Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
User avatar
Topic Author
SimpleGift
Posts: 3869
Joined: Tue Feb 08, 2011 3:45 pm
Location: Central Oregon

Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by SimpleGift »

PREFACE: This is the eighth in a series of posts highlighting the classic investing insights of William Bernstein from the 1990s and early 2000s. Many new Bogleheads have never been exposed to his early writings — and while the data sets used may seem antiquated, his portfolio concepts and novel analyses are still helpful to investors today, new and old alike.

Previous topics in the series: 1-Asset Allocation & Time Horizon, 2-Choosing Portfolio Bond Duration, 3-Diversifying Portfolio Equities, 4-Stocks Always Beat Bonds?, 5-What’s a Thing Worth?, 6-The Value Premium & Inflation, 7-The Great Fund Fee Mystery
------------------------------------------------------------------------------------------

The standard advice when selecting bonds for one’s portfolio is that they should be of high-quality and of intermediate-to-short duration. Yes, there is a premium from junk bonds, but over the long haul, it’s not large enough to justify the extra risk. Plus, junk has a high correlation with small stocks, so it offers little diversification value. But what about with one’s play money? Do high-yield bonds ever make sense for a small portion of the portfolio?

The Basics. To answer this question, Mr. Bernstein first examined the Junk-Treasury Spread (JTS) over the 13-year period from 1988-2000 (chart below). Note the relative difference in yields varied from about 3% to nearly 10%. But what does a JTS of 3% actually mean? In short, a junk bond investor would have been better off in Treasuries if the loss rate exceeds 3%. Even if the loss rate is only half that, a 1.5% return premium does not seem adequate for the risk.

Note: The default rate is obviously the proportion of companies defaulting each year. But not all companies that default eventually go bankrupt — some recover. Thus, if the default rate is 4% and 50% of these companies eventually recover, the loss rate (how much of one’s investment actually disappears) is 2%.
  • Image
    Note: The spread is between B-rated debt and Treasury bonds of similar duration.
    Source: William Bernstein, Efficient Frontier (4/01)
The Study. From the wealth of historical data on the bankruptcy/default rates of junk bonds, Mr. Bernstein determines that BB-rated bonds seem to default at about 2% per year and B-rated bonds about 4% per year (though default rates can temporarily be much higher, on the scale of 8%-10%). Since about 40% of this defaulted debt is eventually recovered, the long-term annual loss rate is actually about 1.2% for BB-rated and about 2.5% for B-rated debt. Armed with this data, he looked at the junk-Treasury spread versus the forward 5-year difference in returns between junk and Treasuries (chart below). As expected, the higher the spread, the greater the advantage of bearing credit risk.
What overall conclusions did Mr. Bernstein draw from this analysis?
  • a) Though most of the time it does not pay to take credit risk, there are periods when expected returns are too high to ignore. When expected returns start approaching 5% over Treasuries, junk bonds may be a risk worth taking with a small corner of one’s portfolio.

    b) Though stocks can remain cheaply-valued for many years, junk bonds have a fixed maturity. Thus, a distressed bond selling at 60% of par with a maturity of 8 years (that does not default) must of necessity yield its coupon, plus a capital gain of 67% after eight years.

    c) If purchased when spreads are very high, the only way of being burned with a properly diversified, high-yield bond portfolio is if future default and loss rates are much higher than they’ve been in the past.
Thoughts?
Last edited by SimpleGift on Sat May 28, 2016 12:47 pm, edited 2 times in total.
User avatar
midareff
Posts: 7200
Joined: Mon Nov 29, 2010 10:43 am
Location: Biscayne Bay, South Florida

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth It?

Post by midareff »

Nothing to argue with there. A small percentage to high yield, such as VG's VWEAX counterbalanced against IT Treasuries and played off each other intelligently would seem to offer opportunity.
garlandwhizzer
Posts: 3021
Joined: Fri Aug 06, 2010 3:42 pm

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth It?

Post by garlandwhizzer »

Totally agree on this good point. I bought Vanguard's HYB fund (which avoids the worst of junk bonds) during the worst of the collapse in 2008-9 at which time the spread to Treasuries of similar maturities was greater than 11%. I sold some of my GNMA fund at the time which had held up beautifully during the crisis and accepted the risk/reward tradeoff to HYB using a portion of my "safe" bond position. At the time the Vanguard HYB fund was yielding 12%+ due not to defaults which were actually modest at the time but rather due to panic selling. I only held the HYB fund for about a year, sold it at a large long term capital gain plus the dividends which were substantial, and moved back into safe high quality bonds at that point. The HYB fund recovered to its pre-crisis value much more quickly than equities did (12 months for HYB versus 3.5 years for TSM).

I was lucky. Could have gone the other way but only if the economy collapsed long term and severely into a Great Depression scenario. I didn't believe a total collapse would happen due to aggressive monetary and fiscal policy intervention which did not happen in the Great Depression.

Garland Whizzer
User avatar
saltycaper
Posts: 2650
Joined: Thu Apr 24, 2014 8:47 pm
Location: The Tower

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by saltycaper »

All very good, but since credit spreads tend to widen when equities decline, it seems at the very least a comparison between credit spreads and forward returns on equities is necessary to determine if investing in junk has been the preferable option, or if investors would have been better off plowing more into equities at that time. While the fixed maturity of junk bonds may provide comfort based on reason, we should at least know if it actually has mattered in the past.
Quod vitae sectabor iter?
tibbitts
Posts: 12228
Joined: Tue Feb 27, 2007 6:50 pm

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by tibbitts »

I'm not sure if we should apply the 5% rule identically when treasuries are yielding 1% vs. when they're yielding 15%, but I'm not entirely convinced that's unreasonable, either.
User avatar
Topic Author
SimpleGift
Posts: 3869
Joined: Tue Feb 08, 2011 3:45 pm
Location: Central Oregon

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by SimpleGift »

Just to bring up to date Mr. Bernstein’s B-rated spread chart in the OP:
Clearly, the financial crisis of 2008-2009 was the mother of all buying opportunities for high-yield debt. However, when the stability of the entire global financial system was in serious doubt, it took some exceptional fortitude to invest in below-investment-grade bonds! Those who had the guts and understood the dynamics of the high-yield credit market profited handsomely (such as Garland Whizzer upthread).
Last edited by SimpleGift on Sat May 28, 2016 1:21 pm, edited 1 time in total.
tibbitts
Posts: 12228
Joined: Tue Feb 27, 2007 6:50 pm

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by tibbitts »

saltycaper wrote:All very good, but since credit spreads tend to widen when equities decline, it seems at the very least a comparison between credit spreads and forward returns on equities is necessary to determine if investing in junk has been the preferable option, or if investors would have been better off plowing more into equities at that time. While the fixed maturity of junk bonds may provide comfort based on reason, we should at least know if it actually has mattered in the past.
It seems like the primary justification for junk, at times of reasonable-but-not-extraordinary spreads, would be for an equity market that essentially never recovers. And we don't have enough history to come to any conclusions about how junk would help or hurt in that situation.
User avatar
galeno
Posts: 2109
Joined: Fri Dec 21, 2007 12:06 pm

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by galeno »

And my main concern is that we take too much credit risk by holding a TBM ETF (SEC yield = 2.06% AA) vs an intermediate term ETF of 100% USA Treasury debt (SEC yield =1.30% AAA).

Junk bonds, like commodities, are for speculation. Some are good a/o lucky. Some are bad a/o unlucky.
KISS & STC.
User avatar
Topic Author
SimpleGift
Posts: 3869
Joined: Tue Feb 08, 2011 3:45 pm
Location: Central Oregon

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by SimpleGift »

It’s also worth noting that, if high-yield bonds are purchased at the right spreads over Treasuries, historically one hasn’t had to wait too long for the payoff (chart below). In fact, over the last thirty years, the index has never experienced two years of successive declines. Future performance may of course vary.
  • Annual Returns, Merrill Lynch U.S. High-Yield Index, 1987-2015
    Image
    Source: ValueWalk
jginseattle
Posts: 784
Joined: Fri Jul 01, 2011 7:33 pm

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by jginseattle »

I think credit risk is, for the most part, an inefficient way to invest. I would limit it to short-dated, high quality securities.
User avatar
Topic Author
SimpleGift
Posts: 3869
Joined: Tue Feb 08, 2011 3:45 pm
Location: Central Oregon

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by SimpleGift »

tibbitts wrote:I'm not sure if we should apply the 5% rule identically when treasuries are yielding 1% vs. when they're yielding 15%, but I'm not entirely convinced that's unreasonable, either.
I haven’t seen any discussion of different credit spread rules in high-versus-low interest rate environments. However, I can say that a 5% credit spread over Treasuries does seem low to me overall. Perhaps a 5% spread was appropriate during the period that Mr. Bernstein studied, but I doubt it would motivate me today to exchange a small portion of my high-quality bonds for high-yield bonds.

Why? We now know the long-term median credit spread is about 5.4% (dotted line, chart below) — so the spread would have to be in the 7%-8% range today before I’d personally be convinced to pull the trigger (about once every 8-10 years, it appears).
Bill Bernstein
Posts: 594
Joined: Sat Jun 23, 2007 12:47 am

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by Bill Bernstein »

Hi All:

Larry S. would make the point, and he'd be right, that being opportunistic with high-yield bonds is simply another way of taking equity risk--i.e., you'd be better off simply slightly upping your equity exposure rather than buying junk.

The only arguments I have with that, and they're tiny points, is that during '08-'09 junk turned around about 4 months before equities, and that it's psychologically easier to be paid 10-20% pa while you're waiting for prices to stop falling.

But for the most part, I have no strong argument to avoiding junk altogether and get your equity exposure the old-fashioned way.


Bill
Valuethinker
Posts: 41395
Joined: Fri May 11, 2007 11:07 am

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by Valuethinker »

Bill Bernstein wrote:Hi All:

Larry S. would make the point, and he'd be right, that being opportunistic with high-yield bonds is simply another way of taking equity risk--i.e., you'd be better off simply slightly upping your equity exposure rather than buying junk.

The only arguments I have with that, and they're tiny points, is that during '08-'09 junk turned around about 4 months before equities, and that it's psychologically easier to be paid 10-20% pa while you're waiting for prices to stop falling.

But for the most part, I have no strong argument to avoiding junk altogether and get your equity exposure the old-fashioned way.


Bill
The issuers of junk bonds and their bankers have a significant informational advantage over their buyer (this is true of all corporate bonds, of course).

That reminds me of the IPO market, and it makes me very uneasy.

And another thing the recovery of 2009 was yes, in retrospect a tremendous opportunity. But 2 things:

- for the financial services sector, next time the bond holders will be "bailed in" -- heavily diluted and converted into equity. The regulators and politicians are very clear on that-- no one will rush to make Ireland's mistake (the Finance Minister died of pancreatic cancer, so we cannot ask him what he thinks now)

- I remember Sept 2008-early 2009 and it was the scariest time in financial markets I have ever seen. And people I knew and respected who had decades more experience than I did said it was a lot scarier than anything they had ever experienced. People who had senior roles in finance named blue chip financial institutions that they thought might go under (to the point where I was advised to move my deposits).

We glimpsed oblivion in Q4 2008.

I wonder how the holders of junk bonds would have done 1929-1934?

Greece is right now experiencing the cost of another European bank bailout. To bail the financial institutions which have lent Greece money, the authorities in Europe are inflicting brutal pain (Americans wouldn't stand for that much pain-- they are not congenitally tough enough, American politics would melt down).

If a risk only comes up once in a generation, can we safely discount that risk?
User avatar
siamond
Posts: 5636
Joined: Mon May 28, 2012 5:50 am

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by siamond »

I am getting a sense that a knowledgeable individual *may* be able to make tactical decisions about CDs and bonds (high-yield or not). Personally, I know that the historical reliability of bonds yields as a pretty reliable predictor of the bonds returns of the coming decade does impress me (R2>0.9), and drove some level of decision making. I don't know enough about high-yield bonds to make decisions on those (so I decided to skip those in favor of equity risk, and leave it be), but I'm ready to believe that it might be possible. I would NOT put them in a fixed AA though, too much overlap with equity risk, and not enough rewards.

Hm. Did I just say that some level of market timing for bonds might not be so crazy after all? Ah, the anathema to come... :wink:
Trader/Investor
Posts: 261
Joined: Wed Dec 02, 2015 9:35 pm

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by Trader/Investor »

Hm. Did I just say that some level of market timing for bonds might not be so crazy after all? Ah, the anathema to come... :wink:

Junk bond funds - corp and muni are a short term trader's delight. And you can add in bank/leveraged loan funds too. It's because of their persistency of trend with little to no volatility along the way. Can't say the same for Treasuries and emerging markets bond funds. Of course expect to get the occasional ban from the fund companies for overactive trading of their funds. And don't think for a second attempting any short term trading of a Vanguard, T Rowe Price, or American Century fund.
ANC
Posts: 141
Joined: Sat Mar 01, 2014 7:59 pm

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by ANC »

saltycaper wrote:All very good, but since credit spreads tend to widen when equities decline, it seems at the very least a comparison between credit spreads and forward returns on equities is necessary to determine if investing in junk has been the preferable option, or if investors would have been better off plowing more into equities at that time.
I think this is a good point. When viewed together with GarlandWhizzer's post, what it seems to call for is an active equity manager with broad enough scope to consider high-yield. PRWCX and FPACX come to mind (my only high-yield corporates are in PRWCX).

Given the preference of many on this list for junk stocks ("deep value"), doesn't it make sense at the individual security selection level to choose bonds for some of these junk names in order to put put your investment higher up in the debt structure?

Is a debt--to-equity conversion during a restructuring really a bad thing from the point of view of a broadly defined equity strategy? You may get a stock price boost when the company comes out of restructuring.

One technical point: is the chart in the original post really based on securities of the same duration? Since yield affects the duration calculation, I think you might want to use remaining maturity instead. More importantly, this comparison at equivalent duration may misrepresent the choice the investor is facing. It seems to be presupposing that he or she is adding credit risk on top of their (constant) interest rate risk. I would think that many investors would want to substitute credit risk for interest rate risk and shorten their duration as they move into high yields.

* Last paragraph edited for more detailed explanation.
Last edited by ANC on Sun May 29, 2016 1:28 pm, edited 1 time in total.
User avatar
Kevin M
Posts: 11705
Joined: Mon Jun 29, 2009 3:24 pm
Contact:

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by Kevin M »

I used the FRED spread data (used in the graph shared by Simplegift above) to examine the annual returns of Vanguard High-Yield Corporate Bond fund (VWEHX) relative to the spread at the beginning of the year. Looking at the chart, it seemed that the change in spread was perhaps more relevant in determining annual return; i.e., similar to the inverse relationship of change in bond yield and price. Then I wondered if combining initial spread and change in spread (with sign reversed) would be more predictive (ex-post of course).

Turns out that the correlation of annual return to (the opposite of) change in spread is much higher at 0.97 compared to the correlation of annual return to initial spread at 0.67. The correlation of the combination of initial spread minus change in spread to annual return is 0.93, so much higher than for just initial yield, but slightly lower than for just change in spread. Of course we don't know the change in spread in advance, so this information doesn't do us any good in terms of market timing.

For what it's worth, below is a chart showing initial spread, opposite of change in spread (-dSpread), initial spread minus change in spread (iSpread - dSpread), and annual return of VWEHX.

Image

Kevin
Wiki ||.......|| Suggested format for Asking Portfolio Questions (edit original post)
User avatar
LadyGeek
Site Admin
Posts: 67130
Joined: Sat Dec 20, 2008 5:34 pm
Location: Philadelphia
Contact:

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by LadyGeek »

We now have a wiki page which captures the series: Classic Bernstein

When a new post is added, just update the wiki.

Update: I bumped all of the prior series with a link to the wiki. There's no need to go back and revise the topics when a new post is added.
Wiki To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.
stlutz
Posts: 5574
Joined: Fri Jan 02, 2009 1:08 am

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth Taking?

Post by stlutz »

Larry S. would make the point, and he'd be right, that being opportunistic with high-yield bonds is simply another way of taking equity risk--i.e., you'd be better off simply slightly upping your equity exposure rather than buying junk.

The only arguments I have with that, and they're tiny points, is that during '08-'09 junk turned around about 4 months before equities, and that it's psychologically easier to be paid 10-20% pa while you're waiting for prices to stop falling.

But for the most part, I have no strong argument to avoiding junk altogether and get your equity exposure the old-fashioned way.
For kicks I used portfolio visualizer and compared returns of high yield bonds vs. a 50/50 mix of stocks and bonds (I chose 50/50 as this came close to equaling out the volatility between the two series over time).

The results showed that adding a strategic allocation to high yields bonds did not seem to be a good idea, but the times that Bernstein/SimpleGift have highlighted did provide an advantage to high yields bonds over the 50/50 stocks/Treasuries combo.

So, in the past at least, high yield was usually not a good idea, but it did make sense when credit spreads were especially high.
User avatar
nedsaid
Posts: 13918
Joined: Fri Nov 23, 2012 12:33 pm

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth It?

Post by nedsaid »

garlandwhizzer wrote:Totally agree on this good point. I bought Vanguard's HYB fund (which avoids the worst of junk bonds) during the worst of the collapse in 2008-9 at which time the spread to Treasuries of similar maturities was greater than 11%. I sold some of my GNMA fund at the time which had held up beautifully during the crisis and accepted the risk/reward tradeoff to HYB using a portion of my "safe" bond position. At the time the Vanguard HYB fund was yielding 12%+ due not to defaults which were actually modest at the time but rather due to panic selling. I only held the HYB fund for about a year, sold it at a large long term capital gain plus the dividends which were substantial, and moved back into safe high quality bonds at that point. The HYB fund recovered to its pre-crisis value much more quickly than equities did (12 months for HYB versus 3.5 years for TSM).

I was lucky. Could have gone the other way but only if the economy collapsed long term and severely into a Great Depression scenario. I didn't believe a total collapse would happen due to aggressive monetary and fiscal policy intervention which did not happen in the Great Depression.

Garland Whizzer
To get ahead, sometimes you have to take a chance. What I mean by taking a chance is that you take a well-informed chance knowing that the odds are in your favor but that perhaps things won't work out. I wouldn't say that Garland was lucky, he put cards on the table knowing that the odds were in his favor. It wasn't just a random bet. He was pretty sure that the Feds would step in, which they did, and also thought the odds of doomsday were low.

What Garland did was watch the markets, look for opportunity, and when he saw the opportunity present itself he pounced. That is not a bad way to invest. Of course, one cannot know everything and thus there is a risk that the bet won't work out. But I would say the odds were pretty good.

A big part of investing is putting the odds in your favor as much as possible.
A fool and his money are good for business.
dkturner
Posts: 1612
Joined: Sun Feb 25, 2007 7:58 pm

Re: Classic Bernstein 8 — Is Credit Risk Ever Worth It?

Post by dkturner »

nedsaid wrote:
garlandwhizzer wrote:Totally agree on this good point. I bought Vanguard's HYB fund (which avoids the worst of junk bonds) during the worst of the collapse in 2008-9 at which time the spread to Treasuries of similar maturities was greater than 11%. I sold some of my GNMA fund at the time which had held up beautifully during the crisis and accepted the risk/reward tradeoff to HYB using a portion of my "safe" bond position. At the time the Vanguard HYB fund was yielding 12%+ due not to defaults which were actually modest at the time but rather due to panic selling. I only held the HYB fund for about a year, sold it at a large long term capital gain plus the dividends which were substantial, and moved back into safe high quality bonds at that point. The HYB fund recovered to its pre-crisis value much more quickly than equities did (12 months for HYB versus 3.5 years for TSM).

I was lucky. Could have gone the other way but only if the economy collapsed long term and severely into a Great Depression scenario. I didn't believe a total collapse would happen due to aggressive monetary and fiscal policy intervention which did not happen in the Great Depression.

Garland Whizzer
To get ahead, sometimes you have to take a chance. What I mean by taking a chance is that you take a well-informed chance knowing that the odds are in your favor but that perhaps things won't work out. I wouldn't say that Garland was lucky, he put cards on the table knowing that the odds were in his favor. It wasn't just a random bet. He was pretty sure that the Feds would step in, which they did, and also thought the odds of doomsday were low.

What Garland did was watch the markets, look for opportunity, and when he saw the opportunity present itself he pounced. That is not a bad way to invest. Of course, one cannot know everything and thus there is a risk that the bet won't work out. But I would say the odds were pretty good.

A big part of investing is putting the odds in your favor as much as possible.
Very well stated.

We have only made two meaningful changes in our portfolios over the last 16 years, and they have both worked out very well for us. In late 1999 we very heavily tilted our equity portfolios towards "value" stocks and from late 2008 to mid 2009 we changed our fixed income from 75% U.S. Government/Treasuries to less than 20%. From 2000 to year end 2015 our portfolios have returned 143 basis points per year more than a comparably weighted portfolio of Vanguard total market index funds. Opportunities like these only come around a few times in a generation. To me it seems counterintuitive for thinking adults to not take advantage of the massive overreactions that unduly depress asset prices from time to time.
Post Reply