The Real Corporate Bond Puzzle

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 |  Includes: APX, ARK, CMU, COY, CXE, FPT, FT, HIS, HYB, HYG, HYI, HYP, JNK, KHI, KSM, MFM, MHF, MSY, OIA, OIB, OIC, PHF, PMM, SBI, VLT
by: Eric Falkenstein

I noted in my book Finding Alpha that junk bonds have not outperformed investment grade bonds since data on junk bonds really became available, around 1987. This is the real corporate bond puzzle, in direct contrast to the corporate bond puzzle most academics address, which is the anomalously high return premium between BBB and AAA bonds (around 100 basis points annually).

Academics seem to consistently miss the big picture in corporate bonds, which to me is the lame returns on patently riskier junk bonds over the business cycle. For example, Steve Cecchetti’s textbook Money, Banking, and Financial Markets, immediately presents the seemingly straightforward example of how bonds with higher default rates have higher yields: Risk and return rise together. Yet, this is purely an anticipation of the default rates, and so is not risk in the sense of something priced. BBB bonds have, over time, about the same total return as B-rated bonds. One must subtract the expected defaults and the resulting losses from a stated yield regardless of one’s risk tolerance.

The successful and ubiquitous usage of one flavor of 'risk' — the mere statistical volatility and loss estimation — does not imply the second flavor of 'risk' relating to a priced factor affecting future returns as also ubiquitous and essential. The distinction between or default risk by itself and priced risk (a covariance with some systemic metric of aggregate happiness, such as GDP, the S&P500, or unemployment) is a fundamental distinction in modern risk-return theory, yet prominent professors conflate risks when useful for selling the old bromide that risk and return go together like shoes and socks. Financial professionals have a strong, perhaps unconscious, bias toward the big idea: Risk begets average returns.

In addition to stated yield vs. actual returns, or survivorship biases, there is the simple fact of the difference between an annual average, and a cumulative return. Basically, the difference between a geometric mean and an arithmetic mean. In bonds this is huge. As mentioned Tuesday, bond returns were down 26% in 2008, but up 40% in 2009. Does that mean they have a 14% total return? No. Think (1-.26)*(1+.40) and you get an 8% total return. But remember, those numbers are from Merrill Lynch indices using a collection of highly illiquid bonds closing prices. Actual bond fund returns from the beginning of 2008 have been -1%. See below for a collection of returns from the subperiods, and note how they compare to the entire period.

Below are data through August 2009 for a collection of High Yield bond funds:

2008 Ret 2009 Ret 2008-9 Ret
BLACK-HI INC SHS (NYSE:HIS) -37 56 -2
NEW AMER HI INC (NYSE:HYB) -40 94 17
HIGH YLD PLUS FD (HYP) -28 59 14
MORGAN ST HI YLD (NYSE:MSY) -27 45 6
VAN KAMP HI INC2 (NYSE:VLT) -45 59 -12
MFS INTERMEDIATE (NYSE:CIF) -40 56 -6
PUTNAM MGD MUNI (NYSE:PMM) -23 33 3
MFS HIGH INC MUN (NYSE:CXE) -43 74 0
DWS HIGH INCOME (NYSE:KHI) -30 39 -3
MFS HIGH YIELD M (NYSE:CMU) -38 62 1
BLACKROCK-COR HY (NYSE:COY) -39 76 8
BLACKROCK-SR HIG (NYSE:ARK) -49 42 -28
WESTERN ASSET IN (NYSEMKT:SBI) -9 22 11
PACHOLDER H/Y FD (NYSEMKT:PHF) -48 84 -4
FRANKLIN UNIVERS (NYSE:FT) -41 45 -14
HIGH YLD INC FND (NYSE:HYI) -26 40 3
MFS MUNI INC TST (NYSE:MFM) -36 68 8
WESTERN ASSET MU (NYSE:MHF) -5 16 10
MORGAN ST MU IN3 (NYSE:OIC) -28 33 4
DWS STR MUN INCM (NYSE:KSM) -20 49 19
MORGAN ST MU IN (NYSE:OIA) -31 37 -6
BLACKROCK-APEX M (APX) -27 36 -1
FEDERATED I MUNI (NYSE:FPT) -17 45 21
MORGAN ST MU IN2 (NYSE:OIB) -33 35 10
Average -32 50 -1
Click to enlarge