Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

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lack_ey
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Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Tue Jan 31, 2017 1:25 pm

Executive summary

Credit risk is more likely to do poorly when stocks do poorly. However, from what I see, credit risk does not become more sensitive to the stock market and stock-like during bear markets overall. It may fall to some degree with stocks, but not by more than it gains to some degree with stocks. Overall, credit risk is only somewhat correlated with equities. If credit risk is rewarded on average (positive excess returns, which a recent paper argues is true but some previous studies did not find evidence of), then given its properties it seems worth consideration in portfolio construction.

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edit:

Update with a few more graphs and minor things of interest from live funds the last ten years available in two subsequent posts further down in the thread:
viewtopic.php?f=10&t=209748&p=3243425#p3239377
viewtopic.php?f=10&t=209748&p=3243425#p3243425
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Introduction

Opinions are divided on the role and suitability of corporate bonds in asset allocation. Some experts, such as David Swensen, Bill Bernstein, and Larry Swedroe recommend sticking to quality bonds and taking more risk elsewhere. On the other hand, one Jack Bogle himself has suggested that the broad bond index (Bloomberg Barclays Aggregate and variants thereof) and such funds following it such as Vanguard Total Bond Index contain too many government bonds, and he'd like to see more corporate bonds represented. Rick Ferri prefers supplementing total bond with both TIPS and junk bonds. Some fund companies via target date funds include overweights to credit risk, and popular robo advisor platforms like Betterment and Wealthfront do the same.

One of the main criticisms of credit risk from the skeptics is that credit risk shows up at the wrong time, when stocks are tanking, and corporate bonds (especially high yield, but even investment grade) start to act more stocklike when the going gets tough. Is this true? Let's find out.

Disclaimer: Any difference in fixed income, particularly between investment-grade choices and outside of the long end of the yield curve, is unlikely to make much of an impact in terms of overall portfolio behavior. Most allocations are dominated by equity performance unless they own very little in stocks, well under 30%, which almost nobody here does. Also, individual investors can frequently get better deals outside of the bond market in the form of FDIC or NCUA insured CDs.

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Data and background

I use data from "The Credit Risk Premium" by Attakrit Asvanunt and Scott Richardson. The main observation motivating this paper is that many previous analyses of corporate and government bonds, including Fama and French back in 1993, examine bonds of equivalent maturity rather than equivalent duration (or really, option-adjusted duration), leading to a mis-measurement of credit risk. Corporate bonds of equivalent maturity will have higher yields and thus lower durations. The paper attempts to adjust older historical data to account for this, looking over the history of US investment-grade corporate bonds available, 1926-2014. They also examine shorter histories of high yield bonds, corporate bonds in other markets, and credit default swaps to evaluate credit risk in as many markets and scenarios as possible. The paper is worth reading in full, but to summarize, they do find a persistent credit risk premium and show that it can improve the efficiency of portfolios containing equity and term risk.

The main data, for investment-grade corporate bond returns in the US from 1926-2014, is available for download here.

They provide three monthly data series in the spreadsheet: CORP_XS, GOVT_XS, and SP500_XS. GOVT_XS is the difference between government bond and 30-day T-Bill returns, while SP500_XS is the return of the S&P Composite/S&P 500 over 30-day T-Bill returns. (The XS means excess, as in excess returns of the risk-free rate, in this context.) The data series of most interest here is CORP_XS, which is the excess return of corporate bonds over a duration-matched benchmark of government bonds. The data prior to 1988 is less reliable, reflecting some best guesses of duration with all the stipulations and procedures you can read for yourself in the paper. Additionally, they note that the nature of the indexes has changed over time, and the oldest data reflects mostly longer-term bonds of relatively high (AA/A) credit quality.

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Does credit risk act more stock-like when stocks are down?

It is often said that corporate bonds tend to be more likely to underperform during bad equity markets, which is intuitive economically. Stress and uncertainty in corporate fortunes should impact both the equity and debt of a given company. This is clear from any look at the data. For example, in the bottom decile of monthly stock returns (the worst 10% of months from 1926-2014), the arithmetic average excess credit return is -0.27%. Over the full set, the credit return has an average of 0.18%.

But does this simply reflect a constant equity component to credit over all market conditions, or do the equity-like characteristics phase in and out? For reference, the correlation (Pearson's r) of monthly returns over the full data between credit excess returns and S&P 500 excess returns is 0.22 (95% CI between 0.16 and 0.28), so there is a relationship, but credit risk is distinct.

If credit risk truly behaves more like equity risk at certain times, this should be reflected in figures for equity market beta. Here is the rolling 3-year (36-month) equity market beta for the excess credit return. For each date, the figure given is the estimate for beta over the preceding 36 months. The standard error on the estimates averages under 0.04, so while some of the fluctuations likely reflect noise, the larger trends are probably significant. For reference, the S&P 500 rolling 3-year excess return over T-Bills and credit excess return over duration-matched government bonds are also shown below so equity bear markets (in nominal terms) can be identified.

Image

Other than the spike in equity beta for credit risk around the Great Recession, there doesn't appear to me to be much of any relationship between stock market performance and the sensitivity of credit risk to the equity market. Notably, the beta was close to zero through the Great Depression, though again, the data quality that far back is low and the corporate bonds of the day may have been higher quality. I'd also expect that trading on the stock and bond markets is more integrated and related these days.

Now let's focus on data since 1950, as we've clearly seen high stock market volatility and little relationship with credit risk over the beginning period. Maybe that's an extended outlier or represents an era that no longer exists. In these remaining months, if credit risk becomes more equity-like during bear markets, then presumably we should expect higher market beta during months of downwards stock movements than months of upwards stock movements, right? In fact, the data indicates the opposite: 0.056 equity beta for credit risk under 316 negative months and 0.110 beta for the remaining 464 positive and zero excess return months for stocks.

Over the period since 1950, the equity beta is 0.081. If we subtract out 0.081 times the equity return from credit risk, how does the residual do? Again, if credit risk is worse when it counts the most at a level beyond its typical relationship with stocks, then the residual [excess credit return minus its equity market beta influence] should be worse than average at these times. The arithmetic average residual over the period since 1950 is 0.082 (a positive return on average above any amount explained by the equity beta). For the worst decile of stock returns over the period, the arithmetic average residual is 0.162, even higher, rather than being negative.

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Enough theory. How does this work with real funds and asset allocations?

The trouble with portfolio evalution using live trading data from actual mutual funds is that virtually everything we have comes from the bond bull market era the last 35 years, where term risk was overall richly rewarded. Any comparison using corporate bonds of lesser duration than government bonds will inadvertently capture the combined effect of lower term risk along with the credit risk component. This is common, as corporate bonds of equivalent maturity as government bonds will have higher yields and thus lower duration (though this is further complicated by corporate bond call options).

Additionally, most older bond funds are actively managed, with potentially varying credit and term risk exposures. The broad index itself has changed over the years.

One way to minimize the impact of diverging term risk in our comparisons is to restrict bonds to relatively short, constrained maturities. The best two funds I found for this purpose to compare government and corporate bonds are iShares 1-3 Year Treasury Bond (SHY) and iShares 1-3 Year Credit Bond (CSJ), which currently have effective durations of 1.88 and 1.90 years respectively. The expense ratios are 0.15% and 0.20%, an edge to the government bonds.

Here is the performance of three asset allocations over Feb 2007-Dec 2016.

Code: Select all

IVV - iShares Core S&P 500; SHY - iShares 1-3 Year Treasury Bond; CSJ - iShares 1-3 Year Credit Bond
Portfolio 1: 60% IVV, 40% SHY,  0% CSJ
Portfolio 2: 55% IVV,  0% SHY, 45% CSJ
Portfolio 3: 57% IVV, 19% SHY, 24% CSJ
Image
PV link

Over this period, which includes the financial crisis, having corporate bonds actually helped. Portfolios 2 and 3 were slightly superior to Portfolio 1 despite the slightly extra cost and all worries about correlations or betas spiking during the worst of the period. Furthermore, only US stocks were used and US stocks outperformed ex-US stocks over the period, so a similar analysis using a global stock portfolio would have shown an even greater benefit for including corporate bonds (notably, over 35% of the bonds in CSJ are from outside the US such as from KfW Bankengruppe, just denominated in USD). However, the scope of this investigation is limited, looking only at short-term bonds and over less than a decade of returns.

I also attempted to compare corporate and government bonds over longer periods of time, using other funds. The caveats about duration/yield curve positioning mismatch and potential risk exposure drift apply here, so I would not trust this analysis as much as the one above.

In the first case, the bond funds are iShares 7-10 Year Treasury Bond ETF (IEF) and iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), evaluated over Aug 2002-Dec 2016. Corporate bonds here detracted from portfolio efficiency, reducing return and increasing risk. Notably, intermediate-to-long Treasuries were extremely good over this time period, having negative correlation with equities. In the second, the bond funds are Vanguard Intermediate-Term Treasury Fund (VFITX) and Vanguard Intermediate-Term Investment Grade Fund (VFICX), evaluated over Nov 1993-Dec 2016. Corporate bonds again detracted, but not by much.

PV link for IEF/LQD

PV link for VFITX/VFICX

edit: I just realized that the Nov 1993 - Dec 2007 annualized returns for Vanguard Intermediate-Term Treasury Fund (VFITX) and Intermediate-Term Investment Grade Fund (VFICX) were 6.17% and 6.16% respectively. Over this period, the CORP_XS series indicates well over a 1% pa return for credit, so... I'm going to have to assume this is not a fair comparison with respect to term risk, especially considering that the standard deviations were 4.88% and 4.42%.

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Conclusion

I find that historically, credit risk probably does not act significantly more like stocks and misbehave in equity bear markets. The possible exception is with our recent experience during the Great Recession.

Corporate bonds contain both credit risk and term risk. Therefore, if credit risk is additive to returns* and sufficiently distinct from equity and term risk, they should be a useful building block for asset allocation. However, there are challenges in backtesting bond allocations with respect to properly adjusting for and equalizing term risk exposure, as covered in the previous section. The results were encouraging using the better duration-matched funds but less so with the other two comparisons (that are on shakier ground with respect to matching fund durations).

*They are not under Fama and French's finding of 2 bp per month of excess return over government bonds, which as you'll recall was not duration matched. If you assume a near-zero or negative forward return for credit risk, there's no reason to include it.

Factor investors typically attempt to gain exposure to multiple factors in a search for multiple sources of potential return. Some formulate this as gaining exposure to (historically) rewarded risk factors, though others these days drop the conception of factor returns being purely explained by risk. Regardless, there is a clear story behind credit risk. It should not be considered anomalous if credit risk carries a positive return on average.

In light of this factor investing framework, I suggest that credit risk may be another factor worth pursuing. Like SMB (size), it is not expensive to access: with corporate bonds, you load on both term and credit risk simultaneously, and they are not drastically more expensive to own than government bonds. Like SMB, there is some modest correlation with equities, but it remains a distinct factor.

This is not a recommendation to abandon high quality bonds but rather a suggestion to not automatically run away from corporate bonds. The highest quality bonds still are most likely to hold up or even gain in a flight to quality, and you may have spending needs sooner than you might think. As noted near the very top, sometimes CD excess yield over Treasuries, tax considerations, and other factors may make corporate bonds less appealing. Others may be turned off by the convexity and call features of some longer-dated corporate bonds. That is fine. But for the investor mulling bond fund choices in a 401(k), a core bond fund containing significant credit risk may not be such a bad idea. Just be sure to account for the presence of riskier bonds by adjusting the asset allocation overall.
Last edited by lack_ey on Thu Feb 23, 2017 12:57 am, edited 7 times in total.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by Dale_G » Tue Jan 31, 2017 2:20 pm

Thank you lack_ey. A very nice presentation. It is certain to arouse some conversation.

note: I own a very healthy amount of corporates.

Dale

edit: fixed spelling :annoyed
Last edited by Dale_G on Tue Jan 31, 2017 9:54 pm, edited 1 time in total.
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by matto » Tue Jan 31, 2017 7:47 pm

:beer

Seems like there is no reason to avoid corporate bonds. Sure you don't need them, but you also don't need to own companies whose tickers start with the letter H.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by bs1 » Tue Jan 31, 2017 8:46 pm

lack_ey,

perhaps an additional consideration in making the decision is the corporate spread and the absolute level of rates. with low absolute rates one might tilt toward taking more credit risk, depending on the spread. and all else equal if the rates of treasuries and corporates are close it would argue for staying with the former.

in the current environment of low absolute rates and high spreads, even "safe" bond proponents like DFA embraced credi risk (see DGSIX), which as you note has been richly rewarded since the crisis.

addendum: another way of stating this is "valuations matter"
Last edited by bs1 on Wed Feb 01, 2017 5:17 pm, edited 1 time in total.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Tue Jan 31, 2017 9:06 pm

bs1 wrote:lack_ey,

perhaps an additional consideration in making the decision, with rates at such low levels, is the corporate spread and the absolute level of rates. with low absolute rates one might tilt toward taking more call risk, depending on the spread. and all else equal if the rates of treasuries and corporates are close it would argue for staying with the former.

in the current environment of low absolute rates and high spreads, even "safe" bond proponents like DFA embraced call risk (see DGSIX), which as you note has been richly rewarded since the crisis.
Yeah, there's always a case to be made for some tactical allocation, looking at spreads/term structure/carry, etc. I would say that caution is warranted when attempting to increase risk exposures with the idea that assets are priced cheaply (same as trying to aggressively over-rebalance into stocks during an equity crash... they're cheap then for a reason). I think it's worth understanding the long-term behavior before determining any shorter-term deviations.

Are spreads still that wide? I'm seeing BofA Merrill Lynch US Corporate A Option-Adjusted Spread of 1.03. Do you know of a longer running data series than this?
https://fred.stlouisfed.org/series/BAMLC0A3CA
Image

In another thread I noted that Vanguard Short-Term Corporate Bond Index Fund (VCSH) from 8/31/2013 to 8/31/2016 had an SEC yield that moved from 1.63% to 1.73% (I think ER dropped slightly so not quite all yield changes) and an annualized return of 2.70%. I think there was some rolldown return there from Treasury term structure as well as credit term structure.

Of course, rates can always shoot up with inflation, there can be defaults/downgrades, and so on. It's never free money.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by bs1 » Tue Jan 31, 2017 9:25 pm

"Do you know of a longer running data series than this?"
--that's the only series I know of.

"Are spreads still that wide? "I'm seeing BofA Merrill Lynch US Corporate A Option-Adjusted Spread of 1.03."
--my impression is that BB and BBB spreads were wide until recently, whereas higher grade has been about average. however, the SEC yield of VCSH has been approximately double that of a treasury fund for many years now.

agree that utilizing spreads/absolute rates incurs risk, as does Fama's strategy of utilizing information in the term structure, but still seems reasonable to consider.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by larryswedroe » Tue Jan 31, 2017 10:02 pm

few thoughts
First, yes the higher yields in corporates shorten the duration as does the call risk (which helps explain to some degree the higher yield). But when you get deflationary recessions (i.e. 2008 or 30s) when labor capital becomes most at risk you actually want the longer duration of the higher quality treasuries. To me this is the most important point. The call feature of corporates will work against you as any high quality corporate will prepay and refi at lower rates.

Second, don't forget that with you can get higher yields and thus shorter durations also with CDs without taking the credit risks.

Third, sometimes you get bear markets in stocks without UE rising, so you don't have credit risk showing up. Good example would be the recent fall last january, the Brexit crises,and the 2000 fall in stocks when the bubble burst. That is one reason you don't see the correlations one might look for. But it's the tail risk that is of concern. I simply cannot find any good reason to own corporates beyond high quality ST (where you don't have call risk and not much credit risk). Very little benefit, if any once consider CDs and the downside of the 2008 type environment,

Finally, especially if using value tilted portfolios the deflationary recessions are when value tends to do the worse as the risks show up and that is when you want the high quality/longer duration bonds

Best wishes
Larry

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by nisiprius » Tue Jan 31, 2017 10:11 pm

lack_ey wrote:I find that historically, credit risk probably does not act significantly more like stocks and misbehave in equity bear markets. The possible exception is with our recent experience during the Great Recession.
I'm so blinded by the glare from the chart below that I'm having a little trouble seeing anything past it. Blue, stocks; orange, "high-yield" bonds; green, Treasuries.

Source
Image

A question which I don't have an answer to right now is whether the traditional narrative--junk bonds have equity risk--emerged after 2008-2009, or whether people were saying it before then. I vaguely think they were saying it before then. If they weren't, "junk bonds have equity risk" could be a case of falsely inducing a general rule from a single impressive data point. But it they were, then 2008-2009 would be a fulfilled prediction.
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by triceratop » Tue Jan 31, 2017 10:24 pm

nisiprius wrote:
lack_ey wrote:I find that historically, credit risk probably does not act significantly more like stocks and misbehave in equity bear markets. The possible exception is with our recent experience during the Great Recession.
I'm so blinded by the glare from the chart below that I'm having a little trouble seeing anything past it. Blue, stocks; orange, "high-yield" bonds; green, Treasuries.

Source
Image

A question which I don't have an answer to right now is whether the traditional narrative--junk bonds have equity risk--emerged after 2008-2009, or whether people were saying it before then. I vaguely think they were saying it before then. If they weren't, "junk bonds have equity risk" could be a case of falsely inducing a general rule from a single impressive data point. But it they were, then 2008-2009 would be a fulfilled prediction.
nisiprius:
Why focus on HY and direct the discussion that way when the data that lack_ey presents is about investment-grade corporate debt? Let me quote him/her again:
lack_ey wrote: Data and background

I use data from "The Credit Risk Premium" by Attakrit Asvanunt and Scott Richardson. The main observation motivating this paper is that many previous analyses of corporate and government bonds, including Fama and French back in 1993, examine bonds of equivalent maturity rather than equivalent duration (or really, option-adjusted duration), leading to a mis-measurement of credit risk. Corporate bonds of equivalent maturity will have higher yields and thus lower durations. The paper attempts to adjust older historical data to account for this, looking over the history of US investment-grade corporate bonds available, 1926-2014. They also examine shorter histories of high yield bonds, corporate bonds in other markets, and credit default swaps to evaluate credit risk in as many markets and scenarios as possible. The paper is worth reading in full, but to summarize, they do find a persistent credit risk premium and show that it can improve the efficiency of portfolios containing equity and term risk.

The main data, for investment-grade corporate bond returns in the US from 1926-2014, is available for download here.
Could this be a case of incorrectly falsifying a general rule from a single impressive, yet tangential, data point?
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Tue Jan 31, 2017 10:58 pm

larryswedroe wrote:Third, sometimes you get bear markets in stocks without UE rising, so you don't have credit risk showing up. Good example would be the recent fall last january, the Brexit crises,and the 2000 fall in stocks when the bubble burst. That is one reason you don't see the correlations one might look for. But it's the tail risk that is of concern. I simply cannot find any good reason to own corporates beyond high quality ST (where you don't have call risk and not much credit risk). Very little benefit, if any once consider CDs and the downside of the 2008 type environment,
Can you (or anyone) cite any previous examples of where the tail risks really showed up? The only thing that seems to jump out in the data is the financial crisis.

More generally, there's the point to be made that the nature of an equity bear market matters. Every one is different and not all will involve mass panic/credit freezing up/financial sector tanking. But if this is the case, how frequent are financial crises, anyway? Severe equity bear markets are not even that common themselves. If you're allocating to protect against a once-in-a-generation downside, maybe you're missing out on some upside in the meantime, picking up lots of pennies before you get steamrolled?

nisiprius wrote:
lack_ey wrote:I find that historically, credit risk probably does not act significantly more like stocks and misbehave in equity bear markets. The possible exception is with our recent experience during the Great Recession.
I'm so blinded by the glare from the chart below that I'm having a little trouble seeing anything past it. Blue, stocks; orange, "high-yield" bonds; green, Treasuries.

Source
https://s24.postimg.org/kdethipat/Captu ... _19_PM.png

A question which I don't have an answer to right now is whether the traditional narrative--junk bonds have equity risk--emerged after 2008-2009, or whether people were saying it before then. I vaguely think they were saying it before then. If they weren't, "junk bonds have equity risk" could be a case of falsely inducing a general rule from a single impressive data point. But it they were, then 2008-2009 would be a fulfilled prediction.
The post was very long, so let's double check and make sure everyone (including other readers, not saying you missed this) are clear on one thing:

I'm not saying that there's no equity risk component. There is on average, even for investment-grade corporate bonds. I'm saying that the equity risk component generally didn't get larger in equity bear markets, which is not the result I was expecting.

Suppose we had a hybrid asset X that acted like 20% stocks, 80% government bonds all the time. We would expect the correlation of X to equities to increase during equity bear markets, where stock returns are more volatile, because the 20% starts to dictate more of the behavior. We would normally expect X to lose money during equity bear markets as it's subject to 0.2 market beta (unless the 80% outweighs that). The point is that the behavior of X doesn't become more equity-like during bear markets. It's simply that the equity-like component acts out more at certain times.

In practice what I saw was that the market beta of the broad credit market excess return was variable but not particularly sensitive to the equity environment.

As noted above, the data series used was only investment-grade corporate bonds. There's a separate analysis in the linked paper for high yield bonds, but they don't provide data for them. With high yield bonds you should expect a greater relationship with equities. Just for a quick-and-dirty check, I see a much higher equity beta for short-term junk than short-term investment grade the last few years. Actually, iShares provides that information for their bond ETFs, though I have no idea which look-back period they're checking.

Maybe of some interest regardless:

Code: Select all

Ticker  Fund                                      Beta  Duration  OAS(bp) SEC yld%   ER%
AGG     Core U.S. Aggregate Bond                 -0.08     5.77    42.46    2.12    0.05
ISTB    Core 1-5 Year USD Bond                   -0.03     2.71    65.38    1.95    0.08
NEAR    Short Maturity Bond                       0.00     0.46    71.98    1.37    0.26
CSJ     1-3 Year Credit Bond                      0.01     1.89    65.14    1.67    0.20
QLTA    Aaa - A Rated Corporate Bond              0.05     6.79    88.29    2.84    0.15
LQD     iBoxx $ Investment Grade Corporate Bond   0.16     8.12   122.73    3.48    0.15
CLY     10+ Year Credit Bond                      0.21    12.95   162.96    4.36    0.20
SHYG    0-5 Year High Yield Corporate Bond        0.22     2.25   389.88    5.19    0.30
HYG     iBoxx $ High Yield Corporate Bond         0.30     3.88   349.96    5.22    0.49
OAS(bp) means option-adjusted spread (in bp, basis points)

edit: I added some additional detail to the third fund comparison made in the original post. Basically it's clear from this that the funds had mismatched term risk through at least a lot of the comparison.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by Valuethinker » Wed Feb 01, 2017 4:08 am

It is excellent analysis.

I will note a qualitative factor which is "touchy feely" and I don't have the time to go look for data.

I am almost sure that corporate creditworthiness has declined, even for the same credit rating, over the last 80 years.

My reasons are:

- businesses are now valued primarily on intangible assets (look at the price to book of the S&P500 now compared to 50 years ago, about 85% of value now is estimated to be intangibles). These are a lot harder to monetize in a distress/ sale situation

- old industrial companies with large assets have largely been replaced by service companies (think IBM now, Accenture etc.). That reduces asset backing in default.

- economic depreciation rates have increased sharply-- again looking at recovery in default. Look at how often hotels have to be revamped, say, to stay in the market. Office buildings, similarly. What has Airbnb done to the value of hotel assets? Look at the speed at which technology cycles move now, reducing the value of existing companies, brands, assets-- Blackberry what was that?

- courtesy of Modigliani and Miller there has been a much greater readiness of companies to use debt. And investors also. Corporate debt used to be *boring* only the best companies issued bonds. Now? Maybe the ratings agencies have stayed firm but, for example, the number of AAA corporates has plunged

- a lot of corporate debt now is issued by financial companies. Cue systemic risk. The value of their assets is dependent on the financial system as a whole

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Wed Feb 01, 2017 4:23 am

Valuethinker wrote:It is excellent analysis.

I will note a qualitative factor which is "touchy feely" and I don't have the time to go look for data.

I am almost sure that corporate creditworthiness has declined, even for the same credit rating, over the last 80 years.
See exhibits 31, 33, and 34 (yearly default rates, default rates over 1920-2010, default rates over 1970-2010):
http://efinance.org.cn/cn/FEben/Corpora ... 0-2010.pdf

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by nisiprius » Wed Feb 01, 2017 8:01 am

triceratop wrote:
nisiprius wrote:
lack_ey wrote:I find that historically, credit risk probably does not act significantly more like stocks and misbehave in equity bear markets. The possible exception is with our recent experience during the Great Recession.
I'm so blinded by the glare from the chart below that I'm having a little trouble seeing anything past it.
nisiprius: Why focus on HY and direct the discussion that way when the data that lack_ey presents is about investment-grade corporate debt?
The thread title "credit risk," so I thought the place it would be most visible would be in bonds that had more of it. I assumed that he used investment-grade corporate bonds because junk bonds as we know them weren't really invented until the 1980s, i.e. there aren't 89 years of data.
lack_ey wrote:The post was very long, so let's double check and make sure everyone (including other readers, not saying you missed this) are clear on one thing:

I'm not saying that there's no equity risk component. There is on average, even for investment-grade corporate bonds. I'm saying that the equity risk component generally didn't get larger in equity bear markets, which is not the result I was expecting.
I did sort of miss it. I've got it now.

Yes, my naïve mental model is that the bond landscape is like water with reefs and shoals; high credit quality means deep water, low credit quality means shoals, and you'd expect the danger of the shoals to be nonlinear with the tides--they don't wreck ships just because the water gets slightly shallower; they wreck ships only when the tide goes out far enough to expose them as reefs. So, yes, it sounds as if you'd expect equity risk of bonds to get larger in equity bear markets.

You're saying you didn't see a second-order, nonlinear effect. You didn't see evidence of disproportionate decline in equity bear markets. You're suggesting the data you looked at wasn't too different from a mixture of the highest-quality bonds with a small amount of stocks. And therefore can be fairly judged on the merits of its average return, standard deviation, correlations without correcting for nonlinear extra-bad behavior in bear markets.

With regard to investment grade corporate bonds in 2008-2009, intermediate-term investment-grade mostly-corporate bond funds took about a 10% hit (compared to 20% for junk bonds). remember William J. Bernstein expressing surprisingly-to-me strong feelings about this, and dismay at not having been able to rebalance because his corporate bonds were down, and suggesting afterwards that if you want the risk-free asset you should buy the risk-free asset (i.e. Treasuries). Since a 10% hit didn't seem all that terrible to me I actually emailed him to ask just what kind of bonds he was talking about, but he declined to elaborate, so I don't know if he personally experienced anything worse than a 10% hit or if he really was disappointed at having to rebalance from something that was 10% down.

In Total Bond I experienced a very nice balance--the 10% hit on the corporates just about matched the 5% boost from the Treasuries and the total went just about straight through. Not that I was paying attention, but it didn't do anything to get my attention. As for rebalancing, I was too scared to do it.
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by PaulF » Wed Feb 01, 2017 8:22 am

nisiprius wrote:A question which I don't have an answer to right now is whether the traditional narrative--junk bonds have equity risk--emerged after 2008-2009, or whether people were saying it before then. I vaguely think they were saying it before then. If they weren't, "junk bonds have equity risk" could be a case of falsely inducing a general rule from a single impressive data point. But it they were, then 2008-2009 would be a fulfilled prediction.
Well, I bought Larry Swedroe's bond book in 2006, and that is where I first came across this assertion. I structured my holdings a la Larry, which was certainly helpful during the crash!

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by larryswedroe » Wed Feb 01, 2017 8:27 am

Lackey
Just couple of other thoughts
First, as I have noted, the lower the credit rating the more equity like the risks became and the same for horizon. So if you limit yourself to investment grade and short term you are not going to see that much equity like risk, except in a severe situation (never treat the unlikely as impossible). And that is why I've owned at times some high quality ST investment grade bonds that also don't take call risks (though if shorter term that isn't as great a risk). I've owned DFA extended quality as well. Second, if have CDS IMO that is likely a superior option anyway.
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Wed Feb 01, 2017 12:02 pm

nisiprius wrote:Yes, my naïve mental model is that the bond landscape is like water with reefs and shoals; high credit quality means deep water, low credit quality means shoals, and you'd expect the danger of the shoals to be nonlinear with the tides--they don't wreck ships just because the water gets slightly shallower; they wreck ships only when the tide goes out far enough to expose them as reefs. So, yes, it sounds as if you'd expect equity risk of bonds to get larger in equity bear markets.
I'm thinking that maybe you do get wrecked in high yield but don't have the data for it, and honestly the asset class isn't that old so I'd imagine it would be hard to say. Economically I think this largely makes sense, and there can readily be tail risk the likes of which we haven't seen yet. Just because it hasn't happened doesn't mean it can't.
nisiprius wrote:You're saying you didn't see a second-order, nonlinear effect. You didn't see evidence of disproportionate decline in equity bear markets. You're suggesting the data you looked at wasn't too different from a mixture of the highest-quality bonds with a small amount of stocks. And therefore can be fairly judged on the merits of its average return, standard deviation, correlations without correcting for nonlinear extra-bad behavior in bear markets.
That's right, except the second sentence needs to be qualified. On the downside I didn't see much evidence of misbehavior beyond what you'd expect from a mixture of the highest-quality bonds and a small amount of stocks. On the full dataset, as investigated much more thoroughly in the paper from which the data originated, there is evidence of statistically significant positive alpha above term and equity risk. If corporate bonds acted like those two things then ex-post optimal asset allocations wouldn't need to include any of them (can just get the exposures via the other two). Even cutting out some of the best months for credit, looking 1950-2014, I find the intercept (alpha) has a t-stat of 1.88 on the monthly returns when regressing on the market beta. Keep in mind there's also more limited data on high yield, corporate bonds around the world, etc. so it is not just this one data series.
nisiprius wrote:With regard to investment grade corporate bonds in 2008-2009, intermediate-term investment-grade mostly-corporate bond funds took about a 10% hit (compared to 20% for junk bonds). remember William J. Bernstein expressing surprisingly-to-me strong feelings about this, and dismay at not having been able to rebalance because his corporate bonds were down, and suggesting afterwards that if you want the risk-free asset you should buy the risk-free asset (i.e. Treasuries). Since a 10% hit didn't seem all that terrible to me I actually emailed him to ask just what kind of bonds he was talking about, but he declined to elaborate, so I don't know if he personally experienced anything worse than a 10% hit or if he really was disappointed at having to rebalance from something that was 10% down.

In Total Bond I experienced a very nice balance--the 10% hit on the corporates just about matched the 5% boost from the Treasuries and the total went just about straight through. Not that I was paying attention, but it didn't do anything to get my attention. As for rebalancing, I was too scared to do it.
That's the thing. Even if the tail risks are real (they... should be?), how often do they really show up, and should you even care that much about the downside, even assuming you're definitely going to rebalance?

If you're picking up a sufficient number of pennies in front of a sufficiently small, slow steamroller, that is not necessarily a bad strategy.

Anyway, I just don't see evidence to support strong feelings against credit. Though I'm okay with a mild or even moderate stance against, as I can't tell somebody to fully trust the methodology of this one analysis (though the 1988-present numbers tell much the same and don't require their approximate duration matching) or throw away any priors one might have about tail risks and economic theory regarding relatedness, etc.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by Kevin M » Wed Feb 01, 2017 12:47 pm

Nice analysis. Thank you!

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by long_gamma » Wed Feb 01, 2017 12:48 pm

I thought this article is interesting, when we compare high yield OAS to forward returns.

http://econompicdata.blogspot.com/2017/ ... ld-at.html
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Wed Feb 01, 2017 1:18 pm

long_gamma wrote:I thought this article is interesting, when we compare high yield OAS to forward returns.

http://econompicdata.blogspot.com/2017/ ... ld-at.html
I think the conclusions may be a bit different for high yield, and tactically things may be less encouraging right now than maybe the long-term behavior? I have not examined the level of predictability of OAS vs. returns and would be wary of market timing based on an incomplete understanding of what might be a pretty noisy signal. I don't know.

I'd note that the 1995-2016 chart in the article for 4-year return vs. Treasuries looks like a lot of data points, but that's just 21 years and those data points are heavily overlapping. Furthermore, we know spreads were low (though not the lowest in the dataset) around 2005-2007, and all of those points indicate terrible returns on the chart by nature of leading into the financial crisis. That pretty clearly biases the data based on the one event.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by nisiprius » Wed Feb 01, 2017 1:18 pm

lack_ey wrote:...Anyway, I just don't see evidence to support strong feelings against credit...
Please enlighten me on the colloquial use of the word "credit" here. I am not in the investing community and I never heard it used that way before the collapse of the Third Avenue Focused Credit fund. "Focused Credit owns the debt of firms that are restructuring or in bankruptcy proceedings, making it more akin to a distressed-debt hedge fund (for instance, it owns Lehman Brothers bonds) than a typical high-yield mutual fund." In press stories I read language like
As many are aware, Third Avenue launched the Third Avenue Focused Credit Fund earlier this year. I think this is a fantastic vehicle for individual investors investing in the credit space.
and
The genesis for the Fund was driven by a market opportunity in credit that Third Avenue had not seen since the early 1990s. As our colleagues have written about in the other Third Avenue Funds Shareholder Letters, debt became a bigger focus in 2008 and early 2009. Indeed, due to our history and credit heritage, Third Avenue has always had a proclivity to invest in credit and special situations. However, what was occurring in the credit markets were, as Marty Whitman so aptly put it, “investments of a lifetime.” Similarly, it was clear that you, our shareholders, were making inquiries about a credit only product. We believed that a differentiated credit fund with daily liquidity where the Fund Manager would pick the best investments across the bank loan, high-yield bond and busted convertible bond universe was the best structure. Clients also wanted some exposure to distressed investments, given the higher default rates and Third Avenue’s twenty-three year track record of distressed investing.
This led me to infer that "credit" was a euphemism for "sub-junk credit quality" (much as "high yield" is a euphemism for "junk.")
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by triceratop » Wed Feb 01, 2017 1:36 pm

nisiprius:
"credit" here means "credit risk", i.e. the risk of default on corporate debt with an associated expected premium, the default premium. Junk bonds do indeed have more credit risk; however, "credit" is by no means a euphemism. While I won't speak for lack_ey it seems clear to me that the usage is meant to refer to the use of corporate debt in addition to treasuries (which are assumed to have no default risk). Or, Here is a reference found on the first page of a google search for the term.

Again, lack_ey's analysis has nothing to do with high-yield, junk, or the market segments Third Avenue credit traded in.
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by nisiprius » Wed Feb 01, 2017 1:49 pm

triceratop wrote:nisiprius:
"credit" here means "credit risk", i.e. the risk of default on corporate debt with an associated expected premium, the default premium. Junk bonds do indeed have more credit risk; however, "credit" is by no means a euphemism. While I won't speak for lack_ey it seems clear to me that the usage is meant to refer to the use of corporate debt in addition to treasuries (which are assumed to have no default risk). Or, Here is a reference found on the first page of a google search for the term...
No, that's a definition of "credit risk," which I understand. My question concerns the use of the word "credit" in isolation. You are telling me it's just a nickname for credit risk, all levels.

How would you interpret the name "Third Avenue Focused Credit Fund" other than as euphemism? Why do you think it wasn't called the "Third Avenue Distressed Debt fund?"
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Wed Feb 01, 2017 2:08 pm

Here by "credit" I just mean in the context of "credit bond," relating to the credit/default premium. Credit broadly is more or less debt, but I think it's rare in this context to use it to refer to US Treasury bonds (I also don't really see it for high-quality muni bonds), particularly specifically here where the credit excess return is defined as the return above duration-matched Treasury bonds.

It's kind of a superset that contains corporate bonds, generally speaking, also including things like non-agency MBS and other asset-backed securities for which you have to worry about the credit quality. It includes both high yield and investment grade quality.

Many investment-grade bond funds use the word "credit," including iShares 1-3 Year Credit Bond ETF, iShares U.S. Credit Bond ETF, DFA Targeted Credit, Goldman Sachs Investment Grade Credit. In other cases funds may be purely high yield or a mix.

Presumably if credit risk in corporate bonds is rewarded/not rewarded, it is probably not that different in other kinds of credit bonds. Or at least that would be my tentative initial assumption.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by nisiprius » Wed Feb 01, 2017 2:49 pm

Thanks, lack_ey. "Credit" means "anything that isn't a Treasury?"
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by larryswedroe » Wed Feb 01, 2017 3:04 pm

I'll just add that the longest term data shows a pre expense credit premium of just 0.2 percent. Add say even 10bp for ER and you are now at 10bp. And since 1960 it's been slightly negative. Now that's 20 year bond.

And with the much higher yields on CDs vs. Treasuries I just cannot see the benefits, especially when measured against the tails risks that can show up in systemically difficult markets when credit tightens and banks under stress and stocks also killed. For that very small premium which doesn't mix well when needed most.

This is especially true for HIGH yield where if memory serves even Vanguard's fund which is just below investment grade lost over 20% in 08 and real junk lost 50-60%. If going to take corporate risks stick to investment grade and shorter term, and if can avoid call risk (which also can show up at wrong time)

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by triceratop » Wed Feb 01, 2017 3:19 pm

larryswedroe wrote:I'll just add that the longest term data shows a pre expense credit premium of just 0.2 percent. Add say even 10bp for ER and you are now at 10bp. And since 1960 it's been slightly negative. Now that's 20 year bond.
As you know, that's the credit premium (0.18%), which of course is the excess return over treasuries. Most investors here use treasury bond funds, such as VGIT. The expenses there happen to be the same as the expenses for the corporate bond fund, VCIT (lower as % of yield, too) -- 7bp. Ditto for short-term comparison, VCSH vs. VGSH. I just think that it's important to compare apples to apples.

Obviously, if use CDs or individual treasuries then this is not an issue. But that's a separate discussion independent of the question of taking credit risk: individual vs. fund.
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Wed Feb 01, 2017 3:59 pm

The main point behind the dataset is that comparing equal maturity does not mean comparing equal duration or term risk (though the comparison is complicated for the long bonds with call features). Measured over a period of positive return from term risk, you get an understatement of credit excess return by not adjusting for equivalent duration.

The average excess credit return given for 1936-2014 from the dataset is 1.74% but only 0.07% if not duration matching. Fama and French's 1993 paper found 0.02% (not duration matched). This makes a big difference. If the excess return is 0.07% or 0.02% or even 0.20% you probably don't want it, given the characteristics and downside. If it's over 1% then maybe we're talking.

I didn't mean to address the estimate for the mean return here; regardless of your issues with the premise and the procedure they used to attempt to duration match older bond data, I think the overall trends should still hold. If the data is biased let's say 130 bp too high, this probably shouldn't significantly impact the analysis and conclusions relating to credit risk exposure to equity risk.


By the way, I just realized I've been reading the label wrong and the data series reflects CORP_XS as specified and not CORP_XS_SPLICED. So this uses long-term corporate bonds from Ibbotson's data I think including high yield for the later years. Still should be primarily investment grade as most junk bonds aren't long term. Prior to the '80s basically everything should be investment grade. CORP_XS_SPLICED is the same data through 1988 and then switches to the Barclays data (which show a lower but still positive return for investment-grade credit risk).

In any case if it does include some high yield later on, that kind of fits with the higher equity beta later in the period.

So most of the data in the paper is not actually available online, just that one bit from preliminary work. For some of their other papers they have more comprehensive data that is kept up-to-date but here they haven't updated for anything past the end of 2014.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by Kevin M » Wed Feb 01, 2017 5:35 pm

larryswedroe wrote:I'll just add that the longest term data shows a pre expense credit premium of just 0.2 percent.
Larry, I think one of the main points of the paper that lack_ey's analysis is based on is that this credit premium estimate is low due to not duration-matching the bonds in the analysis, and when duration-matched the credit premium appears to be much larger.
And with the much higher yields on CDs vs. Treasuries I just cannot see the benefits, especially when measured against the tails risks that can show up in systemically difficult markets when credit tightens and banks under stress and stocks also killed. For that very small premium which doesn't mix well when needed most.
I think one of lack_ey's main points is that credit risk is a risk factor that is distinct from the equity risk factors. If so, and if the credit premium, when properly measured, is much higher than other analyses have shown, then many years of the risk being rewarded should more than offset the very rare instances in which it shows up big time.

I use CDs in preference to Treasuries, exclusively, and rather than use Treasuries for exposure just to term risk, I use a relatively small allocation to investment-grade bonds for exposure to both term risk and credit risk. The relatively small and rare rebalancing bonus from combining Treasuries with stocks doesn't persuade me to use Treasuries for just this benefit.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by larryswedroe » Wed Feb 01, 2017 6:31 pm

Lackey and Kevin
Yes I am well aware that the higher yield creates bit low duration, and so does the call risk---and thus it understates the credit premium but then overstates the term premium earned by the same bonds. In other words the returns are the same, but where you attribute the return to is understated in one case and overstated in the other. And again you can get the higher yield and thus shorter duration without the credit risk and without the negative tail risk either simply by purchasing CDs.

And again with that said, I've owned shorter term investment grade corporates without call risks at times, but believe CDs are superior alternatives when you have the option, which you don't in 401k plans typically.

Best wishes
Larry

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by markfaix » Thu Feb 02, 2017 12:21 am

larryswedroe wrote:Lackey and Kevin
Yes I am well aware that the higher yield creates bit low duration, and so does the call risk---and thus it understates the credit premium but then overstates the term premium earned by the same bonds. In other words the returns are the same, but where you attribute the return to is understated in one case and overstated in the other. And again you can get the higher yield and thus shorter duration without the credit risk and without the negative tail risk either simply by purchasing CDs.

And again with that said, I've owned shorter term investment grade corporates without call risks at times, but believe CDs are superior alternatives when you have the option, which you don't in 401k plans typically.

Best wishes
Larry
Larry
A rookie question re CD purchases. Suppose you want to purchase a 10 year CD ladder, with average maturity 5 years.

Do you simply buy equal amounts of 1,2,3, ..., 10 year CDs?

Or do you pick and choose depending on steepness of yield curve? (eg 1 yr 1.0% and 2 yr 1.6%, so buy 2 yr and not 1 yr CD).

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by larryswedroe » Thu Feb 02, 2017 7:28 am

Makrfaix
No hard an fast rules, but could simply buy equal amounts for each year.
We basically do that, though will extend a bit when curve steeper and shorten a bit when curve flatter. So might move to average off 4 or 6 years instead of 5. But want to keep balance between reinvestment and inflation risk

Larry

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by Robert T » Thu Feb 02, 2017 7:42 am

.
Few thoughts.

Findings from Fama-French 1993 paper using data from 1963-1991 - https://faculty.fuqua.duke.edu/~charvey ... n_risk.pdf . When looked at in isolation:

“Default” load in stocks (Table 3, t-stats in parenthesis)
  • 0.78 (3.60) = large growth
    1.52 (5.45) = small value
Message: there is ‘default’ risk already embedded in all stocks, more so in small value than large growth (the former had double the default load than the latter).

“Equity load” estimates on bonds (from Table 4 in FF paper, t-stats in parenthesis)
  • 0.08 (5.24) = 1-5 government
    0.13 (5.57) = 6-10 government
    0.19 (7.53) = Aaa
    0.20 (8.14)= Aa
    0.21 (8.42) = A
    0.22 (8.73) = Baa
Message: there is ‘equity’ risk in bonds which increase as credit ratings decline.

Portfolio comparisons

1992 – 2016 (25 years)

Annualized returns (%) /SD
  • 7.5 / 7.9 = Vanguard Long-term Investment Grade
    7.2 / 12.0 = Vanguard Long-term Treasury
    5.6 / 6.3 = Vanguard Intermediate Treasury
Combining in 75:25 DFA ‘Balanced Equity”:bond portfolio
  • P1 = 10.5 / 13.7 = with Vanguard Long-term Investment Grade
    P2 = 10.7 / 12.4 = with Vanguard Long-term Treasury
    P3 = 10.5 / 12.6 = with 50:50 Vanguard Long-term Treasury: Intermediate Treasury
1992 – 2007 (to exclude 2008)

Combining in 75:25 DFA ‘Balanced Equity”:bond portfolio
  • 12.5 / 10.6 = with Vanguard Long-term Investment Grade
    12.6 / 10.3 = with Vanguard Long-term Treasury
    12.5 / 10.2 = with 50:50 Vanguard Long-term Treasury: Intermediate Treasury
Message: Over the last 25 years, despite the superior returns/SD of long-term corporate bonds relative to treasuries on a stand-alone basis, inclusion of treasuries in a 75:25 DFA ‘Balanced Equity’:bond portfolio (P2) provided slightly higher returns and lower volatility than adding corporate bonds (P1). Adjusting durations, crudely reflected by the 50:50 long-term:intermediate treasury mix [P3], provides similar returns as P1 but with lower volatility). Adjusting the stock:bond mix didn’t change the overall result. Excluding 2008 (using data from 1991 to 2007) didn’t change the overall result.

Quite a long-time ago now, I did some simulations that showed some benefit to adding shorter duration corporate bonds when equity (risk) allocations are low, but showed no benefit for higher equity allocations.

Obviously no guarantees.

Robert
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Thu Feb 02, 2017 11:54 am

Robert T wrote:“Default” load in stocks (Table 3, t-stats in parenthesis)
  • 0.78 (3.60) = large growth
    1.52 (5.45) = small value
Message: there is ‘default’ risk already embedded in all stocks, more so in small value than large growth (the former had double the default load than the latter).
Yeah, if tilting equities then corporate bonds are worse as you're getting more overlap in exposure. This even shows up in Asvanunt and Richardson, where they do a regression of excess credit return on excess S&P 500, excess S&P 500 prior month, excess government bond, SMB, HML, and UMD. There's a load of 0.0250 (t = 2.16) on SMB and 0.0143 (t = 1.26) on HML over 1936-2014.

Robert T wrote:“Equity load” estimates on bonds (from Table 4 in FF paper, t-stats in parenthesis)
  • 0.08 (5.24) = 1-5 government
    0.13 (5.57) = 6-10 government
    0.19 (7.53) = Aaa
    0.20 (8.14)= Aa
    0.21 (8.42) = A
    0.22 (8.73) = Baa
Message: there is ‘equity’ risk in bonds which increase as credit ratings decline.
But over this 1963-1991 period, this is not that strong, with less relationship than you might think. Going from 0.19 in Aaa to 0.22 in Baa? Also, the t-stats are for confirming that the figures aren't 0. I wonder if the difference between those 0.19 through 0.22 is even significant (it may be, and it definitely follows from theory, so I don't question the result).

Those figures fit curiously with what I see from the other paper's data:

For CORP_XS: 0.0448, standard err. 0.0155, t = 2.880
For GOVT_XS: 0.2479, standard err. 0.0415, t = 5.973

Remember that CORP_XS is the series with duration-matched government bond exposure zeroed out. Corporate bonds would be exposed to both GOVT_XS and CORP_XS. Given that GOVT_XS is formed using long-term government bonds, and Fama/French see higher equity loads on 6-10 government than 1-5 government, it seems like the longer the government bonds over that period, the higher the equity beta. Might the corporate bonds analyzed by them from Moody's data be longer term than the 6-10 government?

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by larryswedroe » Thu Feb 02, 2017 12:05 pm

Lackey
As I said, if you stick with ST it's not that much difference, but big difference for high yield, But also keep in mind with corporates have to use funds and pay expenses and their trading costs but with Treasuries can do on own and avoid them or better buy CDs and get even higher returns without the costs.
Also as I said, to me there are far worse "mistakes" then including investment grade bonds especially if limiting to shorter end, but IMO it's not optimal
Best wishes
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by scotbogle » Thu Feb 02, 2017 3:35 pm

Larry,

What if you are an European investor, as I am, and don't have access to CD's ?

Should you then combine government debt worlwide (euro hedged) with corporate bonds (IG) worlwide (euro hedged) ?

Because, if I only stick to government bonds in Europe then yields are almost zero.
And which government to include ? What about governments like France, Italy and Spain ??

Personally I stick to a minimum of 45-50% AAA/AA and max 30% BBB.
50-60% is Treasury (worlwide), corporate debt (IG) is 30-40% and securitized is 5-10%.

In addition to European benchmark I add a worldwide bond index fund to get 25-30% exposure to US debt and underweight gov.debt of Italy, Spain, France.

What do you think ?

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by larryswedroe » Thu Feb 02, 2017 7:06 pm

Scot
First, he level of rates should not matter, it's the spread. And are you being rewarded well for taking risks.

Second, if you decide to take corporate risk I would see if could eliminate or minimize call risks present in many US corporate bonds, with that said, if taking credit risk I would urge avoiding high yield and make sure you at least correct your AA to account for the equity like risks in corporates.
Now one last thing, the problem with owning BBB's is that if they go one level below they become high yield and then funds are forced to sell them, which is actually a bad thing as the one type of corporate bonds that have performed reasonably well are those fallen angels. The reason is they get dumped at same time, prices driven way down and the call risk is virtually gone. So I'd stick with the higher grades like AAA/AA and reduce the risk of credit downgrades to below BBB

Hope that helps
Larry

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by grabiner » Thu Feb 02, 2017 10:29 pm

lack_ey wrote:
Robert T wrote:“Equity load” estimates on bonds (from Table 4 in FF paper, t-stats in parenthesis)
  • 0.08 (5.24) = 1-5 government
    0.13 (5.57) = 6-10 government
    0.19 (7.53) = Aaa
    0.20 (8.14)= Aa
    0.21 (8.42) = A
    0.22 (8.73) = Baa
Message: there is ‘equity’ risk in bonds which increase as credit ratings decline.
But over this 1963-1991 period, this is not that strong, with less relationship than you might think. Going from 0.19 in Aaa to 0.22 in Baa? Also, the t-stats are for confirming that the figures aren't 0. I wonder if the difference between those 0.19 through 0.22 is even significant (it may be, and it definitely follows from theory, so I don't question the result).
The standard error of the difference between two numbers, assuming independence, is the square root of the sum of the squares of the individual numbers. Thus, if both numbers have similar standard errors, the standard error of the difference is the standard error of the individual numbers, divided by the square root of two.

Thus the 0.03 difference between 0.19 for Aaa and 0.22 for Baa is equivalent to a t-stat of about 0.85, which is very likely to occur at random.

I was also surprised to see such a small difference. If the difference is actually this small, then it doesn't matter what quality of investment-grade bonds you use to diversify the stock portfolio, but it does matter whether they are corporate or government.
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by long_gamma » Sun Feb 05, 2017 8:48 pm

lack_ey wrote: Do you know of a longer running data series than this?
Not exactly OAS. FRED added HQM corporate bond spot rate based on methodology developed by Treasury.
https://news.research.stlouisfed.org/20 ... ate-bonds/

This is the comparison between 10 year spread between treasury and corporate bond spot & BofA corp.OAS. I am not sure about duration of BofA index, probably less than 10.

Imageimgupload
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Tue Feb 14, 2017 9:35 pm

I took a look at fund returns data to examine equity beta for funds directly and not credit risk itself, and high yield sure does look different from investment-grade bonds. Beta below, with returns also shown for reference. I used these iShares bond funds because I wanted to capture the period through the financial crisis; more popular options like Vanguard's short-term and intermediate-term corporate bond index funds started in 2009. The Vanguard non-index mutual funds look mostly similar.

Image

Data source is daily returns via Yahoo Finance adjusted closes hopefully correctly taking into account dividends, which I'm not sure is completely accurate. The 60 days is over trading days, not calendar days. So a little under 3 months.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by jalbert » Tue Feb 14, 2017 9:56 pm

Need to be careful analyzing the data. Credit spreads may widen as perceived risk of a recession increases and credit risk is repriced. Stock prices may fall as perceived risk of a recession increases and equity risk is repriced.

There is no reason these two events must happen in the same month. Monthly correlations of credit and equities, or computations of credit beta relative to equities (which is a dubious measure as beta is defined to measure a security's sensitivity to its own market) are both based on correlating price movements that occur at the same time frame.

On the other hand, if the timeframes are shifted enough, a diversification benefit is still possible.

I view the market turmoil of 2008/2009 as a stress test of diversification benefits of asset classes. While that event probably won't be repeated, when an adverse behavior actually occurs, then the idea that there is risk of it occurring in the future is vindicated.
Last edited by jalbert on Thu Feb 16, 2017 10:08 pm, edited 1 time in total.
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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Tue Feb 14, 2017 10:03 pm

Of course there are big limitations with just this one measure for the reasons stated (though I don't see why one would object to looking at equity beta for anything, with the understanding of what that does and doesn't entail), and it doesn't measure exactly what you might think on a casual look, but those caveats don't explain why there should be a huge difference between high yield and investment grade bonds through the whole period.

These funds are reasonably well traded and daily movements should at least be some kind of proxy for investor demand and asset behavior. Why risk on/off with high yield at the same time as equities so sharply but not investment grade bonds?

Now, I do think it's worth checking a coarser timeframe so I'll look at that eventually too.

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by lack_ey » Fri Feb 17, 2017 11:53 am

I just did some scatterplots of VTI vs. other asset returns over roughly the last 10 years. Not much data here, and this covers a kind of unique period, so don't take anything too seriously, but again clearly here you see at least in this period a pretty noticeable relationship any way you look at it between stocks and high yield bonds. There is something with investment-grade bonds but not nearly to the same extent.

Many many caveats here and to be honest linear trend lines are a bit of an abuse here given the nature of the data with variable vol etc.

Reminder:
VTI - Vanguard Total Stock Market Index
CIU - iShares Intermediate Credit Bond (1-10 yr)
CSJ - iShares 1-3 Year Credit Bond
IEI - iShares 3-7 Year Treasury Bond
VBR - Vanguard Small Cap Value Index
EFA - iShares MSCI EAFE (most developed ex-US stocks)
VWO - Vanguard Emerging Markets Index
DBC - PowerShares DB Commodity Index Tracking Fund

Looking at 5-day periods:
Image

Doesn't seem like much of anything between investment-grade bonds and the stock market, but notably the Treasuries did have some negative correlation. Fair enough, equity market risk may not be priced during the same "frame" or period as credit risk, so maybe not co-movement seen then, so how about 21 days, roughly a month in real time?
Image

Looks like something. But what's the one extreme lower-left point mean? Shifting all the periods by roughly half, starting two weeks later, again 21-day periods but different ones:
Image

Notice how the data fits less for investment-grade just because we shifted everything by two weeks. Again, lots of noise, maybe not capturing things in the right periods. How about roughly a quarter, 60 days?
Image

For reference, here's what other stocks and commodities vs. VTI looks like:
Image

all images album
PV daily correlations, annualized returns, standard deviations over the period (despite the obvious correlation seen in the last chart, don't forget how much US stocks outperformed ex-US)

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Re: Does credit risk show up at the wrong time? [A look at 89 years of corporate bond data]

Post by jalbert » Sun Feb 19, 2017 2:27 pm

Nice work.
Looks like something. But what's the one extreme lower-left point mean?
The scaling of bond returns on the y-axis is "slower" than the scaling of stock returns on the x-axis, so tge lower left point is closer to the regression line than the visual representation suggests.

It is interesting that short-term credit appears more correlated to equities than intermediate credit. I suppose that is not unexpected as there is less interest rate sensitivity so that price movements are more driven by changes in credit spreads.
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