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?

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.