Rick Ferri vs Larry Swedroe on the role of junk bonds

[fredd]

To me Larry won by a knockout. As he pointed out, Junk seeems to correlate with equities at just the wrong time. In this brutal bear market the Vanguard Junk fund is down in excess of 20% while the Total Bond Market Fund is flat! Larry said to take your equity risk with equities, and that is paying off in spades. After reading the debate I sold my junk fund and bought Tips fund, glad I did.

fredd

[ddb]

To me Larry won by a knockout. As he pointed out, Junk seeems to correlate with equities at just the wrong time. In this brutal bear market the Vanguard Junk fund is down in excess of 20% while the Total Bond Market Fund is flat! Larry said to take your equity risk with equities, and that is paying off in spades. After reading the debate I sold my junk fund and bought Tips fund, glad I did.

fredd

I think Larry wins this argument, too, but not just because of the last 12 months of performance. Rick could just as easily say that from 1995-1999, your performance was greatly enhanced by using high yield instead of short-term treasuries. Can't draw conclusions based on short periods.

- DDB

[larryswedroe]

Thanks but one should not confuse strategy and outcome

What this period does point out is that the risks I pointed out do in fact exist and they played out EXACTLY as expected.

Would not matter if junk did well--the reason is that you could have gotten the same return more efficiently in equities and Treasuries mixed.

Junk simply adds fixed income assets that exhibit equity like characteristics in times of crisis. That exacerbates the shortfall risk so dangerous for those in withdrawal phase--

Like I said, I cannot think of a single reason to own junk bonds--and no one has yet offered a compelling reason either--certainly it is not diversification as the academic papers and this episode demonstrate as there is really very little unique attributes in junk bonds

[fredd]

I have enormous respect for the both of you. Each of you have forgotten more about investing than I will ever know.

fredd

[Roy]

After reading the debate I sold my junk fund and bought Tips fund, glad I did.

Thanks to Larry's books, I never owned junk, used Short Treasuries instead, and am glad I did too. On this topic, the arguments he presented before the downturn, supported as they were academically, are solid. But looking at their books and posts, I think the two would agree on many more fundamental mutual fund investing issues than the junk topic alone would suggest.

Roy

[ecastilla]

I don't believe Rick ever argued that high yield should be considered part of your "safe assets" (i.e., bonds, treasuries, TIPS). They should be looked at as part of your equity allocation..and in fact...if you had part of your equity location in high yield you would be doing better than if it was all in equities during this period (20% drop versus 40% drop).

Another advantage of high-yield I think is that it lets you diversify your risk. Just like international bonds let you diversify yourself away from country risk and small value (arguably) diversifies you away from fat tail risk...the same can be said of high yield. Stocks may underperform for the next 20 years but high yield may shine. Of course the only problem is the tax efficiency..so I agree with Larry that if your AA spills out of your tax -deferred you should not be in high yield..unless of course you have room for non-bonds.

[tibbitts]

If you treat junk as 50/50 equity/fixed, then being down 40% in equities and 5% in bonds or whatever is pretty similar to being down 20% in junk.

You could have gotten somewhat different results with ST treasuries vs. ST corporates, but the common thinking here seemed to be that historically, risk has paid off for high quality ST corporate bonds, at least in deferred accounts.

Paul

[Sammy_M]

I agree with Larry that if your AA spills out of your tax -deferred you should not be in high yield..unless of course you have room for non-bonds.

I believe the argument is you should not be in high yield, period. Fat tails tell the story. With high yield you unfortunately participate in negative fat tail events, but have no prospect of participating in positive fat tail events. The coupon on a bond does not adjust if company realizes phenomenal growth. Not the same as with equities, where you participate in both types of fat tails. Therefore, take your risks in equities.

[ecastilla]

I agree with Larry that if your AA spills out of your tax -deferred you should not be in high yield..unless of course you have room for non-bonds.

I believe the argument is you should not be in high yield, period. Fat tails tell the story. With high yield you unfortunately participate in negative fat tail events, but have no prospect of participating in positive fat tail events. The coupon on a bond does not adjust if company realizes phenomenal growth. Not the same as with equities, where you participate in both types of fat tails. Therefore, take your risks in equities.

The problem with those types of arguments is that you are making predictions based on the past. Look how much the REITS asset has changed in the last decade..... Perhaps the global equity market will suffer a Japan effect and high-yield will provide 7-8% returns... Everyone knows high yield has been a terrible asset going backwards but going forward nobody knows what the best assets will be or what will be the efficient frontier...so why not diversify as much as possible.

[Sammy_M]

ecastilla,

First, my statement above has nothing to do with past performance. It's merely a comment about how debt and equity are each structured to respond to unforeseen risks, both positive and negative.

Second, regarding your scenario of the global equity market suffering a Japan effect and high-yield providing high returns, it's highly unlikely. As Dr. Berstein points out in his article Dark Side of the Moon, it's quite unnatural for credit risk to be rewarded more than equity risk and almost certainly will not persist. Again, this is a comment regarding the rights of debt holders vs. equity holders, not a comment on past performance.

Third, I'm not aware that Larry advocates holding high yield anywhere. Perhaps you meant to say you agree with Rick?

Best wishes.

[ecastilla]

ecastilla,

First, my statement above has nothing to do with past performance. It's merely a comment about how debt and equity are each structured to respond to unforeseen risks, both positive and negative.

Second, regarding your scenario of the global equity market suffering a Japan effect and high-yield providing high returns, it's highly unlikely. As Dr. Berstein points out in his article Dark Side of the Moon, it's quite unnatural for credit risk to be rewarded more than equity risk and almost certainly will not persist. Again, this is a comment regarding the rights of debt holders vs. equity holders, not a comment on past performance.

Third, I'm not aware that Larry advocates holding high yield anywhere. Perhaps you meant to say you agree with Rick?

Best wishes.

Larry is against holding high yield..but he doesn't necessarily think its the end of the world if it's done in tax-deferred space.

Your argument about the rights of debt holders versus equity holders is something I have not really thought of much but I suppose you're right. I read Larry's bond book where he discussed the "other" risks of corporate bonds such as the bonds being callable....I think I actually agree more with Larry..I can't imagine ever buying into high-yield even if I had the tax deferred space and I also like to keep my fixed income as TIPS and CD's/Treasuries.

Despite this I do not think Rick should be criticized because of high-yields 20% decline...I'm sure he always agreed that high yield is very risky (i.e., like equities) but that its current high yields make it an attractive alternative (i.e., diversifier) for the risky side of your AA. If I were retired, had lots of tax deferred space, and felt a need to diversify my risky assets more..I would consider high yield...although I fall into neither.

[larryswedroe]

ecastillo
I could be wrong but if my memory is correct Rick suggested a typical portfolio's fixed income allocation be split equally among 4 groups, EM bonds and high yield were two of the four. And there was never any suggestion about adjusting the equity allocation to account for the equity like risks in these risky asset classes---that was one of the big issues in the discussion

And as you have correctly stated, to me IF you make the adjustment then it is only a misdemeanor to own junk not a "felony" since you might be making a location mistake and you are paying too much for the bond allocation --and the other problem is that you have this SHIFTING asset allocation as the tendency is for high yield and EM bond risk to show up at the wrong time---becoming more equity like in times of crisis. That gets nasty especially if in withdrawal phase

[seugene]

In this battle between smart people's opinions on whether junk bonds have a place in individuals' portfolios, I also tend to agree with Larry. BUT (there is always a "but"): see this other very smart person's opinion. The current junk-to-treasuries spread is an incredible 9.05% (as measured by the difference between Vanguard fund's 12.35% yield and treasuries of roughly the same duration at 3.3%). How many dots above 9% do you see on that last graph in Bill Bernstein's article? Exactly!

Call it market timing if you will. I call it using your head when everybody is losing theirs. Larry likes the idea of timing nominal bond allocation v. TIPS depending on the spread between the two. Going away from "safe" bonds into junk now is really no different, as it is also driven by a spread that historically has predicted future returns rather reliably.

That said, I do agree you should not go ALL junk for the bond allocation. And if you do go there even for a little tilt, you need to re-think and possibly increase your bond v. equity ratio, as what you'll be holding is significantly riskier than treasuries.

[Valuethinker]

In this battle between smart people's opinions on whether junk bonds have a place in individuals' portfolios, I also tend to agree with Larry. BUT (there is always a "but"): see this other very smart person's opinion. The current junk-to-treasuries spread is an incredible 9.05% (as measured by the difference between Vanguard fund's 12.35% yield and treasuries of roughly the same duration at 3.3%). How many dots above 9% do you see on that last graph in Bill Bernstein's article? Exactly!

Beware the future that is not like the past.

Treasury yields have gone down, more than junk yields have gone up?

So there's a question whether junk yields are fully discounting higher default rates. The quality of junk bonds is also potentially lower than it was in previous cycles (see the work of Martin Fridson of FridsonVision, a junk bond expert).

Also I recommend reading Edward Altman's work (professor at NYU).

Larry's objections to junk bonds are:

- equity like risk, but not equity like returns
- tax inefficient (highly)

I would add that bonds probability of default rises as a bond ages, in junk. So since we are in a period of low junk issuance, you are getting an increasingly 'old' portfolio

Call it market timing if you will. I call it using your head when everybody is losing theirs. Larry likes the idea of timing nominal bond allocation v. TIPS depending on the spread between the two. Going away from "safe" bonds into junk now is really no different, as it is also driven by a spread that historically has predicted future returns rather reliably.

If it's the same old game this time.

That said, I do agree you should not go ALL junk for the bond allocation. And if you do go there even for a little tilt, you need to re-think and possibly increase your bond v. equity ratio, as what you'll be holding is significantly riskier than treasuries.

A better strategy might be to increase your exposure to small cap value stocks.

If you want equity risk in your bond portfolio, take a look at investment grade bonds, which are also highly depressed relative to norms.

[larryswedroe]

valuethinker
You forget to include in my objections to junk one of the biggest objections---the presence of call risk (from two sources with junk, unlike with AAAs where it is only one source). And historically the call risk has been a big problem

You can see Fridson's paper on original issue junk bonds which I discussed here a while ago

[Rick Ferri]

I have never said that high yield spreads do not have some equity like characteristics. I have said that the correlation between equity returns and credit spreads varies considerably over any 12 to 36 month period. So, sometimes those characteristics matter, and sometimes they don't. In the past 12 months, they have mattered. In the next 12, they may not.

Larry claims that high yield returns can be reconstructed using only equity plus Treasuries. That statement by Larry is also completely false because you cannot reconstruct the return of high yield in any given year or three year period with only equity and Treasury. He is looking at a 25 year total return period to make that claim and that has no relevance in year over year returns. Since the correlations between credit spread and equity returns shift from highly correlated to no correlation from year to year. it is proof that there are unique risks in high yield not associated equities.

Also, I have also never said high yield bond returns will go up when the equity markets go down. However, that was Larry's primary argument for heavily pushing commodity funds, which turned out to be a complete disaster and will prove to be much more harmful to a portfolio in this recent equity downturn than the temporarily widening of credit spreads.

I will also say that people who have been waiting to get into high yield or are thinking about to rebalancing their fix income assets classes that includes high yield would be wise to do it now. IMO, it is one of the best time in decades to own high yield bonds. I am anticipating the total return from the Vanguard HY Corporate bond fund will be in the double digits for several years to come as you get paid 12% interest while you wait for credit spreads to narrow.

Rick Ferri

[Electron]

I wonder if this discussion should take into account the fact that investment grade corporate bonds and municipal bonds are also acting like equities in the current unprecedented crisis. Take a look at the chart on Vanguard Long Term Investment Grade - symbol VWESX.

The current issue of Barron's mentions that investment grade corporate bonds currently have the highest yield spread relative to Treasury bonds since 1932-33. I believe they also indicated that high yield bonds currently have the highest spread ever seen.

The same issue also mentions that the upper tier in junk bonds is experiencing the majority of the selling because those are the only high yield bonds that can currently be sold in any volume. This factor could result in Vanguard High Yield seeing a larger drop in NAV compared with lower quality funds.

It appears that there is a lot of forced selling and de-leveraging by hedge funds and large institutions that must sell at any price. Individuals are undoubtedly adding to the selling with redemptions from high yield bond mutual funds. Hedge funds apparently allow withdrawals quarterly so one hope is that hedge fund selling may slow considerably very soon.

Kent