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Components of risk for junk bonds [ClearOnMoney]
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Components of risk for junk bonds

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Commentary

Components of risk for junk bonds

14 Feb 2012 by Jim Fickett.

For the long-term investor there are two main kinds of bond risk: either you might not get your principal back (default risk), or you might get paid back in cheaper dollars (inflation risk).

In one neat and tidy view of the world, Treasuries exhibit only inflation risk and, since inflation risk is the same across all bonds, the extra yield that other bonds return, in excess of Treasury yields – the yield spread – is a measure of default risk.

The trouble with this view is that prices and yields are often driven by bureaucratic fund managers whose transactions are motivated by career risk – they buy junk when they are afraid of appearing to be stupid for ignoring the extra yield, and they buy Treasuries when they are afraid of getting caught with short-term losses due to rising yields. This gives rise to oscillatory risk-on, risk-off trades that give exaggerated movements in the yield spread.

If one could really measure inflation risk with Treasury yields and default risk with yield spreads, then one would expect that Treasury yields and junk bond yields would show positive correlation, since the two have the component of inflation compensation in common. But the Aleph Blog shows that, in fact, Treasury yields and junk bond yields are uncorrelated. I.e. the risk-on, risk-off trading swamps any real measure of risk in junk bond spreads.

The take-home lessons are (1) ignore spreads and deal directly with yields, and (2) make your own worst-case assessment of credit risk and inflation risk, and then assess whether yields are sufficient to compensate you for the two risks.