Strategies For Bond Portfolio Selection: Beware Of “Lottery Demand”

Summary

• Why do otherwise rational investors pay $1 for a lottery ticket that on average only pays 70 cents on the dollar?
• One should know the answer to that question before investing in "high yield" bonds, more correctly described as "junk bonds."
• This note explains the existing (but still incomplete) research that suggests that lottery tickets and junk bonds may have a lot in common.  Beware!

Kamakura’s individual investor service The Corporate Bond Investor is a daily ranking of all senior fixed-rate bonds with at least $1 million in trading volume by “best value.”  How is “best value” measured?  We use a simple but power measure: the reward (credit spread) to risk (annualized default probability) ratio. Once we have the best value rankings, how do we use the results for bond portfolio construction and (just as important) portfolio modifications?  A subscriber to The Corporate Bond Investor asks this question:

“Is cumulative default probability matched to bond’s maturity the best metric of risk?  Do you have any notional ideas of how much cumulative default probability should trigger a sell? “ 

This is a critically important question and the answer has been much debated.  Our answer has been heavily influenced by Prof. John Y. Campbell of Harvard University and Arrowstreet Capital LP, Prof. Jens Hilscher of University of California at Davis and Kamakura Corporation, and Dr. Jan Szilagyi.  They authored two key papers in 2008 and 2011:

“In Search of Distress Risk”, Journal of Finance, 63:2899-2939, December 2008.“Predicting Financial Distress and the Performance of Distressed Stocks”, Journal of Investment Management 9(2):1-21, First Quarter 2011.  Winner of Harry M. Markowitz Award, 2011.

In these papers, the authors find that high default risk common stocks underperform low default risk common stocks by every risk-adjusted performance measure.  These findings have been independently confirmed by Prof. Robert Jarrow, Cornell University, who is Kamakura Corporation’s Managing Director for research.  These findings are evidence of a much-discussed behavioral economics phenomenon that is labelled “lottery demand.”  Why do rational and well-educated people buy a lottery ticket whose pay-off on average will be no more than 70% of cost of the lottery ticket?  There seems to be a human cognitive bias in favor of highly skewed pay-offs where the probability of success is very low but the payoff is very high.  We believe that the bias found in equity markets (i.e. high default risk common stocks are on average over-priced and therefore perform poorly) is also found in the bond markets.  Recent work by doctoral students of Prof. Jarrow indicates that this hypothesis is correct.

Back to the question posed above: at what level of default risk does this “lottery demand” bid up high default risk equities and bonds to the point where underperformance is highly likely?  This is a question that is still unanswered but one that is getting a lot of attention at Kamakura Corporation.  We believe that the “best value” measure, the ratio of credit spread to default probability, is a good indicator of lottery demand.  Normally one would expect the ratio of credit spread to default probability to rise dramatically as the default risk rises to near-certain levels.  Instead, as we show in the graph above, the ratio tends to fall as default risk rises to the 2% level (annualized basis), and then it generally stays flat. Anecdotal comments from investors on the SeekingAlpha website over the last six years have consistently reflected “lottery demand” at high default risk levels. For that reason, we don’t think the rewards are worth the risk for default probability levels over 2% unless there is something truly unique about the bond in question.  Investor due diligence becomes very critical at those high risk levels.

For More Information

If you would like to use modern KRIS default probabilities in your personal equity or bond investments, please visit us at The Corporate Bond Investor or contact us at [e-mail] and ask for an individual investor subscription to the KRIS default probability service.