Is the investment-grade vs. junk bonds divide arbitrary?

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kagantx
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Is the investment-grade vs. junk bonds divide arbitrary?

Post by kagantx » Tue Mar 13, 2018 3:28 am

Many Bogleheads invest their bond allocations in "Total Bond Market" funds. Such funds invest in only "investment-grade bonds," so they are not actually total market bond funds.

I am aware that there are reasons to avoid bonds with very low credit ratings. They tend to have a much higher correlation with stocks than high-quality bonds, and they have much more risk. But the "total bond market' approach seems to indicate that an S&P BBB- bond is a high-quality bond that will provide safety against crashes, while an S&P BB+ bond (one step down) is a risky junk bond that is barely safer than a stock.

It seems very unlikely to me that this is the case. I think it's quite possible that (say) only AA bonds are safe enough to fulfill the bond role. Or on the other hand, it might be that even B- grade bonds would provide enough safety while enhancing return.

So should we be adding higher-grade junk bonds to our portfolios (and is there a practical way to do so)? Or should we instead restrict ourselves to Treasuries? Is there any academic support for the dividing line between investment grade and junk being set where it is?

Valuethinker
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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by Valuethinker » Tue Mar 13, 2018 3:57 am

kagantx wrote:
Tue Mar 13, 2018 3:28 am
Many Bogleheads invest their bond allocations in "Total Bond Market" funds. Such funds invest in only "investment-grade bonds," so they are not actually total market bond funds.

I am aware that there are reasons to avoid bonds with very low credit ratings. They tend to have a much higher correlation with stocks than high-quality bonds, and they have much more risk. But the "total bond market' approach seems to indicate that an S&P BBB- bond is a high-quality bond that will provide safety against crashes, while an S&P BB+ bond (one step down) is a risky junk bond that is barely safer than a stock.

It seems very unlikely to me that this is the case. I think it's quite possible that (say) only AA bonds are safe enough to fulfill the bond role. Or on the other hand, it might be that even B- grade bonds would provide enough safety while enhancing return.

So should we be adding higher-grade junk bonds to our portfolios (and is there a practical way to do so)? Or should we instead restrict ourselves to Treasuries? Is there any academic support for the dividing line between investment grade and junk being set where it is?
If you read David Swensen and Larry Swedroe's books, they will take you through the arguments about why a HY bond fund is not a good idea for an individual investor.

Anti Ilmanen's books ("Expected Returns" and the CFA Institute one) are classics. Credit risk is a factor which can generate returns. Separate from equity risk, term risk (interest rate yield curve), inflation risk.

However there are issues of taxable location and the correlation between HY bonds & equities. HY bonds have equity risk, thus reducing your portfolio diversification.

The actual BBB- dividing line appears to be somewhat arbitrary. However I don't know the history of it -- it's literally 70+ Years old I believe. Historically all bonds at issue were investment grade, and you only had "Fallen Angels" - bonds downgraded below BBB- on the S&P scale. There is some evidence that FA outperform relative to risk-- the fact that many investors (pension funds, insurance companies, IG bond funds) can be forced to sell means they are underpriced.

Michael Milliken invented the Original Issue HY market in the late 1970s. The evidence there is OI bonds don't give you a free lunch-- higher return and risk.

Many investors here, and William Bernstein (a piece on Efficient Frontier website) exploited the blow out in yield spreads in early 2009. When the HY yield spread over IG blows out in the credit cycle, then there may be a buying opportunity. But blow out means several hundred basis points (say 5%+, I think in early 09 it was more like 1000 bps, not less-- and it only happens a few times in a cycle.

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by kagantx » Tue Mar 13, 2018 4:47 am

Valuethinker wrote:
Tue Mar 13, 2018 3:57 am
kagantx wrote:
Tue Mar 13, 2018 3:28 am
Many Bogleheads invest their bond allocations in "Total Bond Market" funds. Such funds invest in only "investment-grade bonds," so they are not actually total market bond funds.

I am aware that there are reasons to avoid bonds with very low credit ratings. They tend to have a much higher correlation with stocks than high-quality bonds, and they have much more risk. But the "total bond market' approach seems to indicate that an S&P BBB- bond is a high-quality bond that will provide safety against crashes, while an S&P BB+ bond (one step down) is a risky junk bond that is barely safer than a stock.

It seems very unlikely to me that this is the case. I think it's quite possible that (say) only AA bonds are safe enough to fulfill the bond role. Or on the other hand, it might be that even B- grade bonds would provide enough safety while enhancing return.

So should we be adding higher-grade junk bonds to our portfolios (and is there a practical way to do so)? Or should we instead restrict ourselves to Treasuries? Is there any academic support for the dividing line between investment grade and junk being set where it is?
If you read David Swensen and Larry Swedroe's books, they will take you through the arguments about why a HY bond fund is not a good idea for an individual investor.

Anti Ilmanen's books ("Expected Returns" and the CFA Institute one) are classics. Credit risk is a factor which can generate returns. Separate from equity risk, term risk (interest rate yield curve), inflation risk.

However there are issues of taxable location and the correlation between HY bonds & equities. HY bonds have equity risk, thus reducing your portfolio diversification.
But do these books provide evidence that higher credit rating categories of the HY bonds have these characteristics, or only a market-cap weighted fund with all HY bonds? For all I know (right now), BB bonds have the same correlation to equities as AA bonds do but higher returns, and only C bonds and below have significant equity risk.

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by oldcomputerguy » Tue Mar 13, 2018 5:44 am

kagantx wrote:
Tue Mar 13, 2018 3:28 am
Many Bogleheads invest their bond allocations in "Total Bond Market" funds. Such funds invest in only "investment-grade bonds," so they are not actually total market bond funds.

I am aware that there are reasons to avoid bonds with very low credit ratings. They tend to have a much higher correlation with stocks than high-quality bonds, and they have much more risk. But the "total bond market' approach seems to indicate that an S&P BBB- bond is a high-quality bond that will provide safety against crashes, while an S&P BB+ bond (one step down) is a risky junk bond that is barely safer than a stock.

It seems very unlikely to me that this is the case. I think it's quite possible that (say) only AA bonds are safe enough to fulfill the bond role. Or on the other hand, it might be that even B- grade bonds would provide enough safety while enhancing return.

So should we be adding higher-grade junk bonds to our portfolios (and is there a practical way to do so)? Or should we instead restrict ourselves to Treasuries? Is there any academic support for the dividing line between investment grade and junk being set where it is?
I think it all depends on one's individual definition of "safe enough". Only you can decide how much risk you want to take.

Yes, the delineation between "investment-grade" and "junk" bonds would seem to be an arbitrary line. I'm sure the "cliff" you describe doesn't actually exist, but if one needs to make a distinction between high-grade and junk bonds, that distinction must involve a boundary somewhere, regardless of how sharp that boundary is. Perhaps it's an imperfect distinction, but it seems to serve the vast majority.

There are investors who feel as you describe, that only Treasuries are "safe enough" to provide ballast to a portfolio. (For example, Paul Merriman only includes Government bond funds in his "Recommended Portfolios.") Others feel differently. I'd suggest you read Rick Ferri's "All About Asset Allocation", specifically Chapter 8 ("Fixed-Income Investments"). He discusses how one might want to diversify one's fixed-income portfolio to include not only Government bonds and commercial investment grade, but also some high-yield.
It’s taken me a lot of years, but I’ve come around to this: If you’re dumb, surround yourself with smart people. And if you’re smart, surround yourself with smart people who disagree with you.

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by carolinaman » Tue Mar 13, 2018 7:19 am

The quality or lack of quality of HY funds vary widely. Some are much closer to BB than others. I owned the Vanguard Corp HY for many years and it did very well. It is one of the more conservative HY bond funds. Conversely, there are some that are more akin to riverboat gamblers, investing heavily in very high risk bonds. HY is a hybrid bond fund that has characteristics of both equity and bonds. When equity is down, HY corporates are also usually down. HY can be negatively affected when a market segment is a downturn. For example, a few years ago it was hit by defaults from shale oil producers, who are big issuers of HY bonds, when that market segment was down. Another example was the HY muni funds who invested (gambled) with Puerto Rico bonds.

I sold my Vanguard HY because I was convinced of Swedroe's argument that you should take your investment risk with equities, not bonds. I sold my HY bond fund and reinvested the proceeds into equal parts equity and IG bonds.

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by patrick013 » Tue Mar 13, 2018 10:55 am

kagantx wrote:
Tue Mar 13, 2018 3:28 am

So should we be adding higher-grade junk bonds to our portfolios (and is there a practical way to do so)? Or should we instead restrict ourselves to Treasuries? Is there any academic support for the dividing line between investment grade and junk being set where it is?
Altman Z-score - Wikipedia
Altman Z-Score - Investopedia

No doubt high yield bonds would have a worse Altman Z-score.

Although it is surprising how many high yield bond funds do
not suffer from many defaults they do have more defaults.
That is the main risk when investing in a high yield index
or an investment grade bond index. Diversification is almost
mandatory as even an investment grade bond index can have
defaults, especially muni's, and the bond index is the best way
to go then.

So even as correlation with equities occurs the default rate
will give an estimate of the future possible default deduction
for statistical purposes also.

Image

Check with the S&P or Moody's website for actual ratings methodology.
Hopefully ratings are very reliable.
age in bonds, buy-and-hold, 10 year business cycle

ztn
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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by ztn » Tue Mar 13, 2018 11:17 am

As others have noted, the dividing line of BBB and BB is arbitrary and the tradition goes back decades.

HOWEVER, there is a very real price effect when a bond gets downgraded below BBB- or upgraded to above BB+. A big reason for this is related to large institutional investors who have legal constraints related to minimum bond ratings for their bond portfolio holdings. That's why is is quite common to see a significant point drop on a downgrade below BBB- and a significant spike up in price on an upgrade above BB+. In many cases this price action occurs even though it is well understood in advance and even expected that the rating agencies will be re-rating the bond up or down. The legal-listed institutional holders of the bonds are forced out on the way down and on the other side the investment-grade institutional portfolios buy on the upgrade knowing that the bond will be included in the IG index at the beginning of the next month, so they get ahead of the passive portfolios that will buy on the first of the month.
The above is an important reason why some active fixed income managers can consistently outperform the indexes.

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by alex_686 » Tue Mar 13, 2018 11:24 am

kagantx wrote:
Tue Mar 13, 2018 3:28 am
I am aware that there are reasons to avoid bonds with very low credit ratings. They tend to have a much higher correlation with stocks than high-quality bonds, and they have much more risk. But the "total bond market' approach seems to indicate that an S&P BBB- bond is a high-quality bond that will provide safety against crashes, while an S&P BB+ bond (one step down) is a risky junk bond that is barely safer than a stock.
This is a known issue. In theory there should be a smooth curve between AAA bonds and B bonds in regards to risk and returns. There is not. There is a kink at the BBB/BB spot - between investment grade and junk. Lots of regulations requiring certain portfolio to hold investment grade. It is a common example showing how regulations distort the market. There are active investment strategies to exploit this issue.

One could make a different determination - for example, set your cut off at AA or BB or whatever. But I don't think it is actionable unless you create your own bond portfolio instead of buying a fund. I hold a modest sliver of HY debt, along with preferred stock.

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by lack_ey » Tue Mar 13, 2018 1:36 pm

kagantx wrote:
Tue Mar 13, 2018 4:47 am
But do these books provide evidence that higher credit rating categories of the HY bonds have these characteristics, or only a market-cap weighted fund with all HY bonds? For all I know (right now), BB bonds have the same correlation to equities as AA bonds do but higher returns, and only C bonds and below have significant equity risk.
Are you sure? Over which data? Are there differences in term risk between the bonds?

I just did a quick check of AA and BB option-adjusted credit spreads compared to excess stock market returns (returns above cash). On monthly data since the start of the data series in 1997 (may be less data than you've looked at), changes in BB spreads have been more negatively correlated to excess stock returns than changes in AA spreads have been.

Correlations (Pearson r) are -0.473 between AA and stocks, -0.581 between BB and stocks, 0.76 between AA and BB spreads. The difference between -0.473 and -0.581 is statistically significant (p = 0.003)

Negative correlation means when stocks go down, credit spreads rise (so prices relative to government bonds should fall).

Changes in spreads don't even account for losses in BB bonds from defaults. That said, the above analysis doesn't account for the volatility changing over time. But anyway, there does seem to be some effect.

You can regress A/BBB corporate bond returns on stocks and find a higher relationship there than between Treasury bonds and stocks. A number of ways of looking at this.

I'll grant that the higher-end range of junk is not as related to equities as the lower end, that's for sure.

In any case, the dumbest part about this binary delineation is that investment-grade managers (index funds and others with that mandate) have to basically simultaneously sell downgraded bonds because they become labeled as junk—fallen angels. If you want to be roughly on the other side of that trade, there are actually two fallen angels ETFs, iShares Fallen Angels USD Bond ETF (FALN) and the older and more established VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL).

Despite ANGL's poor tracking performance (it's hard to trade the underlying issues), the performance since inception has been good:
http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D

edit: a bit of the above can be attributed to greater term risk, but compared to HYG (the index fund), that's lower vol for lower credit risk taken and significantly higher return even accounting for that
Last edited by lack_ey on Tue Mar 13, 2018 2:06 pm, edited 1 time in total.

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by fennewaldaj » Tue Mar 13, 2018 1:56 pm

Valuethinker wrote:
Tue Mar 13, 2018 3:57 am
kagantx wrote:
Tue Mar 13, 2018 3:28 am
Anti Ilmanen's books ("Expected Returns" and the CFA Institute one) are classics. Credit risk is a factor which can generate returns. Separate from equity risk, term risk (interest rate yield curve), inflation risk.
If I recall from that It seemed like he was implying that most of the losses in corporate bonds occur from the sale of BBB that get downgradeded and this is the main explanation for the Spreads averaging over 1% while actual excess return averaging 0.3% of investment grades over treasuries. The other main reason he sights is sale when they become short term. He also notes that CCC and lower bonds have terrible risk return profiles. It seems that one would be best off holding corporates in a fund that bought them as investment grade and did not sell them until they were downgraded to B or CCC. It does not seem that many funds operate in this way though. Maybe Dodge an Cox income?

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by dkturner » Tue Mar 13, 2018 2:05 pm

The OPs points are well taken - at least by the fixed income managers at the Vanguard Group. Their short, intermediate and long-term actively managed investment grade bond funds have higher allocations to A and higher rated bonds than the Vanguard corporate bond index funds.

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by alex_686 » Tue Mar 13, 2018 2:11 pm

dkturner wrote:
Tue Mar 13, 2018 2:05 pm
The OPs points are well taken - at least by the fixed income managers at the Vanguard Group. Their short, intermediate and long-term actively managed investment grade bond funds have higher allocations to A and higher rated bonds than the Vanguard corporate bond index funds.
So?

First, does the fund have a higher allocation to A and higher or does the fund have a higher allocation to A and higher than the underlying index?

Second, a fund manager has to care about liquidity and yield. Who knows when redemption may happen? The higher the liquidity the lower the yield.

Not saying that you are wrong, just asking if we have enough info to see if this is right or not.

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by jalbert » Tue Mar 13, 2018 2:26 pm

Many investors here, and William Bernstein (a piece on Efficient Frontier website) exploited the blow out in yield spreads in early 2009.
Others exploited Dow 6400 at that time.
But the "total bond market' approach seems to indicate that an S&P BBB- bond is a high-quality bond that will provide safety against crashes, while an S&P BB+ bond (one step down) is a risky junk bond that is barely safer
The total bond index is a diversified index with about 37% allocated to corporate bonds of all investment grade credit ratings. Yes, if your entire bond portfolio were rated BBB- it would not provide protection against an equity downturn. Currently, the Vanguard total US bond index fund is 14.7% bonds rated Baa which corresponds to BBB+, BBB, and BBB-. Assuming equal distributions, that's less than 5% BBB-.

There are those who argue you should take risk with equities and hold treasuries, TIPs, and CDs for fixed income, enabling a slightly higher equity allocation.
Last edited by jalbert on Tue Mar 13, 2018 7:21 pm, edited 2 times in total.
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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by nisiprius » Tue Mar 13, 2018 4:59 pm

Of course it's arbitrary, just like the division between growth and value, developed markets versus emerging markets, even US versus international (there are at least 17 foreign companies in the S&P 500 index).

As to what to do, the decision is entirely up to the individual investor's personal tastes for risk and return, but Larry Swedroe has written:
In 'The Quest for Alpha, p. 154, Larry Swedroe wrote:If the security has a high yield, you can be sure the risks are high, even if you cannot see them.
If you choose to take the extra risk, that's your decision, but don't kid yourself into thinking extra risk isn't really there. Obviously, of course, a small amount isn't going to add much risk.

In recent years, there have been cases of investors getting pretty badly hurt by thinking that they had found something that made them a bit more return, with essentially negligible additional risk: auction-rate securities, and the Schwab Yield-Plus fund (often suggested as a safe-enough alternative to money market funds), to name two.

Some people have commented on the effects of regulators requiring certain institutions to invest in, well, investment-grade bonds. I think it's worth remembering the story of the Executive Life Insurance Company, once the largest life insurance company in California. It had a close association Mike Milken and Drexel, Burnham, Lambert. I'm not sure just how it happened, but the company convinced state regulators that the "high-yield" bonds it was investing in were good enough to back the life insurance policies they were writing. It turned out not to be true, and it became the biggest insurance company ever to fail. The two morals here are that insurance regulations requiring the use of investment-quality bonds are probably well-founded, and that experts who are sure they know how to control the extra risk of investing in "high-yield" bonds can be seriously mistaken.
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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by Electron » Thu Mar 15, 2018 2:22 pm

kagantx wrote:
Tue Mar 13, 2018 3:28 am
I think it's quite possible that (say) only AA bonds are safe enough to fulfill the bond role. Or on the other hand, it might be that even B- grade bonds would provide enough safety while enhancing return.
The answer may be different for a long term investor versus someone with a shorter term time horizon. Higher yields may more than compensate for other factors affecting total return.

It's always interesting to bring up a Total Return Chart on Morningstar and compare different types of bond funds over the last 15 years. Take note of the period 2008-09.

There are portfolios that only hold Treasury bonds. Take a look at the Yale University portfolio.

https://www.marketwatch.com/lazyportfolio

This is a little off topic, but I was surprised at the recent performance comparison between Vanguard High Yield Corporate and Vanguard Total Bond Market Index fund.

Code: Select all

Morningstar Total Return % 3-14-18

Period   3-Mo    YTD    1-Yr    3-Yr    5-Yr    10-Yr   15-Yr

VWEAX 	-0.94 	-1.19 	5.24 	4.60 	4.64 	7.16 	6.88

VBTLX 	-1.91 	-1.81 	2.05 	1.33 	1.78 	3.60 	3.89
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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by Phineas J. Whoopee » Thu Mar 15, 2018 3:51 pm

kagantx wrote:
Tue Mar 13, 2018 3:28 am
Many Bogleheads invest their bond allocations in "Total Bond Market" funds. Such funds invest in only "investment-grade bonds," so they are not actually total market bond funds.
...
At the risk of linking to my own post from quite some time back, perhaps as a supplement a Total Default Bond Index Fund would be lucrative to found.

PJW

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Re: Is the investment-grade vs. junk bonds divide arbitrary?

Post by Electron » Thu Mar 15, 2018 5:36 pm

kagantx wrote:
Tue Mar 13, 2018 3:28 am
Is there any academic support for the dividing line between investment grade and junk being set where it is?
Wikipedia has an excellent summary on Bond Credit Ratings with a lot of detailed information. The dividing line that you mention is between Lower Medium Grade and Non-Investment Grade Speculative.

https://en.wikipedia.org/wiki/Bond_credit_rating
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