly bonds rated A and BBB, which are medium-quality, but give a relatively high yield with Vanguard's low expenses. Morningstar puts the Vanguard fund in the intermediate-term or long-term general municipal bond category, not the high-yield category.
Also, Vanguard High-Yield Tax-Exempt differs from Vanguard's usual practice in that it holds private activity bonds, which tend to have higher yields (all else being equal) because they only are tax-exempt for people who aren't subject to AMT.

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Re: An analysis my colleague did on high yield

Post by Rick Ferri » Sat Jun 15, 2013 11:45 am

Sure, high yield bonds have similarities to other bonds - because they ARE bonds! And at times they have high correlation with stocks just like investment grade corporate bonds (how soon people forget what happened to ALL corporate bond funds during the financial crisis). So, of course the long-term return is going to be similiar to a stock and bond mix, but this DOES NOT and has never made HY a stock and bond hybrid.

High yield outperformed stocks and bonds following the financial crisis. That could not have happened under this "hybrid" theory of HY being put foward. It doesn't matter how many old and incomplete acedemics studies of HY are mentioned in an attempt to cover up facts and rewrite history - it didn't happen that way.

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Sat Jun 15, 2013 12:36 pm

Rick has made the following claim repeatedly
High yield outperformed stocks and bonds following the financial crisis. That could not have happened under this "hybrid" theory of HY being put foward. It doesn't matter how many old and incomplete acedemics studies of HY are mentioned in an attempt to cover up facts and rewrite history - it didn't happen that way.
This statement is simply false as I explained. There are no facts to cover up nor any history to rewrite. In fact I have no clue what he is talking about. Rick asked how it happened and I showed how and why. And I noted that his own book provided the answers--correlations drift, they are not constant--it doesn't mean that the returns are not explained by factors.

Now let's specifically examine Rick's statement about VWEHX outperforming stocks and bonds
HY companies are typically value stocks, though this has become less true over time (as covenants became lighter) and also small companies

Here are annual returns from 2009 through today for VWEHX
39.09
12.4
7.13
14.36
2.59
Total return of about 96%

DFA small value fund had returns of
33.6
30.9
-7.55
21.72
18.56
Total return of about 133%

So it's not even close here. High yield did not outperform similarly risky small value stocks.

Want to try small stocks. DFA Micro over period returned about 125%. Again not even close to being true.

High yield underperformed high quality bonds so miserably in 2008, underperforming Vanguard's Intermediate Treasury by about 35% (greatly increasing the tail risk to investors) that when the world did not end you got the reversion and it outperformed by 41% in 2009. The cumulative returns for the two years are about 11% for the Treasury fund and about 11% for the HY fund. Remember downside performance requires much larger gains on upside to recover

Now you have the actual facts

Best wishes
Larry


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Re: An analysis my colleague did on high yield

Post by Frengo » Sat Jun 15, 2013 4:03 pm

Rick Ferri wrote: And at times they have high correlation with stocks just like investment grade corporate bonds
Not in the least. IG corporates and the stock market are quite uncorrelated. Depending on the exact credit quality the correlation can be as low as Treasuries (about zero).
On the other hand, HY correlation is in the neighborhood of 0.5.

It doesn't matter that in 2008 both IG bonds and the stock market crashed. They are uncorrelated, not anti correlated. That means occasionally the two can behave very similarly.

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Re: An analysis my colleague did on high yield

Post by Beagler » Sun Jun 16, 2013 5:32 pm

3247 wrote: ...I would like to know what other Vanguard fund I would be wiser to invest in than VWEAX that will produce $1100 to $1200 per month like clockwork?
If you listen closely you can hear the sounds of crickets chirping.

The stock reply (no pun intended) might be that, in addition to the VFINX + Treasuries combination mentioned in the article, there is the approach of tilting to size and value in equities and selling off appreciated shares. But who could blame an investor who is comfortable with the payout, if the NAV fluctuation does't bother her and she does't plan on liquidating shares. Every investor must decide for themselves.

Since the IT Treasuries used in the study have seen a huge rise in value not likely to be repeated anytime soon, I'm not sure the data have any predictive value.

VG found their HY fund so popular it"s currently closed to most new investors.
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Re: An analysis my colleague did on high yield

Post by Rick Ferri » Sun Jun 16, 2013 5:43 pm

Frengo wrote:
Rick Ferri wrote: And at times they have high correlation with stocks just like investment grade corporate bonds
Not in the least. IG corporates and the stock market are quite uncorrelated. Depending on the exact credit quality the correlation can be as low as Treasuries (about zero).
On the other hand, HY correlation is in the neighborhood of 0.5.

It doesn't matter that in 2008 both IG bonds and the stock market crashed. They are uncorrelated, not anti correlated. That means occasionally the two can behave very similarly.
This is simply not true. Any rolling correlation on investment grade spreads and high yield spreads shows an increase in correlation during times of economic stress. BTW, the correct terminology is positive correlation, non-correlated, and negative correlation. Uncorrelated is often used when would two asset classes were correlated and at this point are non-correlated. The term anti-correlated doesn't exist.

BTW, Larry's "correlation drift" explanation of why high yield outperformed both stocks and bonds is a backward way of saying his hybrid model does not work in the real world. High yield bonds are bonds. They are not part stock and part bond. There will always be some stock index, someplace whose performance looks like a high yield and T-note mix (S&P 500, SV, micro cap, whatever) this does not mean high yield returns "drift" among these asset classes.

I wish to know TODAY, exactly what mix of stock and bond indexes will equal the return of high yield in the future. Can anyone tell me this? If the answer is no, then this entire conversation is senseless.

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Re: An analysis my colleague did on high yield

Post by Frengo » Sun Jun 16, 2013 6:27 pm

Rick Ferri wrote: This is simply not true. Any rolling correlation on investment grade spreads ... shows an increase in correlation during times of economic stress.
"spread" is the word. I said IG grade are about uncorrelated to the stock market, AAA in the highest degree, BBB less. Naturally spreads amongst IG increase during periods of stress, since BBB are more sensitive than AAA.
BTW, the correct terminology is positive correlation, non-correlated, and negative correlation. Uncorrelated is often used when would two asset classes were correlated and at this point are non-correlated. The term anti-correlated doesn't exist.
Since you seem to be a purist:
"uncorrelated" means "correlation equal to zero"
"perfectly anticorrelated" means "correlation equal to minus one", but sometimes "perfectly" is dropped for the sake of brevity.
It is kind of Statistics 101, at a good college...
High yield bonds are bonds. They are not part stock and part bond.
Nobody thinks that HY are not bonds, but differently from IG bonds the chance of default has large influence over their return.
As such, they present a much higher correlation to the stock market (i.e. the state of corporate economy), since when things are very well, defaults are at a minimum and when things are really bad, defaults are pouring.
This is true also for IG bonds, but their issuers have a chance of default in the low single digits, and if 2% default instead of 1%, it is not such a catastrophe. Compare to HY defaults going from 10% to 25%...
I wish to know TODAY, exactly what mix of stock and bond indexes will equal the return of high yield in the future. Can anyone tell me this? If the answer is no, then this entire conversation is senseless.
You never know future returns, but for cash and perhaps the very highest quality bonds (and that only in nominal terms).
What I can offer you, is a portfolio with a similar expected return to an HY portfolio and with comparable volatility (past volatility, it goes without saying).

Disclaimer: I'm not a fan of this synthetic HY portfolio; I think there are differences with a "real" HY portfolio, but they are not the ones you mention.

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Sun Jun 16, 2013 7:41 pm

, Larry's "correlation drift" explanation of why high yield outperformed both stocks and bonds is a backward way of saying his hybrid model does not work in the real world.
Saying this doesn't make it true. In fact it's sheer nonsense.

As Rick notes in his own book, correlations drift, that doesn't mean that the relationships that explain returns don't exist. It means certain factors play more important roles at different times. For example, liquidity risk can become more important at times--like in 2008, so the correlation rises. In other periods it becomes less important, so correlations fall.

What matters is two things:
A) the long term correlations
B) When the correlations turn high and when they turn low---

Assets that do poorly in bad times should carry high risk premiums. That's one explanation for example of the value premium and also the ERP.
Unfortunately with HY not only is there not a high risk premium, there is barely one and within portfolios there has been a negative impact

Those again are the facts, not opinions
And in fact, in another thread I show clearly that the literature uses the term hybrid very distinctly, and explains why.http://www.bogleheads.org/forum/viewtop ... 0&t=118144

The following also is a statement which IMO makes no sense whatsover
I wish to know TODAY, exactly what mix of stock and bond indexes will equal the return of high yield in the future. Can anyone tell me this? If the answer is no, then this entire conversation is senseless.
What is true is the following: You cannot know what mix will synthetically create the same return as including HY. But that's all you can say. And that's irrelevant. There are far superior ways to increase expected returns than adding HY, simply tilt more to small value and stick with high quality.

And While we cannot know exactly what the mix will be we do know that there is stock risk in HY, and we do know that the risks show up at the wrong time, the tail risks increase. At very least a rational investor should account for that risk in their AA, at least estimating it, otherwise they will be underestimating the risks in the portfolio. But in fact it's far worse. First the risks show up at the wrong time so any long term average correlation will underestimate the risks. Second, if you cannot know for certain what the correlations will be why would you give up control of the risk of the portfolio? Especially since the historical corporate default premium has been basically 0 for the last 40 years and only 0.4% for the last 87!!!


And here is quote from one of the many papers that say the same thing, reaching the same conclusion
“Significant positive correlations of the all-inclusive, low-grade bond portfolio with the matched equity portfolio and with the Treasury bonds support the intuition that low-grade bonds are hybrid securities.”


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Re: An analysis my colleague did on high yield

Post by Rick Ferri » Sun Jun 16, 2013 8:15 pm

larryswedroe wrote:
I wish to know TODAY, exactly what mix of stock and bond indexes will equal the return of high yield in the future. Can anyone tell me this? If the answer is no, then this entire conversation is senseless.
What is true is the following: You cannot know what mix will synthetically create the same return as including HY. But that's all you can say. And that's irrelevant. There are far superior ways to increase expected returns than adding HY, simply tilt more to small value and stick with high quality.

And While we cannot know exactly what the mix will be we do know that there is stock risk in HY, and we do know that the risks show up at the wrong time, the tail risks increase. At very least a rational investor should account for that risk in their AA, at least estimating it, otherwise they will be underestimating the risks in the portfolio. But in fact it's far worse. First the risks show up at the wrong time so any long term average correlation will underestimate the risks. Second, if you cannot know for certain what the correlations will be why would you give up control of the risk of the portfolio? Especially since the historical corporate default premium has been basically 0 for the last 40 years and only 0.4% for the last 87!!!


And here is quote from one of the many papers that say the same thing, reaching the same conclusion
“Significant positive correlations of the all-inclusive, low-grade bond portfolio with the matched equity portfolio and with the Treasury bonds support the intuition that low-grade bonds are hybrid securities.”


Larry
Larry,

You're making the argument that high yield in a hybrid security that is a mix of stock and bond returns, yet cannot say what the mix is or even what the stock index to use is because "correlations drift". Then you say you cannot know what the mix will be in the future or what stock index. You say that only tail risk that matters, yet when HY rallied strongly from Dec 2008 to March 2009 while stocks tanked, you offer no explanation why the tail risk didn't show up.

All the papers you quote from are incomplete or period specific. They only look at HY for a very limited time when interest rates were falling from double digits to low simple digits. There are no studies that look at high yield over a complete interest rate cycle.

You're trying to pass the hybrid idea off as fact when it is not.

Frango,

I have been studying asset class correlations for 20-years. Never have I seen the term "anti-correlation" used in any academic study or research report. Perhaps it's used in medicine or some other discipline, I would not know.

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Re: An analysis my colleague did on high yield

Post by larryswedroe » Sun Jun 16, 2013 9:27 pm

Rick
I already explained that HY tends to LEAD, which is part of the reason the correlations drift. As I explained, while the stock market is more impacted by emotional retail investors and their cash flows, bonds are more dominated by institutional players--in fact almost all bond trading is done by institutions. But that is minor issue. Just look at any period when the equity risks show up and you see HY getting hit. Just look at the spread table I showed-- I blind man couldn't miss the dramatic widening of the spread in 2000-02 and 2008 at the same time stocks were getting hit. And then in the recoveries they went up together--though not perfect correlation.

And it's only your opinion on the papers. These are peer reviewed articles in most cases and the judges didn't think they were incomplete. And all studies are period specific. We don't have data for high yield for any longer periods because it's a relatively new product. But as I have shown there isn't almost any premium in any corporate debt and mixing any corporate debt in portfolios has not been rewarded. PERIOD. And that is over many cycles.

And your argument on that period specific doesn't hold up--as was shown to you by ERIC, HY underperformed in both rising and falling periods. But that is one of the very problems anyway with high yield. The call risks reduces the benefits of HY in demand shocks, just when needed most. Another problem

And as I said, everyone but you believes they are hybrid. At least every paper and every academic I've spoken to. Every single one. And note when DFA created their ST extended credit fund we worked with them to estimate the amount of beta exposure in the fund.

Now that doesn't mean there isn't any unique risk in HY but there is very clearly significant equity risk--only a blind man cannot see that. And as you know I'm sure the way you tell if there is exposure to a factor is you run regressions. And the data shows very clearly and with statistical significance that HY has very significant equity exposure.

And as to limited time. The Vanguard fund has been around now almost 30 years and over it's life it hasn't added value in portfolio.I'm sure you've made decisions on much shorter data.

Larry

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Re: An analysis my colleague did on high yield

Post by Frengo » Sun Jun 16, 2013 10:28 pm

Rick Ferri wrote: Frango,

I have been studying asset class correlations for 20-years. Never have I seen the term "anti-correlation" used in any academic study or research report. Perhaps it's used in medicine or some other discipline, I would not know.
Rick,
Even if you have never taken a statistics class of scientific level, there is always google.
And if you had taken a physics class of scientific level, you wouldn't have any problems in recognizing that HY are substantially more correlated to the stock market than IG bonds and without even having to see historical data. It is enough to understand how HY returns work to be convinced.

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Re: An analysis my colleague did on high yield

Post by Electron » Mon Jun 17, 2013 3:23 pm

I just had a thought about High Yield bonds that I don't recall being discussed before. My belief is that the High Yield bond market varies significantly over time in terms of the quality and risk profile of new issues including the industries represented. This ultimately affects any index of High Yield bonds.

The same situation is not the case for a Total Stock Market index or Total Bond Market index at least to the same degree.

Recently there has been strong demand for High Yield bonds, and securities have been issued that might not have sold at all during other periods. Convenant protection has been very low. I seem to recall a lot of Telecom related bonds issued years ago that later got into trouble. Junk bond defaults exceeded 14% in 1990, 10% in 2001-02, and 10% in 2008-09. Trouble in any area of the High Yield market typically impacts all non-investment grade securities once investors start selling bonds or redeeming shares from High Yield Bond mutual funds.

In summary, it would appear that the quality and characteristics of an index of High Yield bonds might vary over time to a much greater degree than other portions of one's portfolio.
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Re: An analysis my colleague did on high yield

Post by larryswedroe » Mon Jun 17, 2013 5:21 pm

electron
That certainly is true. It used to be that only companies that could put up significant collateral could issue such debt. Typically value companies, borrowing in effect against their assets. Then came the 90s and growth companies like telecom started to be able to issue HY, and convenants loosened and defaults not only increased but losses on defaults increased. This goes in cycles. Whenever you have rush for yield, covenants weaken. Likely happened now. Another problem for the asset class

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Re: An analysis my colleague did on high yield

Post by Electron » Mon Jun 17, 2013 10:21 pm

larryswedroe wrote:Whenever you have rush for yield, covenants weaken. Likely happened now. Another problem for the asset class.
Here is an article on that exact subject.

http://blogs.barrons.com/incomeinvestin ... n-january/

I also read that a major Barclays High Yield Bond index saw its yield drop below 5% for the first time ever recently.
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Re: An analysis my colleague did on high yield

Post by larryswedroe » Tue Jun 18, 2013 8:07 am

Electron
check the Fed chart on Merrill Lynch's index on spreads--5% appears to be about the long term average--though with weaker convenants that the same thing as a lower spread--not being compensated for the risks
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Re: An analysis my colleague did on high yield

Post by Electron » Wed Jun 19, 2013 12:58 pm

larryswedroe wrote:check the Fed chart on Merrill Lynch's index on spreads--5% appears to be about the long term average--though with weaker convenants that the same thing as a lower spread--not being compensated for the risks.
Thanks Larry. I was talking about the actual yield on the Barclays High Yield Bond Index and not the spread relative to Treasury bonds. The index yield dropped below 5% for the first time ever earlier this year, and that seems quite low for junk bonds. That may be another sign that investors have been very enthusiastic about the sector.

Attached below is an interesting chart showing the NAV and Dividend Trend for Vanguard High Yield Corporate going back to 1989.

http://i1118.photobucket.com/albums/k61 ... dTrend.jpg

It's interesting to speculate on why NAV has trended lower for so many years. It also looks like investors need to be prepared for long periods of declining NAV such as 1998-2002. The dividend payout was relatively high in earlier years and I believe total return was slightly positive over that particular time frame.
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Re: An analysis my colleague did on high yield

Post by larryswedroe » Wed Jun 19, 2013 3:31 pm

electron
IMO looking at the yield is not the right way to analyze relative value--it's the spread that matters

Best wishes
Larry

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Re: An analysis my colleague did on high yield

Post by Rick Ferri » Thu Jun 20, 2013 11:01 am

Frengo wrote:
Rick Ferri wrote: Frango,

I have been studying asset class correlations for 20-years. Never have I seen the term "anti-correlation" used in any academic study or research report. Perhaps it's used in medicine or some other discipline, I would not know.
Rick,
Even if you have never taken a statistics class of scientific level, there is always google.
And if you had taken a physics class of scientific level, you wouldn't have any problems in recognizing that HY are substantially more correlated to the stock market than IG bonds and without even having to see historical data. It is enough to understand how HY returns work to be convinced.
Your attempt to discredit my view by suggesting I do not understand what correlation means is uncalled for. You obviously have not read All About Asset Allocation where I discuss high yield in detail and include many correlation charts. The "default risk" unique to HY is different than credit risk, which is in both investment grade and HY securities, as I point in my book. There are times when the default risk of high yield is correlated with equity risk, and there are times it is non-correlated. There are even periods when credit risk and default risk are non-correlated, i.e. the two spreads are moving in opposite directions. There is not a lot of unique risk in high yield, but there is enough to warrant an allocation.

Also, the very idea of trying to pick winning in losing fixed income sectors doesn't fit with the idea that markets are efficient. I believe over 25% of the corporate bond marketplace is now HY and growing. This is as good a reason as any to have an allocation. If the asset class was so bad and inefficient, as some claim on this board, then the marketplace will correct for it through pricing, and if that doesn't work then the entire HY market would go away. the HY market does exists and it is growing.

People have made good money investing in high yield bond funds - much more money than in commodity funds - that's for sure!

Rick Ferri
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Re: An analysis my colleague did on high yield

Post by larryswedroe » Thu Jun 20, 2013 12:54 pm

There is not a lot of unique risk in high yield
Glad to see Rick and I are now basically on same page here (:-))

As I said before, it's perfectly fine to have a different view on the implications. Rick looked at the weight of the evidence and believes that there is enough unique risk to warrant an allocation (and considered costs, returns, tax efficiency, location issues as well) and I come to a different conclusion. But at least we now agree on the fact that there isn't a lot of unique risk, but some.

My colleague Jared Kizer ran a five factor regression on long term data for Vanguard's fund
Here is the finding, note the TSTATS are all statistically significant, loading/tstat
Market .16/8
Size .07/3
Value 0.7/3
Term 0.48/8
credit 1.19/16

Now if you eliminate the credit factor we still see that the returns are well explained by the remaining for factors
Market .3/16
Size .13/4
Value .15/6
Term .46/7

With tstats that high, like 16 for market it's hard to make the case that HY doesn't have equity risk. The odds of it being just lucky outcome are as close to zero as you can get. And in both cases you see statistically significant loadings on size and value, as you should expect

One last thing; Another example of making the mistake of thinking of returns in isolation
People have made good money investing in high yield bond funds - much more money than in commodity funds - that's for sure!
I have shown repeatedly that adding HY has reduced portfolio efficiency while adding CCF has improved it, over various time periods including ones where commodities had very low returns.
What get's people in trouble isn't often what they don't know but what they know for sure that isn't so!

What's also important to understand is that HY is a risky investment, one which tends to produce it's worst returns at the wrong time. Assets like that, like value stocks, should have high expected returns, big premiums. Unfortunately this isn't the case. On the other hand CCF has hedging qualities and any asset with such qualities should have low expected returns---which doesn't mean you should not invest, just expect low returns.

Best wishes
Larry
Last edited by larryswedroe on Thu Jun 20, 2013 1:56 pm, edited 2 times in total.

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Re: An analysis my colleague did on high yield

Post by gerrym51 » Thu Jun 20, 2013 12:57 pm

Rick Ferri wrote:
Frengo wrote:
Rick Ferri wrote: Frango,

I have been studying asset class correlations for 20-years. Never have I seen the term "anti-correlation" used in any academic study or research report. Perhaps it's used in medicine or some other discipline, I would not know.
Rick,
Even if you have never taken a statistics class of scientific level, there is always google.
And if you had taken a physics class of scientific level, you wouldn't have any problems in recognizing that HY are substantially more correlated to the stock market than IG bonds and without even having to see historical data. It is enough to understand how HY returns work to be convinced.
Your attempt to discredit my view by suggesting I do not understand what correlation means is uncalled for. You obviously have not read All About Asset Allocation where I discuss high yield in detail and include many correlation charts. The "default risk" unique to HY is different than credit risk, which is in both investment grade and HY securities, as I point in my book. There are times when the default risk of high yield is correlated with equity risk, and there are times it is non-correlated. There are even periods when credit risk and default risk are non-correlated, i.e. the two spreads are moving in opposite directions. There is not a lot of unique risk in high yield, but there is enough to warrant an allocation.

Also, the very idea of trying to pick winning in losing fixed income sectors doesn't fit with the idea that markets are efficient. I believe over 25% of the corporate bond marketplace is now HY and growing. This is as good a reason as any to have an allocation. If the asset class was so bad and inefficient, as some claim on this board, then the marketplace will correct for it through pricing, and if that doesn't work then the entire HY market would go away. the HY market does exists and it is growing.

People have made good money investing in high yield bond funds - much more money than in commodity funds - that's for sure!

Rick Ferri

i read anti- correlation and EFFECTIVE as same word :mrgreen:

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Re: An analysis my colleague did on high yield

Post by pascalwager » Fri Jun 21, 2013 2:35 am

OK, I admit I am a neophyte in understanding bond and 'bond like' funds. I study Bogleheads to learn more about investing (I am 71). I have read this complete thread (including the linked information) and am now more confused about what to do with my VWEAX fund than when I started.

My VWEAX comprises approximately 20% of my Vanguard portfolio and pays me in the neighborhood of $1100 to $1200 per month seemingly regardless of the NAV. But what I take away from this thread is that I should not be invested in VWENX for all the various points made, leading me to conclude that it is not a good long term investment. I only use it for the cash it generates (along with VWENX, VWIAX and stock dividends). I would like to know what other Vanguard fund I would be wiser to invest in than VWEAX that will produce $1100 to $1200 per month like clockwork?

My total investment portfolio (brokerage, Vanguard and local Bank) is 66% in dividend paying small to micro cap stocks, 22% in Bonds (including VWEAX, VWENX, VWIAX), 12% cash and is in the multiple 7 figure range.
You might start by x-raying your portfolio and then decide if you really want these allocations. For example, the equity portion seems to be very highly tilted toward riskier small caps which can underperform for decades. But given the size of your portfolio, there's probably room for "error".

As for HY, it's the entire portfolio that's important, not just a single fund showing short-term success. W. Bernstein recommends no more that 2% HY, and only when the spread (between HY and 10-year Treasuries) is very large. The main purpose of bonds is to reduce portfolio volatility and hopefully provide a small real return.

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Re: An analysis my colleague did on high yield

Post by Frengo » Fri Jun 21, 2013 3:04 am

Rick Ferri wrote: Your attempt to discredit my view by suggesting I do not understand what correlation means is uncalled for. You obviously have not read All About Asset Allocation where I discuss high yield in detail and include many correlation charts.
People write all sorts of things. Aristotle wrote a lot too; you are in excellent company.

I'm not opposed to HY. I think they are a wonderful asset, at times. You don't have to convince me, but you cannot convince me that HY returns are not more correlated to the stock market returns than IG bond returns are. It's evident from past data, it is evident from the mechanics of the asset.
btw credit risk is default risk, since default is any change in the stipulated terms of a bond.
There are even periods when credit risk and default risk are non-correlated, i.e. the two spreads are moving in opposite directions.

I'm sorry, but if two things are "non correlated" it means their correlation is zero, i.e. when one moves in a direction we have no information about how the other may move. If we do have information pointing to an opposite move that's an anticorrelated asset.
And I didn't start this.

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