Hi Yield Bond Funds - Bond or Equity?

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faltuk1
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Hi Yield Bond Funds - Bond or Equity?

Post by faltuk1 »

Hi Yield bond funds - Do you consider them part of bond allocation or equity allocation? In my opinion, any thing that produces equity like returns should be considered part of equity allocation. Any opinions?
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Re: Hi Yield Bond Funds - Bond or Equity?

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faltuk1 wrote:Hi Yield bond funds - Do you consider them part of bond allocation or equity allocation? In my opinion, any thing that produces equity like returns should be considered part of equity allocation. Any opinions?
Hi faltuk:

Hi-yield bonds, aka junk bonds, are by definition "bonds" which often correlate with equity. See this recent Conversation:

http://www.bogleheads.org/forum/viewtop ... 1262280289
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Re: Hi Yield Bond Funds - Bond or Equity?

Post by ddb »

faltuk1 wrote:Hi Yield bond funds - Do you consider them part of bond allocation or equity allocation? In my opinion, any thing that produces equity like returns should be considered part of equity allocation. Any opinions?
If I were to use them, which I don't and probably never will, I'd consider them part equity and part fixed income. The actual breakdown would depend on the fund or individual holdings that make up my position.

- DDB
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Re: Hi Yield Bond Funds - Bond or Equity?

Post by faltuk1 »

ddb wrote:
faltuk1 wrote:Hi Yield bond funds - Do you consider them part of bond allocation or equity allocation? In my opinion, any thing that produces equity like returns should be considered part of equity allocation. Any opinions?
If I were to use them, which I don't and probably never will, I'd consider them part equity and part fixed income. The actual breakdown would depend on the fund or individual holdings that make up my position.

- DDB
My only bond fund is LSBRX. 10% of my portfolio. Any opinion on how would you break it?
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Re: Hi Yield Bond Funds - Bond or Equity?

Post by ddb »

faltuk1 wrote:
ddb wrote:
faltuk1 wrote:Hi Yield bond funds - Do you consider them part of bond allocation or equity allocation? In my opinion, any thing that produces equity like returns should be considered part of equity allocation. Any opinions?
If I were to use them, which I don't and probably never will, I'd consider them part equity and part fixed income. The actual breakdown would depend on the fund or individual holdings that make up my position.
My only bond fund is LSBRX. 10% of my portfolio. Any opinion on how would you break it?
According to Morningstar, approximately 71% of the value of LSBRX's underlying bonds are rated BBB or better, so it's relatively conservative as far as high-yield bonds go (Morningstar doesn't consider it a high-yield fund, for what it's worth). It's a judgment call, but I'd probably label it something like 75% fixed income and 25% equity.

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Post by nisiprius »

It's like asking whether ice cream should be considered ice or cream.

Non-investment-grade bonds are fundamentally different from investment-grade bonds because the chance of default can't be ignored, and therefore the value of the investment depends on one's judgement of the business prospects of the company.

For investment-grade bonds, the business barely enters in to it. If there are two bonds, both rated AA, both maturing in 5 years, both with a 5% coupon, you do not need to know anything about the company; the bonds can be treated as equivalent.

Non-investment-grade bonds are fundamentally different from stocks because they are a (shaky) promise to pay certain specified amounts on a certain specified days, and no matter how well the company does, it will never do anything more than keep that promise.

So they're just not one thing or the other. In my non-expert opinion, if the reason you are classifying them is to assess the risk of your portfolio, it would definitely be a mistake simply to count them as "bonds" because they are significantly riskier than other bonds. And it would definitely be a mistake simply to count them as "stocks" because they are not going to earn 7% real in the long run.

The most conservative thing to do would be to classify them separately from either. I'm not enough of an expert to go beyond that.
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Post by faltuk1 »

nisiprius wrote:It's like asking whether ice cream should be considered ice or cream.

Non-investment-grade bonds are fundamentally different from investment-grade bonds because the chance of default can't be ignored, and therefore the value of the investment depends on one's judgement of the business prospects of the company.

For investment-grade bonds, the business barely enters in to it. If there are two bonds, both rated AA, both maturing in 5 years, both with a 5% coupon, you do not need to know anything about the company; the bonds can be treated as equivalent.

Non-investment-grade bonds are fundamentally different from stocks because they are a (shaky) promise to pay certain specified amounts on a certain specified days, and no matter how well the company does, it will never do anything more than keep that promise.

So they're just not one thing or the other. In my non-expert opinion, if the reason you are classifying them is to assess the risk of your portfolio, it would definitely be a mistake simply to count them as "bonds" because they are significantly riskier than other bonds. And it would definitely be a mistake simply to count them as "stocks" because they are not going to earn 7% real in the long run.

The most conservative thing to do would be to classify them separately from either. I'm not enough of an expert to go beyond that.
You are absolutely right, I want to assess the risk of my portfolio. I have decided to have 60% stock and 40% fixed income portfolio. I have no problem classifying 90% of my portfolio. Just 10% of LSBRX has been an issue with me. For last 5 years, I have put it in my fixed income column, but with wild ride of last 2 years (30% down than 30% up), I am not sure how to classify it. I want to keep the fund, so seeking the guidence as to how others do it for similar kind of funds?
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Post by spam »

Why not consider the book "Investors Manifesto" which details the evolution of different types of securities? You may never have to worry about such things again.

Bond holders have a better position in bankruptcy court than equity holders, and a worse position than bank loans. Maybe a better question would be if the fixed income part of your portfolio should be allocated by considerations of yield or risk.
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Re: Hi Yield Bond Funds - Bond or Equity?

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ddb wrote:
faltuk1 wrote:Hi Yield bond funds - Do you consider them part of bond allocation or equity allocation? In my opinion, any thing that produces equity like returns should be considered part of equity allocation. Any opinions?
If I were to use them, which I don't and probably never will, I'd consider them part equity and part fixed income. The actual breakdown would depend on the fund or individual holdings that make up my position.
Larry Swedroe posted about an article that mentioned Vanguard's junk bond fund is ~22% equity for "behavioral" purposes.

The BIG problem with this is when we have a bear market it essentially acts like 100% equity and it dives about as much as equity. If HY bonds are counted as equity there isn't any disappointment in a down market, but an investor will then grump at them in an up market.

Paul
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Re: Hi Yield Bond Funds - Bond or Equity?

Post by ddb »

stratton wrote:
ddb wrote:
faltuk1 wrote:Hi Yield bond funds - Do you consider them part of bond allocation or equity allocation? In my opinion, any thing that produces equity like returns should be considered part of equity allocation. Any opinions?
If I were to use them, which I don't and probably never will, I'd consider them part equity and part fixed income. The actual breakdown would depend on the fund or individual holdings that make up my position.
Larry Swedroe posted about an article that mentioned Vanguard's junk bond fund is ~22% equity for "behavioral" purposes.

The BIG problem with this is when we have a bear market it essentially acts like 100% equity and it dives about as much as equity. If HY bonds are counted as equity there isn't any disappointment in a down market, but an investor will then grump at them in an up market.
???

The Vanguard High-Yield Corporate Fund was down 21.29% in 2008, while US Total Stock Market was down 37.04%. Further, although High Yield bonds can act more like equities in down markets, they can also act more like equities during rallies - e.g. in 2009, VWEHX was up 39.06%, well ahead of equities which were up only 28.70%!

(not saying I like the asset class, though)

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Re: Hi Yield Bond Funds - Bond or Equity?

Post by stratton »

ddb wrote:
stratton wrote:
ddb wrote:
faltuk1 wrote:Hi Yield bond funds - Do you consider them part of bond allocation or equity allocation? In my opinion, any thing that produces equity like returns should be considered part of equity allocation. Any opinions?
If I were to use them, which I don't and probably never will, I'd consider them part equity and part fixed income. The actual breakdown would depend on the fund or individual holdings that make up my position.
Larry Swedroe posted about an article that mentioned Vanguard's junk bond fund is ~22% equity for "behavioral" purposes.

The BIG problem with this is when we have a bear market it essentially acts like 100% equity and it dives about as much as equity. If HY bonds are counted as equity there isn't any disappointment in a down market, but an investor will then grump at them in an up market.
???

The Vanguard High-Yield Corporate Fund was down 21.29% in 2008, while US Total Stock Market was down 37.04%. Further, although High Yield bonds can act more like equities in down markets, they can also act more like equities during rallies - e.g. in 2009, VWEHX was up 39.06%, well ahead of equities which were up only 28.70%!

(not saying I like the asset class, though)
Ok, VWEHX acted more like Dividend Appreciation on the downside, but that still doesn't invalidate that it acted like an equity. The ralley upside is still part of the bear market. At this point Vanguard's junk fund is fairly valued and you won't see that kind of upside in 2010. With TBM you don't have to deal with the rollercoaster.

This is why WBern buys into junk when yields go 4 or 5% above treasuries and then sells them later when the yield drops under that limit in the future as the bonds appreciate.

Look at Fido's Capital and Income (FAGIX) and you'll see a fund that acts like an EM index.

The point is if you have a typical Rick Ferri portfolio:

35% TSM
15% Intl
30% TBM
10% TIPS
10% Junk

In a bear market this portfolio will act like 60% equity as it drops. There is nothing wrong with this as long as the investor understands this aspect of junk bonds.

Paul
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Re: Hi Yield Bond Funds - Bond or Equity?

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stratton wrote:Ok, VWEHX acted more like Dividend Appreciation on the downside, but that still doesn't invalidate that it acted like an equity. The ralley upside is still part of the bear market. At this point Vanguard's junk fund is fairly valued and you won't see that kind of upside in 2010. With TBM you don't have to deal with the rollercoaster.
The Vanguard High Yield fund was down about half as much as the equity market, so I'm not understanding your continued assertion that it "acted like an equity". It acted partially like an equity, which supports the notion that High Yield funds should be considered part equity and part fixed income when plugging them into a target allocation (with the breakdown dependent on the credit quality of the fund's underlying holdings).
stratton wrote:Look at Fido's Capital and Income (FAGIX) and you'll see a fund that acts like an EM index.
Again, I don't see this as a valid comparison:
<table class="tableizer-table">
<tr class="tableizer-firstrow"><th>Year / Total Return</th><th>Fidelity Capital & Income</th><th>Vanguard Emerging Mkts Stock Idx</th></tr> <tr><td>2000</td><td>-9.43%</td><td>-27.56%</td></tr> <tr><td>2001</td><td>-4.66%</td><td>-2.88%</td></tr> <tr><td>2002</td><td>-0.40%</td><td>-7.43%</td></tr> <tr><td>2003</td><td>39.13%</td><td>57.65%</td></tr> <tr><td>2004</td><td>12.57%</td><td>26.12%</td></tr> <tr><td>2005</td><td>5.04%</td><td>32.05%</td></tr> <tr><td>2006</td><td>13.08%</td><td>29.39%</td></tr> <tr><td>2007</td><td>3.78%</td><td>38.90%</td></tr> <tr><td>2008</td><td>-31.90%</td><td>-52.81%</td></tr></table>
stratton wrote:The point is if you have a typical Rick Ferri portfolio:

35% TSM
15% Intl
30% TBM
10% TIPS
10% Junk

In a bear market this portfolio will act like 60% equity as it drops.
No, it will act like somewhere between 50% and 60% equity, depending on the makeup of the junk fund being utilized.

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Post by Rick Ferri »

Over the long-term, the risk of HY is going to fall about halfway between Treasury bonds and US stocks. Accordingly, the expected long-term return should also be half-way between Treasury bonds and stocks. However, this does not mean HY is a hybrid asset that is only influenced by the stock and bond market. The first quarter of 2009 proves that there is unique risk and return in the HY market:

1st Quarter 2009 return of Vanguard funds
-14.5% = US Stocks
+0.4% = Treasuries
+4.5% = HY

All 2009 total return of Vanguard funds
+28.7% = US Stocks
-1.6% = Treasuries
+39.1% = HY

The 'hybrid' theory suggests that HY returns should fall between Treasuries and stocks. As you can clearly see, they did not in the short-term. Thus, there is some unique characteristics in high yield that is cannot be attributed to interest rate risk from bonds or beta from stocks.

MPT is all about risk diversification. I choose not to ignore the unique risk and return characteristics in HY, or call it something that it is not. Rather, I put little in a portfolio to try and take advantage the unique characteristic when it occurs.

Rick Ferri
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Post by nisiprius »

Rick Ferri wrote:MPT is all about risk diversification. I choose not to ignore the unique risk and return characteristics in HY, or call it something that it is not. Rather, I put little in a portfolio to try and take advantage the unique characteristic when it occurs.
But, returning to the original poster's question, if they're unique, when you need to talk about the "asset allocation" of that portfolio, how do you categorize them?

Do you recognize them as a separate category: Stocks, investment-grade bonds, high yield bonds, cash?

If for any reason you are forced to lump it into stocks/bonds/cash, in which category do you put high yield bonds?

Or do you describe the allocation as Stocks/bonds/cash/other?

To revisit a recently-asked question: some target retirement funds have a significant allocation of high-yield bonds, and categorize them simply as "bonds." Doesn't this understate their risk vis-a-vis target retirement funds that use only investment-grade bonds?

Of course, if high-yield bonds constitute only "a little" of the portfolio then it doesn't matter much... but if there's only "a little," they're not giving much diversification benefit, either.
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Post by hidesert »

I held Fidelity's capital & income (FAGIX) until recently. I think I owned it for about 3 years. It correlated with the SP500 but the rises and falls were steeper. It has been doing very well lately and I decided to take my profit (about 16%).

I'd classify it as an equity.
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Post by ddb »

Rick Ferri wrote:Over the long-term, the risk of HY is going to fall about halfway between Treasury bonds and US stocks. Accordingly, the expected long-term return should also be half-way between Treasury bonds and stocks. However, this does not mean HY is a hybrid asset that is only influenced by the stock and bond market. The first quarter of 2009 proves that there is unique risk and return in the HY market:

1st Quarter 2009 return of Vanguard funds
-14.5% = US Stocks
+0.4% = Treasuries
+4.5% = HY
Rick, why do you continue to assert that a single quarter (or single year) proves anything?

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Post by Rick Ferri »

ddb wrote:Rick, why do you continue to assert that a single quarter (or single year) proves anything?

- DDB
It PROVES that high yield is NOT strictly a hybrid stock/bond security, which is the single biggest complaint that the naysayers have about this asset class. HY has some unique risk and return characteristics that cannot be attributed to stocks or bonds, and having a small amount in a portfolio should benefit a portfolio in the long-term. I have been saying this for more than decade. Last year proves my point.

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Post by ddb »

Rick Ferri wrote:
ddb wrote:Rick, why do you continue to assert that a single quarter (or single year) proves anything?

- DDB
It PROVES that high yield is NOT strictly a hybrid stock/bond security, which is the single biggest complaint that the naysayers have about this asset class. HY has some unique risk and return characteristics that cannot be attributed to stocks or bonds, and having a small amount in a portfolio should benefit a portfolio in the long-term. I have been saying this for more than decade. Last year proves my point.
I fail to see how it proves anything. You could just as easily say that Consumer Discretionary stocks have unique risk and return characteristics because they were up 46% in 2009 (compared to only 29% for US stocks), or that Consumer Staples stocks have unique risk and return characteristics because they were only up 17% in 2009 (compared to 29% for US stocks).

I'll have to check with Ken French on this one, but I'm quite sure that "unique risks and returns" cannot be identified from a one-year time frame.

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Post by Robert T »

.
Deleted - see Rick's comment in next post.

Will post again later when have more time.

Robert
.
Last edited by Robert T on Tue Jan 05, 2010 2:16 pm, edited 1 time in total.
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Post by Rick Ferri »

There is a fallacy about HY that needs to be corrected. The fallacy is that HY is nothing more than a hybrid of stocks and bonds, and the justification for this fallacy is that in the very long long-run, when using lineir regression methods to analize the return of HY, the return falls between stocks and bonds. Therefore, it must be a hybrid of stocks and bonds. That is false logic and false analysis, the returns in the first quarter 2009 proved that. HY returns are not a hybrid of stock and bond return. It is it's own asset class, with unique risks and returns at times. I don't know how many times I have to say this same thing in a different way before my point is clear.

Now, my comment does not anwer the question of whether one should invest in HY. That is a subjective decision. I beleive investing in HY as a unique asset class can help a portfolio in the long-term. Others do not. It is fair to ask that question, but it is a different question.

Rick Ferri

BTW, Robert T, VWEHX performed –21.29% last year, not -37.04% and VTSM performed -37.04%, not –21.29%. You have your data backwards.
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Post by stratton »

Rick Ferri wrote:Now, my comment does not anwer the question of whether one should invest in HY. That is a subjective decision. I beleive investing in HY as a unique asset class can help a portfolio in the long-term. Others do not. It is fair to ask that question, but it is a different question
My point is this doesn't matter. During a down market and the following recovery HY has equity like behavior. Even if it (appears to?) anticipates equity behavior it still has similar risks. I even agree that it provides diversification benefits as you're showing. Investors in HY need to be aware it can take a big dip like stocks. Even if its not at the same time.

Paul
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Post by linuxizer »

Here's what I wrote in the wiki:
While high-yield bonds are a distinct asset class, with their own risk and reward characteristics, they have a higher correlation with equities than do investment-grade bonds. For an investment-grade bond, the growth prospects and future profitability of a company are somewhat irrelevant as long as they are judged to be sufficient to meet future bond obligations. For a high-yield bond (or for a stock), the value of the security is intimately linked to the exact state of future profitability. Therefore, junk bonds are much more sensitive to the particulars of the market's valuation of future financial prospects.

"The high-return characteristics and generally junior position in the capital structure makes this security class much closer to equity than traditional fixed income securities," according to Robert Long in the Handbook of Fixed Income Securities, 1991. He continues, "Financing techniques of recent years have developed a variety of instruments including bonds with equity interests, variable payments depending on operating results or commodity indexes, extendable maturities, resettable coupons, automatic conversion to equity, and other esoteric features that further blur the traditional distinction between bonds and stocks."

At the same time, high yield bonds have as a category had returns which cannot be replicated by simply averaging corporate bonds and equity results, and therefore cannot merely be a hybrid of the two categories. Rick Ferri points out the 1st Quarter 2009 Vanguard Results: +4.6% = High Yield bonds (VWEHX) +0.1% = Intermediate-Treasury (VFITX) -10.7% = US Total Stock Market (VTSMX) -18.1% = US Small Value (VISVX)

In All About Asset Allocation, Ferri states that, "Statistically, only about 25 percent of the default risk in high-yield corporate bonds can be attributed to the same factors affecting equity returns; however the results are not statistically significant. If you allocate 10 percent of your total portfolio to one of the B-BB rated bond funds listed at the end of the chapter, at most perhaps 2 percent of that could be considered equity related. ... That being said, very-low-quality bond funds (those with an average credit quality of CCC or less) do have a higher correlation with equity returns."
Further revision/correction/refinement of this topic on the wiki by everyone here who has been kind enough to share your enlightened opinion would be appreciated, and would help move future discussions forward rather than rehashing the basics. If you are not already a wiki editor, send a PM to http://www.bogleheads.org/forum/privmsg ... =post&u=42 .

Thanks,
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Post by bilperk »

stratton wrote:
Rick Ferri wrote:Now, my comment does not answer the question of whether one should invest in HY. That is a subjective decision. I beleive investing in HY as a unique asset class can help a portfolio in the long-term. Others do not. It is fair to ask that question, but it is a different question
My point is this doesn't matter. During a down market and the following recovery HY has equity like behavior. Even if it (appears to?) anticipates equity behavior it still has similar risks. I even agree that it provides diversification benefits as you're showing. Investors in HY need to be aware it can take a big dip like stocks. Even if its not at the same time.

Paul
Paul,

Why then in 2000-2002 did VWEHX return -.88%, +2.9%, and +1.73% while TSM returned -10.57, -10.97, and -20.96 ?

Where was the equity like behavior in the last bear that wasn't driven by credit issues?
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Post by Robert T »

.
Okay, here’s the point I was trying to make earlier (made here with monthly data).
Rick Ferri wrote:It PROVES that high yield is NOT strictly a hybrid stock/bond security, which is the single biggest complaint that the naysayers have about this asset class. HY has some unique risk and return characteristics that cannot be attributed to stocks or bonds, and having a small amount in a portfolio should benefit a portfolio in the long-term. I have been saying this for more than decade. Last year proves my point.
FWIW - the other side of the argument/complaint often put forward: HY risks show up at the wrong time (i.e. when diversification is needed the most). And sticking with recent performance, some could argue that it proves this point.

Code: Select all

 
            Russell   iBoxx $ Liquid 
             3000    High Yield Index 

Jan-08      -6.06         -1.97
Feb-08      -3.11         -0.72
Mar-08      -0.59         -0.19
Apr-08       5.00          3.89
May-08       2.05          0.54
Jun-08      -8.25         -3.78
Jul-08      -0.80         -0.26
Aug-08       1.55          0.12
Sep-08      -9.40         -7.44
Oct-08     -17.74        -17.28
Nov-08      -7.89         -7.11
Dec-08       1.91          9.77

2009        28.33         44.45

Source:  iShares website
Yes, perhaps a different question.
.
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Post by Rick Ferri »

Robert T

Please continue with your data and show each month in 2009 so we can all see what happened to HY in the first quarter while equity tanked.

Rick Ferri
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Post by Robert T »

.
Here it is:

Code: Select all

            Russell   iBoxx $ Liquid 
             3000    High Yield Index 

Jan-09      -8.39        6.30
Feb-09     -10.48       -4.25

Same source as earlier post
.
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Post by nisiprius »

Please recall, the original poster's question was not whether high-yield bonds were good or bad or whether they helped lower portfolio volatility through diversification. The original poster asked a simple question:
faltuk1 wrote:Hi Yield bond funds - Do you consider them part of bond allocation or equity allocation?
Rick, others, could you please answer this?

When you describe asset allocation, do you put high-yield bonds in their own segment of the pie chart--stocks, investment-grade bonds, high-yield bonds, cash? Stocks, investment-grade bonds, cash, and "other?"

If for any reason you need to state allocation simply as stocks, bonds, and cash, in which category do you place high-yield bonds, and why?
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Post by Rick Ferri »

nisiprius wrote:When you describe asset allocation, do you put high-yield bonds in their own segment of the pie chart--stocks, investment-grade bonds, high-yield bonds, cash? Stocks, investment-grade bonds, cash, and "other?"
HY is part of a bond allocation - because that is what they are - bonds. This is no different than baving utility stocks as part of a stock allocation even though they have bond characteristics at times.

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Post by Robert T »

.
Just to revisit an earlier analysis: Here’s the FF5 factor analysis on the Vanguard High Yield Fund

Code: Select all

Factor loads: January 1979 to December 2004 (t-stats in parentheses)

Market (Mkt-Rf)   0.20   (10.7)
Size (SmB)        0.11    (4.8)
Value (HmL)       0.13    (4.7)
Term              0.41   (15.8)
Default           0.72    (9.5)

R^2               0.64

So for the above listed period about two thirds of the variation in the Vanguard HY fund was due to factor exposure, reflective of a 20:80 equity:bond allocation, with the equity portion having a 0.57/0.64 size and value factor load (i.e. small value similar to a S&P600 value type exposure), and the bond portion having a 0.51/0.89 term and default factor load (i.e. intermediate term bond, with high default risk).

What explains the remaining one third of the return variation in the HY fund? One possible explanation is Vanguard’s active management. The Vanguard HY fund does not track its benchmark that closely (as seen on the Vanguard site), and if I recall there were earlier concerns about reasons for NAV declines. The other explanation is unique risk – as suggested by Rick. But if so, this risk does not seem to have been compensated with premium returns. The average value, or monthly returns, of the residual variation unexplained by the five factors was negative for this 25 year period implying no direct compensation for ‘unique’ risk, if indeed that’s what it is. Was there an indirect compensation through additional diversification returns from including the Vanguard HY fund? Its hard that see that this was the case, as the residual ‘risks’ seem to show up at the wrong time i.e. when the Vanguard HY fund underperformed the factor simulated portfolio by large amounts the average equity premium was also negative (and when there were large declines in the equity premium (e.g. between -5% to -10% monthly loss, and above a 10% monthly loss, the average residual ‘risk’ was correspondingly more negative). Now there will be some months where the HY outperforms as in January 2009, but on average, at least historical this does not seem to have added much value. Obviously no guarantees the future will be like the past. Just my take.

FWIW - here's another analysis that may be of interest. Explaining the Rate Spread on Corporate Bonds

Robert

PS: added t-stats to table results
Last edited by Robert T on Wed Jan 06, 2010 1:46 pm, edited 1 time in total.
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Post by ddb »

Robert T wrote:.
Just to revisit an earlier analysis: Here’s the FF5 factor analysis on the Vanguard High Yield Fund
Hi Robert, do you know where one can locate the historical factor values for term risk and credit risk, ideally on a monthly basis? The Ken French online data library appears to only maintain the equity factors.

Thanks!
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Post by Rick Ferri »

Robert T wrote:.
Just to revisit an earlier analysis: Here’s the FF5 factor analysis on the Vanguard High Yield Fund

Code: Select all

Factor loads: January 1979 to December 2004

Market (Mkt-Rf)   0.20
Size (SmB)        0.11
Value (HmL)       0.13  
Term              0.41 
Default           0.72

R^2               0.64

So for the above listed period about two thirds of the variation in the Vanguard HY fund was due to factor exposure, reflective of a 20:80 equity:bond allocation, with the equity portion having a 0.57/0.64 size and value factor load (i.e. small value similar to a S&P600 value type exposure), and the bond portion having a 0.51/0.89 term and default factor load (i.e. intermediate term bond, with high default risk).

What explains the remaining one third of the return variation in the HY fund? One possible explanation is Vanguard’s active management. The Vanguard HY fund does not track its benchmark that closely (as seen on the Vanguard site), and if I recall there were earlier concerns about reasons for NAV declines. The other explanation is unique risk – as suggested by Rick. But if so, this risk does not seem to have been compensated with premium returns. Robert
.
This is good analysis (because it agrees with what I have been saying for years!)

+First, in my book All About Asset Allocation, I stated that equity accounted for about 25% of HY return. Robert's analysis finds it has been about 20%.

+Second, he points out the VWEHX performance has been disappointing for many decades. And he is correct, the fund has been disappointing. I will point out that Vanguard benchmarks the fund against the wrong HY index, so that is no help. It should be benchmarked to comparable B-BB rated index, not a total HY index that includes lower quality C rated bonds. None the less, the fund has underpeformed the Merrill Lynch B-BB index for many years (a proper benchmark) and by a measurable amount.

+Third, he suggests that perhaps VWEHX is not well managed, AND THAT IS A VALID EXPLANATION. I spent many hours on the phone in 2007 complaining to Vanguard that, IMO, Wellington was not doing a good job managing the portfolio. I wanted to know how long the trustees would let the fund underperform before seeking out a new manager or switching to an index track. The management people I talked with at Vanguard had absolutely no interest in hearing this complaint. I got the sense that any critical discussion about terminating Wellington was off limits. IMO, there is a conflict with the Trustees if they refuse to address the performance issue because Wellington is untouchable.

+Fourth, if HY has unique risk, where is it? That is a good question. I'm still waiting for it (we could ask the same question about small cap). HY has only been around for about 30 years when Drexel Burman created the market for HY bonds. Perhaps that created over-valuations in HY, and perhaps in next 30 years there will be a risk premium. I don't know.

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Post by ddb »

Rick Ferri wrote:+First, in my book All About Asset Allocation, I stated that equity accounted for about 25% of HY return. Robert's analysis finds it has been about 20%.
I don't think that's what his analysis shows. He shows that the market loading factor for the Vanguard fund has been 0.2, which is different than saying that equity accounts for 20% of the return of high yield (the factor coefficients aren't designed to add up to 1).
Rick Ferri wrote:+Fourth, if HY has unique risk, where is it? That is a good question. I'm still waiting for it (we could ask the same question about small cap). HY has only been around for about 30 years when Drexel Burman created the market for HY bonds. Perhaps that created over-valuations in HY, and perhaps in next 30 years there will be a risk premium. I don't know.
Correct me if I'm wrong, but I think you should be saying that original-issue high yield bonds have been around for 30 years; so-called "fallen angels" could be found long before that, i.e. debt that was issued at investment-grade but suffered a decline in credit quality.

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Post by Rick Ferri »

ddb wrote:
Rick Ferri wrote:+First, in my book All About Asset Allocation, I stated that equity accounted for about 25% of HY return. Robert's analysis finds it has been about 20%.
I don't think that's what his analysis shows. He shows that the market loading factor for the Vanguard fund has been 0.2, which is different than saying that equity accounts for 20% of the return of high yield (the factor coefficients aren't designed to add up to 1).
- DDB
You are correct. I'm not sure how to convert the 0.2 number to something relevant. The number does confirm equity characteristics using this long-term linear regression model, and I have never refuted that. What is debatable is the amount of equity, and when. We do know that it varies over different parts of the economic cycle. I have found there is low correlation at turning points in the economy, and higher correlation during the upward and downward parts of the cycle.
ddb wrote:
Rick Ferri wrote:+Fourth, if HY has unique risk, where is it? That is a good question. I'm still waiting for it (we could ask the same question about small cap). HY has only been around for about 30 years when Drexel Burman created the market for HY bonds. Perhaps that created over-valuations in HY, and perhaps in next 30 years there will be a risk premium. I don't know.
Correct me if I'm wrong, but I think you should be saying that original-issue high yield bonds have been around for 30 years; so-called "fallen angels" could be found long before that, i.e. debt that was issued at investment-grade but suffered a decline in credit quality. - DDB
There was a new issue market prior to the 1980s, but it was deep over-the-counter market and very illiquid. Drexel basically created the liquid secondary market for HY debt by creating a large primary market during the LBO craze in the 1980s. I recall the day Drexell crashed and burned. There was no trading in HY because no one else was making a market in these bonds.

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AAAA

Post by EyeDee »

Rick Ferri wrote:
Robert T wrote:. . . So for the above listed period about two thirds of the variation in the Vanguard HY fund was due to factor exposure, reflective of a 20:80 equity:bond allocation, . . .
This is good analysis (because it agrees with what I have been saying for years!)

+First, in my book All About Asset Allocation, I stated that equity accounted for about 25% of HY return. Robert's analysis finds it has been about 20%.
.
Rick,

Although you do use 25% in "All About Asset Allocation" copyright 2006 for general junk bond, your recommendation for Vanguard's High Yield matches Robert T analysis of 20%. On pages 146-147, you say "Statistically, only about 25 percent of the default risk in high-yield corporate bonds can be attributed to the same factors affecting equity returns", but say if you use a higher quality junk bond like those referenced at end of chapter which includes Vanguard's High Yield you put it at 20%. You point out that if you use a very low quality junk bond funds you recommend 40% be part of equity allocation.

You and Robert T definitely agree.
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Re: AAAA

Post by Rick Ferri »

EyeDee wrote:..if you use a very low quality junk bond funds you recommend 40% be part of equity allocation?
You have to consider the 'total risk' in your portfolio, and the amount and type of HY you have is definitely a factor. There is no doubt that the lower down the high yield totem pole you go, the more equity-type risk is present. That said, the high equity correlations tend to show up during parts of the economic cycle, not the entire cycle.

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Re: AAAA

Post by EyeDee »

Rick Ferri wrote:
EyeDee wrote:..if you use a very low quality junk bond funds you recommend 40% be part of equity allocation?
You have to consider the 'total risk' in your portfolio, and the amount and type of HY you have is definitely a factor. There is no doubt that the lower down the high yield totem pole you go, the more equity-type risk is present. That said, the high equity correlations tend to show up during parts of the economic cycle, not the entire cycle.

Rick Ferri
.
I agree. I was just pointing out your comment about low quality junk to give the broader spectrum of your comments in your book.
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Re: AAAA

Post by ddb »

EyeDee wrote:Although you do use 25% in "All About Asset Allocation" copyright 2006 for general junk bond, your recommendation for Vanguard's High Yield matches Robert T analysis of 20%. On pages 146-147, you say "Statistically, only about 25 percent of the default risk in high-yield corporate bonds can be attributed to the same factors affecting equity returns", but say if you use a higher quality junk bond like those referenced at end of chapter which includes Vanguard's High Yield you put it at 20%. You point out that if you use a very low quality junk bond funds you recommend 40% be part of equity allocation.

You and Robert T definitely agree.
Robert's linear regression analysis does not attempt to answer what percentage of high yield returns has historically come from an equity/credit risk component, so there's nothing to agree on there.

A linear regression simply tries to explain a series of data by assigning coefficients to certain inputs, and then testing whether one can reject the null hypothesis that the coefficient values are equal to zero. There is no information given on the significance of the coefficients for each of the five factors, so I don't even know if any of them are useful. Still, a coefficient of 0.2 does not mean that the particular factor explains 20% of anything.

Plus, as Robert points out, the low R-squared value means that only 64% of the variance (not returns) of the Vanguard High-Yield fund is explained by the FF 5-factor model.

I guess my bottom line on this particular analysis is that due to the low R-square value and the lack of significance information for the factor coefficients, there aren't many useful interpretations that can be made (particularly when you throw the "active management" wrench into the mix!).

Edit to add: Common Risk Factors in the Returns on Stock and Bonds by Fama and French also looks at this issue. See page 28 (table 7b) for a regression analysis on LowGrade bonds. Similar findings as Robert.

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Post by Robert T »

.
Hi Robert, do you know where one can locate the historical factor values for term risk and credit risk, ideally on a monthly basis?
They can be calculated from the Ibbotson Yearbook following the Fama-French TERM and DEFAULT definitions. Unfortunately Ken Frech doesn't have these on his website for easier access.

On the interpretation of the 0.2 equity (market) load.

I think I have the interpretation correct. It closely corresponds to the implied stock:bond allocation i.e. a 0.2 equity load ~ 20:80 equity:bond allocation, a 0.3 equity load ~ 30:70 equity:bond allocation etc (IMO that’s also the implication of low beta stocks). For example the market load on a 20:80 Russell 2000 Value:Intermediate Treasury = 0.19 (as in the table example). And fairly close approximations of the equity size and value loads can be derived as follows (from the last column results in the table bleow): size load = 0.13/0.19 = 0.68, value load = 0.12/0.19 = 0.63, which are not too far off the equity factor loads of the Russell 2000 Value over this period (0.66 and 0.61 respectively in the first column in the table below). And the fixed income term load = 0.29/(1-0.19) = 0.36 (derived from the last column in the table), which is the same term load on the 100% LB Intermediate Treasury over this period (second column in the table). This is how I reported/interpreted the earlier results (have added the t-stats to the earlier table.

Code: Select all

Example: February 1979 to December 2004

                                     ALLOCATION

Russell 2000 Value            100%        0%        20%     
LB Intermediate Treasury        0%      100%        80%

FACTOR LOADS for each allocation:

Market                       1.00          -      0.19          
Size                         0.66          -      0.13  
Value                        0.61          -      0.12
Term                            -       0.36      0.29

Robert
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