Credit Risk

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Robert T
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Credit Risk

Post by Robert T »

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An example of credit (or default) risk showing up at the same time as general equity risk (table below). IMO not an appealing characteristic for a fixed income allocation (in an equity dominated portfolio).

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Vanguard Funds           YTD Return 
                           9/16/08

LT Treasury                 +7.7
IT Treasury                 +6.3
ST Treasury                 +4.1

ST Investment Grade         -0.6         
IT Investment Grade         -2.6     	  
LT Investment Grade         -2.4         

HY Corporate                -3.8

US TSM                     -15.1
Developed Market           -25.1
EM Stocks                  -34.5

Robert
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larryswedroe
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Post by larryswedroe »

Robert
And things could get lot worse

Example--already this year 134 LBOs have blown up--and many more almost certainly will follow

Reasons--they financed with ST debt that will not be rolled over. They often leveraged at 6-8x and now banks wont lend at that multiple and spreads will be wider. So you will see failures. Same for junk bonds in general---the terms will get tougher and those that mature will have hard time rolling over. IMO the default rates will rise significantly--at least risk of that is high. Those relying on historical default rates might be badly hurt.

Note same issue is arising with preferreds as liquidity becomes king and risks show up
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Post by stratton »

Here's the muni funds. Long term doesn't look so good either.

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Vanguard Funds                   YTD Return 
                                   9/16/08 

High-Yield Tax-Exempt               -0.4
Insured Long-Term Tax-Exempt        -0.3
Long-Term Tax-Exempt                +0.4 
Intermediate-Term Tax-Exempt        +2.0
Limited-Term Tax-Exempt             +3.1
Short-Term Tax-Exempt               +2.8
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Post by SmallHi »

As someone who doesn't think Treasuries are particularly necessary in a balanced portfolio (TIPS are fine I guess, but I prefer ST Credit to ST Treasury), I thought I would add some perspective for the equity oriented investor who mistakenly feels like they are missing something by not being in Treasuries:

a) For an investor who is 75% Equity, 25% Fixed utilizing ST bonds as a portfolio stabilizer, there is very little difference in performance for your portfolio between Treasuries and high quality Corporate bonds. Assume 50% TSM, 35% EAFE, and 15% EM for equities, diluted with either ST Treasuries or ST Investment Grade...here are the YTD returns:

w/ST Treasuries = (15.11%)
w/ST Investment Grade = (16.28%)

So, regardless of your bond choice, you are getting your rear end handed to you. If that 1.2% difference means that much to you, you are probably to aggressively invested to begin with.

Just to give you an idea of how small a 1.2% advantage is, I thought I would indicate a few other steps that could have led to a similar advantage:

a) Tilt more to US/Developed stocks -- a more conservative equity allocation (60% US, 30% EAFE, 10% EM) when combined with 25% ST Investment Grade Bonds is only down 15.2% for the year. Thats also a 1.2% advantage.

b) Instead of only using TSM for US exposure, an allocation of 25% TSM, 25% SV; 35% EAFE, and 15% EM when combined with 25% ST Investment Grade bonds is only down 14.3% for the year. Thats almost a 1% difference.

c) Only invest in non-socialist Emerging Market Countries (exclude Russia). A 50% TSM, 35% EAFE, 15% EMxRussia portfolio is down 0.8% less than one that uses EM (including Russia).

OK, so that last one was more tongue in cheek than anything. But here are just a few thoughts:

1) ST AAA/AA bonds are not going to 0.

2) Its unfortunate you haven't made as much money in the short term with your corporate bonds as you could have w/treasuries. But if you want to rebalance back into stocks, you can sell Vanguard ST Investment Grade at NAV just as you can sell Vanguard ST Treasury @ NAV. The main driver of your returns over time is not if you own Treasuries or Corp's, but if you rebalance at times like this.

3) the expected Credit premium based on today's yields for high quality corporate bonds over treasuries is about +2.5%. (ST IG yield = 4.7%, ST Treas yield = 2.2%)

4) under almost any reasonable inflation expectation, ST treasuries are exposing you to negative real returns over the next few years (which is more important than what happens over the next few months).

5) most of this credit underperformance has happened this month. Certainly Treasuries have outpaced Corps for much of the last year, but just this month have we seen things really spread out -- just tune out for the next month or two...its hard to believe things won't stabilize somewhat.

Not a big deal, as I see it. I'd love to be as excited about Treasuries as everyone else seems to be...I'm just not that short term oriented.

sh

PS -- my interest in credit risk does not extend to lower quality investment grade bonds (BBB), or junk bonds. I certainly share Robert and Larry's beliefs that EM bonds are also not worth it... AAA/AA just seems OK to me: a bit higher risk (duh!), a bit higher reward.

edited to fix number miscalculations (in bold)
Last edited by SmallHi on Thu Sep 18, 2008 3:21 pm, edited 2 times in total.
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G12
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Post by G12 »

SH, thanks for the post. I would imagine for those with high exposure to developed foreign, EM, and small foreign this year has not been enjoyable at all even if they are sitting on bags of cash or T-bills to redeploy/rebalance. The dollar FX swings haven't helped this matter, either. This market definitely lends credence to lack of benefit from foreign diversification in a volatile bear market. A 30% foreign allocation has been enough for me no matter what form of fixed income I invest in.

Decoupled EM's, what a crock, give the CNBC and Fox news people another raise for spewing nonsense. Hang in there, it has to get better at some point.
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Post by SmallHi »

G12 wrote:SH, thanks for the post. I would imagine for those with high exposure to developed foreign, EM, and small foreign this year has not been enjoyable at all even if they are sitting on bags of cash or T-bills to redeploy/rebalance. The dollar FX swings haven't helped this matter, either. This market definitely lends credence to lack of benefit from foreign diversification in a volatile bear market. A 30% foreign allocation has been enough for me no matter what form of fixed income I invest in.

Decoupled EM's, what a crock, give the CNBC and Fox news people another raise for spewing nonsense. Hang in there, it has to get better at some point.
G12,

My only point, really, is that the equity decision, and small tweeks on the stock side, matter alot more in the short term and the long term.

sh
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Post by G12 »

SH, I understood your point, thus the comment on foreign equity and dollar swing. Don't get me wrong, I would choose to minimized FI losses, but it pales in comparison to losses tied to significant equity exposure. :wink:
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Post by Robert T »

.
Sh,
For an investor who is 75% Equity, 25% Fixed utilizing ST bonds as a portfolio stabilizer, there is very little difference in performance for your portfolio between Treasuries and high quality Corporate bonds. Assume 50% TSM, 35% EAFE, and 15% EM for equities, diluted with either ST Treasuries or ST Investment Grade...here are the YTD returns:

w/ST Treasuries = (20.5%)
w/ST Investment Grade = (21.7%)
As your example was close to my equity:fixed income and regional allocation I decided to take a quick look. This is what I get

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YTD as of 9/16/08:

Vanguard Total Stock Market        -15.05
Vanguard Developed Market          -25.06
Vanguard EM                        -34.48

Vanguard ST Treasury                +4.10
Vanguard ST Investment Grade        -0.58

50:35:15 TSM:DevMkt:EM             -21.47

For a 75:25 equity:fixed income

With ST Treasury                   -15.08 
With ST Investment Grade           -16.25

Not a huge difference, but here’s another way to look at it. An 80:20 equity:ST Treasury portfolio would have declined by the same as a 75:25 equity:ST investment grade (-16.35 vs. -16.25), or a 70:30 equity:ST investment grade would have declined by the same as a 75:25 equity:ST Treasury (-15.08 vs. -15.20). IMO credit risk is better taken on the equity side than in fixed income (just my opinion of course). And from the above numbers the difference with your a,b, & c examples will probably be much smaller.

Robert
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Ariel
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Post by Ariel »

Robert T wrote: ... Not a huge difference, but here’s another way to look at it. An 80:20 equity:ST Treasury portfolio would have declined by the same as a 75:25 equity:ST investment grade (-16.35 vs. -16.25), or a 70:30 equity:ST investment grade would have declined by the same as a 75:25 equity:ST Treasury (-15.08 vs. -15.20). IMO credit risk is better taken on the equity side than in fixed income. And from the above numbers the difference with your a,b, & c examples will probably be much smaller.
Robert - Nice explanation and illustration of why corporate bonds, even investment-grade bonds, have an equity-like component. It's especially true for junk, of course, but during times like these, investment grade and junk can be difficult to tell apart :oops:
Do what you will, the capital is at hazard ... - Justice Samuel Putnam (1830), as quoted by John Bogle (1994)
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Post by larryswedroe »

Another important point
equity risk can be more effectively diversified--owning thousands of stocks, far more than a very high grade bond fund can own---so less unsystematic risk

To SH's point, very high grade bonds have very little equity risk and of course very little risk premium---but you do get some liquidity premium (and that risk can show up) and you get the state tax premium--a free lunch for tax advantaged accounts.

But you also take some other risks--call risks (another reason to stay short, reducing that risk) and EVENT risk--like your strong credit gets acquired by a WEAKER credit (LBO for example) and you are SCREWED, so some of that extra yield is also REAL RISK

IMO just not really worth it, but not a bad risk either--not like junk bonds or preferreds IMO. At least EM bonds get you some unique diversification benefits which junk and preferreds do not.
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Post by SmallHi »

Just wanted to mention I edited my post above to adjust some of the numbers. Good catch by Robert T on my mistakes.

Also, interestingly, in a year where credit risk (even high quality AAA/AA) is showing up, you are seeing a significant premium for small cap and value risk. Even though SV is negative, its off less than half of what TSM is.

This, incidentially, speaks to the very low, and in some senses negative correlations between equity, size, value, term, and credit risk...

sh
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Post by diasurfer »

SmallHi wrote: Also, interestingly, in a year where credit risk (even high quality AAA/AA) is showing up, you are seeing a significant premium for small cap and value risk. Even though SV is negative, its off less than half of what TSM is.
why do you think this is? I thought small value was supposed to get harder in tough times, and more than make up for it in good times. But in this bear they aren't hit as hard. Less exposure to the financial mess?
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Post by gkaplan »

Vanguard Small Value Index Fund holds over thirty-one percent in the financial sector.
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Post by SmallHi »

Well, for one, Vanguard SV holds a fair chunk of REITS, which bottomed early this year and (up until this week) were actually showing a gain. Not that they've done particularly well, they just started falling sooner (Feb of 2007).

And thats kinda the case for SV overall. It started to fall about 3 months or so before the overall market (the high for SV was July, TSM was October). So 2007 was much worse much sooner for SV.

Overall, however, this is actually what you'd expect, because SV stocks are very economically sensitive and tend to be more cyclical in nature. They tend to fall first, and recover first (and quicker). As a matter of fact, one of the best indiciators of a market recovery is when SV starts to outpace LG. This started happening in July of this year...and if the "3 months early/3 months late" trend holds true, you may expect a market recovery to fully begin in October or so?

SV could of course just hold up better in a falling market (if things get worse), as was the case in 1974 and 2002...before the real recovery begins.

stay tuned!

sh
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Post by Robert T »

.
Few more thoughts on credit risk…

Even the highest quality corporate bonds seem to have elements of equity risk
  • Fama-Fench find that 14-18% of the variation in monthly corporate bond returns from 1963 to 1991 was explained by ‘equity risk’. For even the highest quality bonds (AAA), 14% of the variation in returns was explained by ‘equity risk' (table below).

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July 1963 – December 1991

                    Equity (Mkt-Rf)  
Bond Quality            Loading      (t-stat)          R^2

   AAA                   0.19         (7.53)           0.14
   AA                    0.20         (8.14)           0.16
   A                     0.21         (8.42)           0.17
   Baa                   0.22         (8.73)           0.18

Source: Common Risk Factor in the Returns on Stocks and Bonds – by Fama-French

  • From Swensen from Pioneering Portfolio Management: "Even the highest-quality corporate obligations contain elements of equity risk, since a company’s ability to meet fixed obligations depends on its continuing corporate health. In the extreme case of bankruptcy, bonds frequently take on pure equity attributes, as control of corporate assets moves from the previous owners to the holders of defaulted debt obligations".
….and stocks seem to have historically provided slightly more exposure to default risk than bonds

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                                           Default
Bond Quality                               Loading  
   AAA                                       0.94           
   AA                                        0.96           
   A                                         1.02           
   Baa                                       1.10           

Average across 25 FF Equity Portfolios       1.17

Source: Common Risk Factor in the Returns on Stocks and Bonds – by Fama-French

…so IMO no need to take default risk in a fixed income allocation as significant exposure is already provided in equities.
  • The opportunity cost (in terms of lower expected return) of a fixed income allocation is high, so why not limit its share by just holding bonds with characteristics that provide the best protection (insurance) against extreme conditions (as reflected in the earlier example)? Just something to consider.
Robert
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Post by BlueEars »

To add a little data to this thread, here are the 1 week and 3 month returns for a few types of VG short term bond funds:

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VFSTX -0.57%  -1.81%   investment grade
VFISX +0.52%  +2.65%   treasury
VSGBX +0.07%  +2.42%   federal

VTSMX -2.85%  -9.24%   total stock market
I agree with what SH has said that the bond part of the portfolio isn't going to strongly impact the overall if equities are falling off a cliff in a bear market. But for many investors, myself included, when this extreme volatility comes up those safe bonds are a major source of comfort.

Also, a minor point, during the equity decline from Oct 07 to about Feb 08 the big decline in real rates cushioned my portfolio a lot because I had a big TIPS weighting. So there was some real help in maintained the overall return.
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Post by SmallHi »

Robert,

Interesting thoughts, as always.
Fama-Fench find that 14-18% of the variation in monthly corporate bond returns from 1963 to 1991 was explained by ‘equity risk’. For even the highest quality bonds (AAA), 14% of the variation in returns was explained by ‘equity risk' (table below).
Looking at 5YR T-Notes over this same period, we find that the loading on the market factor is +0.10, and equity risk explains aproximately 7% of the returns. Clearly less than corporate bonds (even AAA), but not exactly worlds apart.

In order to avoid any "equity risk", you had to look at 1YR T-Notes -- ie. short durations.
The opportunity cost (in terms of lower expected return) of a fixed income allocation is high, so why not limit its share by just holding bonds with characteristics that provide the best protection (insurance) against extreme conditions (as reflected in the earlier example)? Just something to consider.
Thats one way to look at it, and for investors who look at their accounts daily (which seems like most) or even weekly, you probably should adopt a default free Treasury bond portfolio to dilute stocks.

However, its not a free lunch. AAA corporate bonds offer a credit risk premium (that shows up in times of severe liquidity crisis)...and this has annualized at about 0.60% annually (73-07)* (comparing LEH Treasury with LEH Credit Indexes). Treasury bonds have only outpaced Credit bonds in some downturns (73-74, 90, and 07-08, but not 81-82 or 00-02).

sh

*this is biased somewhat as it looks at bear market to bear market.

assuming yields offer some indiciation of future maturity/credit premiums, high quality bonds now offer risk premiums of 3X as much as the historical average
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Post by SmallHi »

Les wrote:To add a little data to this thread, here are the 1 week and 3 month returns for a few types of VG short term bond funds:

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VFSTX -0.57%  -1.81%   investment grade
VFISX +0.52%  +2.65%   treasury
VSGBX +0.07%  +2.42%   federal

VTSMX -2.85%  -9.24%   total stock market
I agree with what SH has said that the bond part of the portfolio isn't going to strongly impact the overall if equities are falling off a cliff in a bear market. But for many investors, myself included, when this extreme volatility comes up those safe bonds are a major source of comfort.

Also, a minor point, during the equity decline from Oct 07 to about Feb 08 the big decline in real rates cushioned my portfolio a lot because I had a big TIPS weighting. So there was some real help in maintained the overall return.
Les,

I am not against treasuries. I am against the behavior they promote. The winning behavior is not to load up on assets that perform well in crisis. It's to not market your portfolio to market every day during the crisis. There is nothing that says you have to be this obsessive about checking balances. And this "treasury behavior" holds seeds of its own destruction. My personal opinion is that most investors have too much in fixed income to begin with -- and this daily monitoring tendency only perpetuates this. There is no benefit to knowing the exact behavior differences between corporate bonds and treasuries this week. This week! That sounds silly just typing it!

I can tell you, AAA corporates vs. Treasuries in a balanced portfolio make almost 0 difference longer term. One portfoliio will have slighlty higher returns/volatility than the other. Thats it. To trumpet the benefits of an asset class on a particular day or week is borderline insanity IMO for those who claim to be long term investors. Sure, Junk bonds and long term bonds are a different beast, and "take a good thing too far".

Guess the last time I checked our families' portfolio balanances? I honestly cannot remember. Sometime this summer I think? There is without a doubt a negative correlation between how often you check your portfolio and how well you do.

sh
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Post by bookshot »

Smallhi, I would like to agree with you but...
I don't see any evidence that most people have too little in equities. Perhaps that's true in general, but its' not my experience. Do you have any stats? Most working people seem to have an almost mystical belief (until lately) that stocks simply must go up in the long run - after all, that's what history, the talking heads and their advisors tell them. Most retired people I know definitely have too much there - up to 100% - because they fail to differentiate between accumulation and distribution.
Also, I have been a proponent of highly rated corporate bonds, especially ST. But perhaps that isn't rational if as you say long term returns are essentially the same, while they expose you to catastrophic loss, which for all we know now was what we were (are?) facing.
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Post by SmallHi »

bookshot wrote:Smallhi, I would like to agree with you but...
I don't see any evidence that most people have too little in equities. Perhaps that's true in general, but its' not my experience. Do you have any stats? Most working people seem to have an almost mystical belief (until lately) that stocks simply must go up in the long run - after all, that's what history, the talking heads and their advisors tell them. Most retired people I know definitely have too much there - up to 100% - because they fail to differentiate between accumulation and distribution.
Also, I have been a proponent of highly rated corporate bonds, especially ST. But perhaps that isn't rational if as you say long term returns are essentially the same, while they expose you to catastrophic loss, which for all we know now was what we were (are?) facing.
Well, I don't have any studies on the matter. I just know there is a thread currently out there with at least a few hundred posts talking about how suicidal it is to have 100% stocks. I doubt there are but a few diehards with 100% stocks. Most diehards are 75% in stocks or less, with many still following the "100-age" formula instead of their particular situation.

Others have followed this flawed "if I loose more than X, I'll panic. anything less than X is fine"...which we see the clear issues with today (every investor from 100% equity to 20% equity is nervous -- its the enviroment, not the portfolio).

Finally, high quality corporate bonds have higher returns than treasuries, and its a very reliable premium. Only in severe downturns and liquidity crises do Treasuries outperform. We are going through arguably the worst one we've ever seen, and we are still talking about a 4% to 6% advantage...not 20% or 30%.

On a portfolio level I said: stocks/corps and stocks/treasuries doesn't make much difference. The former offers slightly higher returns, the later better "insurance" -- but at a cost. To expect their to be a free lunch in treasuries is just out of touch with long term market equilibrium. Long term, I do expect stocks to beat bonds, and handily...as Robert alluded to above. Market economies (in whatever form) are resiliant, and have a way of rewarding the cost of capital with a fair reward...

I know this much -- the 73-81 period was a long drawn out period of economic distress....and investors probably jumped on Treasuries as they outpaced high quality corp's by almost 0.50% a year. From 1982 through the end of 2006, we saw Leh Credit outpace Leh Treasury by 1% per year. Certainly things have not worked well for Credit bonds on a relative basis in the last year or two...but leaving 1% (using 82-06 as a guide) of credit premium on the table doesn't seem sensible -- especially today!

sh
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Post by ddb »

SmallHi wrote:I know this much -- the 73-81 period was a long drawn out period of economic distress....and investors probably jumped on Treasuries as they outpaced high quality corp's by almost 0.50% a year. From 1982 through the end of 2006, we saw Leh Credit outpace Leh Treasury by 1% per year. Certainly things have not worked well for Credit bonds on a relative basis in the last year or two...but leaving 1% (using 82-06 as a guide) of credit premium on the table doesn't seem sensible -- especially today!
SH, yes corporate bonds should outperform treasuries of similar maturity. Not a free lunch, though. To take a more extreme form of your example, an investor would have been even better off with high-yield bonds; doesn't mean it was a wise move.

Also, as Robert already pointed out, the above "problem" you cite could be rectified by using treasury-only for the fixed income portion, but increasing your equity allocation to make up for the lost fixed income returns. And as Larry points out, this provides much greater diversification to your equity risk than you would get with a typical corporate bond fund.

- DDB
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Post by SmallHi »

ddb wrote:
SmallHi wrote:I know this much -- the 73-81 period was a long drawn out period of economic distress....and investors probably jumped on Treasuries as they outpaced high quality corp's by almost 0.50% a year. From 1982 through the end of 2006, we saw Leh Credit outpace Leh Treasury by 1% per year. Certainly things have not worked well for Credit bonds on a relative basis in the last year or two...but leaving 1% (using 82-06 as a guide) of credit premium on the table doesn't seem sensible -- especially today!
SH, yes corporate bonds should outperform treasuries of similar maturity. Not a free lunch, though. To take a more extreme form of your example, an investor would have been even better off with high-yield bonds; doesn't mean it was a wise move.

Also, as Robert already pointed out, the above "problem" you cite could be rectified by using treasury-only for the fixed income portion, but increasing your equity allocation to make up for the lost fixed income returns. And as Larry points out, this provides much greater diversification to your equity risk than you would get with a typical corporate bond fund.

- DDB
DDB,

No, and this is important. Treasuries to AAA is NOT the same as AAA to Junk. Junk caries very high default rates, much higher yields, and high correlations with equities. AAA bonds offer slightly higher than treasury returns, better <within> asset class diversification, and slightly higher risk (they don't hold up as well in flight to quality scenerios). Contrary to popular opinion, credit risk and equity or value risk is not perfectly correlated. There is almost no correlation between high quality credit risk and equity risk. In maybe a few periods over a lifetime would you expect to see a difference -- and thats the risk.

This risk is fair, however, as we look today -- you are getting paid 2X as much to put up with some short term liquidity risk via high quality ST Investment Grade bonds. For a long term investor, you should be more than willing to assume this risk and reap the reward.

Its only when an investor gives up his chief advantage: a long term perspective (by checking things daily and observing daily or weekly credit/treasury behavior), that they turn their biggest advantage into their biggest disadvantage.

sh
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Post by Robert T »

.
Sh,
Looking at 5YR T-Notes over this same period, we find that the loading on the market factor is +0.10, and equity risk explains aproximately 7% of the returns. Clearly less than corporate bonds (even AAA), but not exactly worlds apart.
Yes Fama-French get the Beta of 1-5 Government bonds at 0.08, with ‘equity risk’ explaining 7% of the variation in excess returns (over the 1963-1991 time period). IMO illustrating a ‘not insignificant’ difference in ‘equity risk’ between Treasuries and AAA/AA bonds (more than seems to be often suggested). But I agree the gap between AAA/AA and junk bonds is larger.
In order to avoid any "equity risk", you had to look at 1YR T-Notes -- ie. short durations
Yes, because there is also term risk in stocks and bonds. But would argue that credit risk shows up more than term risk during times of financial crisis (e.g. Asian Crisis, current credit crunch…).
Thats one way to look at it, and for investors who look at their accounts daily (which seems like most) or even weekly, you probably should adopt a default free Treasury bond portfolio to dilute stocks.
My sense (from the threads on this forum) is that investors look at their portfolios more during extreme conditions. Not everyone's 'bullet-proof' (myself included).
However, its not a free lunch. AAA corporate bonds offer a credit risk premium (that shows up in times of severe liquidity crisis)...and this has annualized at about 0.60% annually (73-07)* (comparing LEH Treasury with LEH Credit Indexes). Treasury bonds have only outpaced Credit bonds in some downturns (73-74, 90, and 07-08, but not 81-82 or 00-02).
Yes, treasuries don’t always outperform, but they seem to help more during times of financial crisis.
assuming yields offer some indiciation of future maturity/credit premiums, high quality bonds now offer risk premiums of 3X as much as the historical average
Expected future equity returns are also now likely higher than they were at the beginning of the year (some of which is likely reflected in the higher expected corporate bond returns – following the FF research). And if an investor has a lower fixed income allocation (due to use of treasuries vs. corporate bonds for fixed income), then the expected portfolio returns are likely higher.

My current interest in credit risk is that we have an environment where we can assess the ex-ante expected performance of bonds of varying quality. The relative performance seems as expected (not based only on back-tested returns, but also on their fundamental characteristics). Interesting to see…

Robert
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Post by SmallHi »

Robert T wrote:.
Sh,
Looking at 5YR T-Notes over this same period, we find that the loading on the market factor is +0.10, and equity risk explains aproximately 7% of the returns. Clearly less than corporate bonds (even AAA), but not exactly worlds apart.
Yes Fama-French get the Beta of 1-5 Government bonds at 0.08, with ‘equity risk’ explaining 7% of the variation in excess returns (over the 1963-1991 time period). IMO illustrating a ‘not insignificant’ difference in ‘equity risk’ between Treasuries and AAA/AA bonds (more than seems to be often suggested). But I agree the gap between AAA/AA and junk bonds is larger.
In order to avoid any "equity risk", you had to look at 1YR T-Notes -- ie. short durations
Yes, because there is also term risk in stocks and bonds. But would argue that credit risk shows up more than term risk during times of financial crisis (e.g. Asian Crisis, current credit crunch…).
Thats one way to look at it, and for investors who look at their accounts daily (which seems like most) or even weekly, you probably should adopt a default free Treasury bond portfolio to dilute stocks.
My sense (from the threads on this forum) is that investors look at their portfolios more during extreme conditions. Not everyone's 'bullet-proof' (myself included).
However, its not a free lunch. AAA corporate bonds offer a credit risk premium (that shows up in times of severe liquidity crisis)...and this has annualized at about 0.60% annually (73-07)* (comparing LEH Treasury with LEH Credit Indexes). Treasury bonds have only outpaced Credit bonds in some downturns (73-74, 90, and 07-08, but not 81-82 or 00-02).
Yes, treasuries don’t always outperform, but they seem to help more during times of financial crisis.
assuming yields offer some indiciation of future maturity/credit premiums, high quality bonds now offer risk premiums of 3X as much as the historical average
Expected future equity returns are also now likely higher than they were at the beginning of the year (some of which is likely reflected in the higher expected corporate bond returns – following the FF research). And if an investor has a lower fixed income allocation (due to use of treasuries vs. corporate bonds for fixed income), then the expected portfolio returns are likely higher.

My current interest in credit risk is that we have an environment where we can assess the ex-ante expected performance of bonds of varying quality. The relative performance seems as expected (not based only on back-tested returns, but also on their fundamental characteristics). Interesting to see…

Robert
.
Agree 100%. Thanks for the thoughts. Have you begun to reconsider LT Treasuries vs. Int'd Term Treasuries? Just curious...as the current situation seems to play out as Swensons LT Treasury summary predicted it would...

over and out...

sh
Last edited by SmallHi on Fri Sep 19, 2008 2:53 pm, edited 1 time in total.
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Post by swaption »

SmallHi wrote:I know this much -- the 73-81 period was a long drawn out period of economic distress....and investors probably jumped on Treasuries as they outpaced high quality corp's by almost 0.50% a year. From 1982 through the end of 2006, we saw Leh Credit outpace Leh Treasury by 1% per year. Certainly things have not worked well for Credit bonds on a relative basis in the last year or two...but leaving 1% (using 82-06 as a guide) of credit premium on the table doesn't seem sensible -- especially today!

sh
Citing your example, you need to take into account that your hypothetical 1982 investor realized significant equity returns through 2006. While investing the bond allocation in treasuries may have left that 1% per annum on the table, it also offered a decent bit of portfolio insurance for the diversified protfolio, just on the off chance that the world had taken a different fork in the road in 1982. I'd much rather earn that risk premium in equities and use the bond portion for uncompromised safety, just in case history doesn't exactly repeat itself.
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Post by SmallHi »

swaption wrote:
SmallHi wrote:I know this much -- the 73-81 period was a long drawn out period of economic distress....and investors probably jumped on Treasuries as they outpaced high quality corp's by almost 0.50% a year. From 1982 through the end of 2006, we saw Leh Credit outpace Leh Treasury by 1% per year. Certainly things have not worked well for Credit bonds on a relative basis in the last year or two...but leaving 1% (using 82-06 as a guide) of credit premium on the table doesn't seem sensible -- especially today!

sh
Citing your example, you need to take into account that your hypothetical 1982 investor realized significant equity returns through 2006. While investing the bond allocation in treasuries may have left that 1% per annum on the table, it also offered a decent bit of portfolio insurance for the diversified protfolio, just on the off chance that the world had taken a different fork in the road in 1982. I'd much rather earn that risk premium in equities and use the bond portion for uncompromised safety, just in case history doesn't exactly repeat itself.
Except the fact that on average, 12 month downturns in a Global Equity portfolio were hedged better by Lehman Credit Index than Lehman Treasury Index (by a meaningless 0.13% on average), and a volatility adjusted Equity/Credit portfolio outpaced an Equity/Treasury portfolio by about 0.35% per year.

Other than that, treasuries were fine...

sh

legend:

Treasury Index = Lehman Intermediate Term Treasury Index
Corporate Index = Lehman Intermediate Term Credit Index

"12 month downturns" looked at over all rolling 12 month periods from 1982-2006 (n = 37/289)
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Post by BlueEars »

SmallHi wrote: Les,

I am not against treasuries. I am against the behavior they promote. The winning behavior is not to load up on assets that perform well in crisis. It's to not market your portfolio to market every day during the crisis. There is nothing that says you have to be this obsessive about checking balances. And this "treasury behavior" holds seeds of its own destruction. My personal opinion is that most investors have too much in fixed income to begin with -- and this daily monitoring tendency only perpetuates this. There is no benefit to knowing the exact behavior differences between corporate bonds and treasuries this week. This week! That sounds silly just typing it!
My purpose in showing the short term differentials between the various short term bond funds was just to highlight the behaviour during what all of us would agree is a crisis period. Probably short term investment grade will do just fine and especially over a period equal to the duration of the fund. We all have different tolerances for volatility and mine is probably about average. Age and whether you are retired and your general prosperity level, etc, etc. also have something to do with how you might view the volatility you want in your FI portfolio.
I can tell you, AAA corporates vs. Treasuries in a balanced portfolio make almost 0 difference longer term. One portfoliio will have slighlty higher returns/volatility than the other. Thats it. To trumpet the benefits of an asset class on a particular day or week is borderline insanity IMO for those who claim to be long term investors. Sure, Junk bonds and long term bonds are a different beast, and "take a good thing too far".
I'm going to assume you don't think I'm borderline insane :). This week was pretty insane in my opinion. I'm most concerned about the longer term behaviour of the FI part of the portfolio particularly in regard to the more extreme inflationary and deflationary environments. I like the TIPS + short term treasury strategies that Larry has discussed. Definitely would not go short term treasury merely as a reaction to a crisis such as today.
Guess the last time I checked our families' portfolio balanances? I honestly cannot remember. Sometime this summer I think? There is without a doubt a negative correlation between how often you check your portfolio and how well you do.
I check the balance weekly. I was close to a rebalancing point at the end of Wednesday and that also has me thinking about the stock/bond balance.

SH, a final point is that a very high percentage of Americans would probably not understand the minor details we are quibbling about. A lot of people would think we're all a bit insane for visiting a web site and good naturedly arguing over the fine points of investment portfolios.
Last edited by BlueEars on Fri Sep 19, 2008 4:22 pm, edited 1 time in total.
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Post by SmallHi »

Les,

I wasn't gonna post again, just wanted to say I don't think you (or anyone) is insane. I enjoy your posts.

sh
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Post by BlueEars »

SH, I very much enjoy your posts as well. Regards, Les.
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Post by swaption »

SmallHi wrote:Except the fact that on average, 12 month downturns in a Global Equity portfolio were hedged better by Lehman Credit Index than Lehman Treasury Index (by a meaningless 0.13% on average)
In situations like this, where the numbers seem to contradict common sense, my tendency is to question the numbers. There is no reasonable arguement to contradict that treasuries provide a better hedge to equities than corporates. I'm not necessarily questioning your calculations. My skepticism is more likely directed at the sufficiency of the data. There are some very bad scenarios where there are substantial hedging benefits for treasuries relative to corproates and perhaps these are not adequately represented in the data. Hopefully, the data doesn't get any better over the next few years :) .
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Post by guest42 »

bookshot wrote:Most working people seem to have an almost mystical belief (until lately) that stocks simply must go up in the long run - after all, that's what history, the talking heads and their advisors tell them. Most retired people I know definitely have too much there - up to 100% - because they fail to differentiate between accumulation and distribution.
I think this is true. Though I didn't take the traditional path from paycheck to no paycheck (medical issues forced me forward, before my investment brain could catch up) if you just look at the percent allocated to equities in the Target Retirement funds - I see an issue (assuming classical retirement age of 65):

Target Retirement 2010 - equities 54.08% -- now 2008, your age 63
Target Retirement 2005 - equities 41.47% -- now 2008, your age 68
Target Retirement Retirement - equities 30.03 -- now 2008, your age 68

100 - 63 = 37% equities
Target Retirement 2010 - equities 54.08% That is an equity poisition to the tune of 14% higher then the classical rule of thumb 100 - your age

100 - 68 = 32% equities
Target Retirement 2005 - equities 41.47% That is an equity poisition to the tune of 9.47% higher then the classical rule of thumb 100 - your age
Target Retirement Retirement - equities 30.03 This is closest

I don't know for sure, but it seems to me those with an equity poistion 9 - 14% higher then the 100 - your age, could be headed for big trouble in a Bear Market at Retirement.

And I suspect, there is a whole demographic bubble in this position, many not looking (the ostrich syndrome). How badly a 20% decline on a 54% equity stake would hurt any given would be retiree, would entirely depend on the size of their Investment portfolio. But as I have read - 100K is the average size of the investment portfolio for those headed into retirement. Assume 50% in equites = 50,000 - 20% = 10,000. 10K might not be a lot to some, but it could be the whole world to those with investment portfolio's as small as 100K.

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Post by rb313 »

Would either side of this debate have trouble with the short term bond index? Isn't that the best of both your worlds? Bob
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Post by BlueEars »

rb313 wrote:Would either side of this debate have trouble with the short term bond index? Isn't that the best of both your worlds? Bob
Bob, my answer is that there is no one right answer for all investors. I think Larry S. would say go with short term treasuries but that short term investment grade has rewarded investors in the past for the extra risk. As you say, short term bond index might be in between. You must choose your poison :? .
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