Investment Grade and High Yield Bonds
We got asked to write about high yield bond portfolios (please send us more topics!). Corporate bonds, both investment grade and non-investment grade (junk or high yield) bonds, are an interesting topic. Fundamentally if you think about it, a bond is essentially a combination of a risk-free bond combined with a short put option on a company’s assets struck at $0. This is because if the company goes bankrupt, hence their stock price would be $0, the bond holders get whatever is left of the company’s assets. As long as the company doesn’t go bankrupt the bond holder will receive the risk-free rate plus a premium for selling the put option. If the company does go bankrupt the bondholder will receive the risk-free return + option premium – the difference in the bonds face value and the value of the assets (that’s why the payoff is similar to that of a put option).
When we look at it this way we can better understand where the returns for corporate bonds come from. The linked paper goes into much more detail than we will here. But very briefly corporate bonds are exposed to:
- Level of interest rates: as interest rates rise, bond prices fall to match the yield of newly issued bonds.
- Equity volatility: as equity volatility increases there is a higher probability of the price reaching $0, therefore bond prices will decrease.
- Bond volatility: as bond volatility increases, bond prices fall.
The first exposure can be captured with Treasuries. Treasuries have no credit risk and are only exposed to interest rate risk. The second two exposure can be captured via options on equities and bonds. When viewed through this lens we see that the diversification potential of bonds is limited.
If you start off with an equity only portfolio and include corporate bonds the volatility will go down. This comes from two sources. The first source is that bonds are less volatile than bonds, so combining both will bring the portfolio volatility down. The second source is from the correlation effects. Bonds tend to have a low correlation to stocks, so even if bond and stock volatility was the same, combining both would still bring down portfolio volatility. However, this low correlation changes through time and it depends on conditions. When companies approach bankruptcy, the correlations tend to go towards 1. This means that when companies are close to going bankrupt, both their stock and their bonds will drop. So, if things get really hairy, corporate bonds won’t diversify your stocks.
High yield bonds react in the same way. The difference is that companies that issue high yield bonds are typically riskier than investment grade companies, in other words, they have a higher probability of default. So again, looking at them from the same lens, the puts sold are closer to the strike price, therefore are sold for a higher premium.
With this in mind, when you make an investment there are two types of risk you are taking, systematic and idiosyncratic risk exposures. Systematic risks are risks that cannot be diversified away, for example the global economy collapsing or interest rates rising. Idiosyncratic risks are those risks that can be diversified away, for example only buying 1 stock. Systematic risks are what you get paid for, idiosyncratic risks aren’t compensated since they can be diversified away. If you only buy 1 company, that company can go bankrupt. However, if you buy 500 companies, the risk that 1 goes bankrupt doesn’t really affect the entire portfolio. So, the idiosyncratic risk of buying 1 company isn’t compensated. Corporate bond portfolios are a mix of exposures to systematic and idiosyncratic risks. The author of the paper linked above decomposes the returns to identify these different exposures, and based on his findings is able to create strategies that mimic corporate bond portfolios using a combination of stocks, bonds and options on stocks and bonds. The strategy has similar returns (some slightly higher) to corporate bond indices over time but were much less volatile and had shallower drawdowns.
This strategy is probably too complex for an individual investor to replicate, and we don’t know of any funds that employ it. Although it might be an interesting avenue to explore in the future.
Private Credit
The second topic we were asked to write about were private credit funds. The same concept above applies to private credit, with the big difference that these companies aren’t publicly traded which brings in another set of issues.
After the 2008 financial crisis, the US government created the Dodd-Frank regulation which significantly curtailed banks’ risk-taking abilities. They did this in order to reign in a lot of the proprietary trading that was taking place in banks and that took the global economy to the brink in 2008. Because of these regulations, a lot of bank lending was also curtailed. This is where private credit funds come in. After banks stopped lending as much to private companies, private funds stepped in to provide this financing. The argument private credit makes is that since the banks left, it’s been an underserved market where there are a lot of inefficiencies (tough to believe with $1.5T invested in the asset class). So, are the higher yields being paid by companies a compensation for extra risk or simply because the market is inefficient? Tough to say…our first instinct is to think that it’s probably a compensation for higher risk. But in reality, it’s probably a combination of both. Related to the above, are you selling puts closer to the strike price? Or are you selling puts in a market where nobody else wants to sell so you can charge a higher premium?
Another issue with private credit is that the funds are private. We won’t go into detail here, but all the same issues we’ve been critical of in private equity apply here (illiquidity, IRR, etc.).
Behind the Markets Podcast: Behind the Markets Podcast: Daniel Di Martino on Apple Podcasts
Interesting podcast talking about several things. One thing that stood out to us that we wanted to point out was their discussion on the BRICS and the US dollar reserve currency status. The term BRIC was originally coined in 2001 and it was meant to refer to Brazil, Russia, India, and China. In 2009 these countries informally created a nation club and a year later were joined by South Africa to become the BRICS. Now they have expanded membership to include Saudi Arabia, Iran, Ethiopia, Egypt, Argentina, and the United Arab Emirates.
Something the BRICS have talked about is creating a common currency to challenge the US dollar and it’s reserve currency status. There are many reasons why this is a far fetched idea:
- Extremely different economic positions. Argentina is battling very high inflation while Saudi Arabia is spending hundreds of millions of dollars on soccer players around the world.
- Different exchange rate regimes, Saudi is pegged to USD while Argentina has capital controls.
- China would probably be hesitant to give up sovereignty in the management of their currency. This would probably be required, at least in the monetary policy space (like in Europe).
But the main reason why it’s far-fetched, even if the above-mentioned points were figured out, is that people want to save in USD. Why does Argentina have currency controls? To avoid their citizens from dumping the peso and converting everything to USD. Why does China manage its exchange rate and prevent capital from freely leaving the country? Again, because their population would rather have USD than renminbi. Until this changes, the US dollar will probably still continue being the reserve currency.
Similar things were said about the Euro when it first launched. Sure, the Euro has gained in popularity since it launched but it is nowhere near close to replacing the US dollar as the reserve currency. Will the dollar always be the reserve currency? Probably not, before the USD it was the British pound and before that the French franc and before that the Dutch guilder. So, these things change over time, but probably won’t change any time soon.
