Three Lessons From The Junk Bond Collapse

The junk bond collapse of the last few months has reminded us of some important lessons going forward.  Here are three that I find most pertinent:

1)  Most investors have no reason to own junk bonds.  As I discussed the other day, junk bonds are basically a crappy version of equity and don’t compare favorably to holding an aggregate bond index.  I said:

Since 1985 high yield bonds have generated an average annual return of 8.1% with a standard deviation of 9.8. An aggregate bond index has generated a 7.1% average return with a standard deviation of 5.2. The risk adjusted returns in the aggregate bond index were far better over this period as Sharpe and Sortino ratios show dramatically better results. Perhaps most importantly, high yield bonds failed to do what bonds should do – protect investors from permanent loss risk. In addition to a 30% decline peak to trough during the financial crisis high yield bonds have consistently generated 8%+ declines in portfolios since 1985 while the bond aggregate has never experienced a calendar year decline greater than -3%. Being sector specific in the high yield bond market has failed to justify the higher risk profile of this segment of the bond market. This has to make an investor wonder – why would they want to own this component in the first place?¹

I think a lot of people own junk bonds purely for the income generation.  They assume that junk bonds will provide a bond-like return with lower risk than something like stocks. And while they are certainly lower risk than stocks they are still a high risk instrument.  That is, they don’t really protect an investor from permanent loss risk to the same degree that something like an aggregate bond index does.  So, why expose yourself to potentially huge losses all in exchange for a few extra % points of annual income?  The extra risk probably isn’t worth the extra return.

2)  Income instruments are not necessarily a safe substitute for bonds.  All bonds are not created equal.  And just because we call something a “bond” doesn’t mean it doesn’t carry many of the same risks as something like stocks.  The same should be said for income generating instruments of all types.  It’s become fashionable to think of income generating instruments as being safer, but as we found out with dividend paying stocks during the financial crisis they actually end up being the instruments most exposed to permanent loss risk because their income isn’t guaranteed.

More importantly, investors have been forced out of true safe haven income generating assets like T-Bonds in the last 7 years as the Fed has reduced the supply of safe income generating assets in the private sector.  This created a surge in demand for substitutes.  And as the overall credit quality of the private sector’s assets declined we should have remained cognizant of the inherent risks here.

Over the last 7 years I’ve repeatedly talked about the dangers of substituting high dividend paying stocks or junk bonds for safe haven assets.  We should not mistake any purely private sector issued instrument for being a “safe haven”.  And when it comes to bonds that’s the primary role they play in a portfolio.  Bonds are the portion of our portfolio that protects us against permanent loss risk.  They are not designed to protect us against purchasing power loss.  So, when we apply certain instruments to our portfolio we should be very clear about the role bonds play.  Bonds are there to protect us against the risk of permanent loss.  If you want to own high income or high return instruments you should acknowledge that most of these instruments more closely resemble instruments with high exposure to permanent loss risk than instruments like T-Bonds which protect primarily against permanent loss risk by being negatively correlated at the times when permanent loss risk becomes most important (like the financial crisis).

3)  Know your product before investing.  There has been a good deal of grumbling about ETFs and mutual funds in the last few weeks as Third Avenue’s Credit Fund collapsed and the junk bond ETFs decline.  The ETF grumbling has been particularly interesting because people seem shocked that a junk bond ETF might be a high risk and illiquid instrument.  Of course, anyone who has looked at the prospectus of these funds or understands the underlying instruments knows that these real-time ETFs are, at best, imprecise substitutes for the basket of underlying instruments.  The underlying trades so infrequently that it is literally impossible for the real-time ETF to fully reflect the underlying prices.

There’s a strange irony in all this hyperventilating about short-term performance in an inherently long-term instrument.  Most of the holdings in the various junk bond ETFs have a maturity of 5-7 years.  But we’re looking at a 2 month period of performance as though that says anything about anything.  In fact, since 1985 junk bonds have had only one brief period of negative rolling 5 year returns.  And given the maturity of the underlying that isn’t terribly surprising. In other words, owning a 5 year bond index for 5 years actually tends to produce a positive return.  Too many people invest in bonds without understanding this basic principle.  And then they judge the short-term performance of an inherently long-term instrument.  This makes very little sense.  We shouldn’t judge long-term instruments based on short-term performance.

Lastly, we should be clear about these products and their recent performance relative to the barrage of ETF criticism –  they’ve performed precisely as they should have performed in the last few weeks.  Despite the underlying illiquidity the ETFs have actually remained highly liquid and transparent unlike some of their mutual fund counterparts who are trying to freeze the funds.  In short, ETFs are proving that they’re a superior asset wrapper even when they hold some illiquid underlying assets.²

¹ – Revisiting the Destabilizing Force of Misguided Market Intervention

² – ETFs Solve the Mutual Fund Bond Problem