Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Understanding the Forces that Shape Bond Investment Outcomes (S1 E12)
Unlock the mysteries of investing in the bond market with us! Your financial landscape is about to get a whole lot clearer as we guide you through the nuances of bond investments, from deciphering the difference between coupon and yields to delving into the depths of default risks. Whether you're a keen investor or an inquisitive citizen, this episode is your ticket to understanding the subtle dance between bond prices, interest rates, and the economy's future outlook.
This time on Not Another Investment podcast, we're setting sail on the choppy seas of bond investing. Grab your life vests as we navigate the intricacies of the yield curve and term risk, shining a spotlight on the pivotal role of inflation expectations and growth forecasts in your bond yields and ultimately returns. As we analyze the inverted yield curve's warnings and the Federal Reserve's monetary maneuvers, you'll gain invaluable insights, arming you with the foresight to bolster your investment strategy in the face of an ever-changing market.
And for those who thrive on the thrill of credit risk, this episode is nothing short of a masterclass. Watch the fog lift as we examine credit premiums, expected loss rates, and Merton's theory with a critical eye. By scrutinizing empirical data alongside the theoretical explanations, we'll challenge assumptions and redefine your understanding of the premium you're owed for shouldering the risk of default. Don't miss out on this journey through the real-world ebb and flow of the bond market—tune in and transform your approach to bond investing.
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Hi, I'm Edward Finley, a sometime professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment podcast. Here we explore topics and markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley.
Speaker 1:Well, we've spent the last couple of episodes thinking about the kinds of risks we own when we own equities. In the first of the last two episodes we talked about public equities and we worked our way up through a lot of different theories of what risks we own, until we got to arbitrage pricing theory, APT, and we stopped there with an understanding that, while imperfect, it does a pretty good job of helping us understand the risks that can explain the cross-section of equity returns. In our last episode, we turned our attention to private equity. There we applied much of the same thinking, except we had to make some adjustments for the fact that private equity is very different and we had to think a little bit more creatively about how to measure risk in return. Today we're going to turn our attention now to the largest of the capital markets, the bond market, but again we're going to think in terms of what, as investors, are we buying when we buy bonds.
Speaker 1:Before we turn our attention to the details of this episode, I want to make a suggestion to those of you who maybe don't have a background in economics or don't quite understand economic policy, especially as it's executed by the Federal Reserve. For those purposes, I highly recommend a 30-minute video that you can find for free on YouTube by Ray Dalio. Ray Dalio is the very famous founder of Bridgewater and Associates, a very successful macro hedge fund. We'll have lots more to say about macro hedge funds later in the podcast, but Ray put together this animated video in which he explains in some very fundamental and basic terms the role that the Fed plays in terms of guiding the macro economy. That's going to be really important in terms of understanding bonds. Bonds are disproportionately affected by those kinds of actions. If you've never thought about it or you don't have much background in it, I encourage you to spend 30 minutes first watch Ray's video and then come back to this episode. But if you've already got a decent understanding of how that works, well, then buckle up and let's get started.
Speaker 1:Like we've always done, I'm first going to define bonds. I'm going to define a few terms to make sure we understand. We're talking about the same things, and then I'll turn our attention to some theory to understand the risk exposures we think we own in bonds. Once we've established some of that theory, as usual we'll test our theory against the empirical data. Does it hold up? And if it doesn't, we'll see if we can't recalibrate our theory. One of the things that I want to emphasize, though, in the beginning, is that we really have to think about bonds in two very different categories. The first category that we're going to think about is just those characteristics that apply to all bonds, no matter who issues them. The second characteristic is when we talk about those risks that are special to those bonds where there's default risk, in other words, corporate issuers. So just have that in the back of your mind while we're speaking. I'm going to be really talking first about things that are relevant to all bonds of all types. So let's define them.
Speaker 1:A bond is a promise to pay the face value of the bond in the future and during the term of which it pays a coupon calculated as a percentage of the face value. So let's take that definition, repeat it and then take it apart. A promise to pay the face value of the bond, which means that a bond is loan. If I buy a bond, it means I'm providing capital to the bond issuer. The bond issuer is promising to pay me, they're going to pay me in the future and they're going to pay me the face value. That's the amount that the issuer owes during the term of which it pays a coupon. A coupon is a periodic payment. That's a fixed percentage of the face value of the bond. Now there are some bonds that have floating rate coupons. I don't want to get bogged down in that. For the most part, bonds, coupons are fixed rate. So we've got a promise to pay the face value, which is the amount that the issuer has borrowed in the future during the term of which it pays a coupon. That's a periodic payment. That's a fixed percentage of the face value. And then we have another term that we don't have in our definition but that's relevant, which is we'll sometimes hear described the bond's yield.
Speaker 1:Now, yield is different than coupon. Yield is the coupon computed as a percentage of the price that you pay for the bond. Now, when a bond is first issued, coupon and yield are the same thing. The coupon might be 8% of the face value, and I buy the bond for the face value and therefore coupon equals yield. But then, as time goes on and those bonds trade, the coupon will remain the same. It will always be 8% of the face value. It is always going to be that amount. The yield will change based on how much I pay for the bond, and so that 8%. Let's say the face value is $1,000. So 8% of the face value is $80. Every year the bond will pay $80. But the yield will be 80 divided by whatever price I paid for the bond.
Speaker 1:Alright, so then what are bond returns? We've talked about face value and coupon and yield, but nowhere in there can we hear anything like we heard with equities, where we're talking about a rate of return. Bond returns are the result of the yield that's the first component and changes in the price of the bond. So as a bond owner, my return is going to be some mixture of the yield on the bond that's, the coupon divided by what I pay and changes of the price in the bond during the period that I hold it. If I hold a bond until maturity, then my return will be the same as the yield when I bought it and that's why some people just use yield and return interchangeably. If I bought a treasury today with a yield of 5% and I held that treasury until maturity and then I got my money back, my return on that bond would be 5%. But during the holding period of the bond, changes in prevailing interest rates will cause changes in the price of the bond, sometimes by quite a lot, which in turn will affect the annual returns during the holding period. So let me break that down. Sure, if I buy a bond and hold it to maturity, the yield will be my return Barring default. That's just a fact. However, during the term of my holding the bond, each year my return is going to potentially look very different because as time is passing and prevailing rates change, the value of my bond will change and returns therefore have as much, or maybe even more, to do with changes in prevailing rates than on the yield.
Speaker 1:All right, how about bond volatility? So we understood volatility in the equity context as a measure of uncertainty, a way to understand the riskiness of an equity, and we have the same concept with a bond. But, of course, because bonds are computed in different ways than equities, we have to think about volatility in a slightly different way. A bonds volatility is measured by something called its modified duration. Now be really careful. We've seen this a bunch of times in this podcast so far.
Speaker 1:There are lots and lots of terms which in English mean one thing, and if we apply that meaning in finance, we get a very confusing result. Lots of terms have different meaning in finance than they do in English. Duration is one of them. Duration does not describe how long the bond will last. That's the bonds maturity.
Speaker 1:Duration is a measure of the bonds volatility, that is, it's the degree to which the bonds price will go up or down in response to a change in prevailing rates. So, for example, if I have a bond with a duration of 5% and there's a 1% rise in prevailing rates, then my bonds price is going to go down by 5%. Likewise, if I have a 1% decline in prevailing rates, then my bonds price is going to go up by 5%. So the modified duration of the bond tells me something about the sensitivity of that bond's price to changes in prevailing rates. You can see why that'll be important if the bond's return is a function of yield and change in price, and I want to know. I know what the yield is when I'm looking at a bond, but how do I know how sensitive that bond's price is going to be to changes in prevailing rates, I'm going to want to know what the bond's duration is.
Speaker 1:Let me just take a pause here for a second and explain something that is pretty fundamental to bonds, and that is when prevailing rates rise, the bond's price falls, and when prevailing rates fall, the bond price rises. Now that might seem weird to say something like that, because of course, usually we're accustomed to thinking about things changing in the economy for the better means equities go up and things changing for the economy for the worse means equities go down. Here we seem to have the inverse, but it's really not so strange after all. Let's just use a simple example. Let's say I own a bond. I bought it for $1,000, and it has a 5% coupon. Terrific, prevailing rates at that time are 5%. I bought the bond with a 5% coupon. Coupon equals yield. That's terrific.
Speaker 1:Now let's say time passes and prevailing rates go from 5% to 10%. Well, now I own this bond and this bond pays 5%, the coupon, 5% on $1,000 or $50. But a person who is in the market for a bond like mine can go out and buy a brand new bond and get paid a coupon of 10%. Well, who's going to want to own my bond? Really nobody. Who wants to own a bond that pays only a 5% coupon? So what's going to happen? Well, the law of supply and demand tells me that if fewer people want to buy my bond, then the price of that bond is going to drop. How much is the price of that bond going to drop? Well, it's going to keep dropping until the coupon $50, is the same as prevailing yields 10% and so that bond's price will fall from $1,000 to $500. Now you get a $50 coupon on that bond. The coupon hasn't changed, it's fixed. But I paid only $500 for the bond and we'll get paid if I hold it until maturity, until I get paid $1,000. And so what's my yield? My yield on that bond is 10%. Well, now investors would be indifferent between my bond and a brand new bond, and so this is the source of the inverse relationship between changes in prevailing rates and bond prices. When prevailing rates go up, it means that existing bonds that are paying lower coupons have to fall in price in order to make the yield on that bond the same as prevailing yields.
Speaker 1:There are two systematic risks that affect yields and therefore the price of bonds and their returns Level risk and term risk. There's a third risk that affects only bonds with the risk of default, and that's credit risk. So up until now we've talked about the character of all bonds. Next we're going to talk about two risks that apply to all bonds and then, at the end, we'll talk about the third risk that applies only to a subset of bonds, namely credit risk. So let's start with level risk. Level risk is the risk associated with changes in prevailing rates due to changes in monetary policy. There's something called the transmission mechanism, and what the transmission mechanism does, it says, all things being equal, if I have a change in the Fed's overnight rate, so that's the rate at which the least risky borrower can borrow from the market, and you'll recall back in our discussion of the money market, that's going to usually be either the T-bill or the repo market If the Fed changes the target rate in that very short-term overnight market and it increases it, all things being equal, it should be the case that yields on bonds of all maturities go up by a proportionate amount.
Speaker 1:If you picture it graphically, if you imagine a yield curve which would look upward, sloping in its typical fashion. More on that in a minute. But if you imagine a yield curve and it's upward sloping, the shorter the term, the lower the yields. The higher the term, the higher the yields. So we have this upward sloping line. If the Fed changes the overnight rate, which is they move that point on the lowest ends of the curve up by 1%, all else being equal, we would imagine a parallel shift in the yield curve. All yields would go up by that 1%. So the level risk is the risk associated with changes in monetary policy, risks that will affect yields and therefore prices. The transmission mechanism is how that operates and that risk explains about 90% of the price movements and therefore returns across all maturities in the yield curve. That's responsible for a lot of bond risk changes in monetary policy.
Speaker 1:Second is term risk. Term risk is the excess return that you demand to own a long bond over owning a sequence of shorter bonds. So let's just take that idea apart for a second. I could go out and buy a 10-year bond today Terrific and that 10-year bond is going to have some yield associated with it. I could also go out and buy a one-year bond today and next year buy another one-year bond and the following year, buy another one-year bond and do that 10 times. And so, if expectations are constant, a long bond's yield is going to be the average of a series of short bond yields. But expectations are not constant, and so yields on long bonds are going to be different than the average series of short term bond yields. And so when we talk about the term risk, what the term risk tells us is really about changes in expectations. Because to the extent that expectations are changing and the longer bond yields become either higher or lower than the average of a series of shorter term bond yields, means that graphically, if you want to picture it in your mind, the yield curve is not going to move parallel, but the slope of the yield curve is going to change. It will flatten or steepen, depending on what expectations are about the future.
Speaker 1:There are primarily two expectations that influence the term risk premium inflation expectations and growth expectations and while they're related, they affect different parts of the yield curve in slightly different ways, and so they affect bond returns in slightly different ways, depending on the maturity of the bond. Let's start talking first about inflation expectations. Inflation expectations tend to explain the returns of bonds if short and intermediate maturities about 83% of short term movement is explained by the expectations in inflation changing the slope of the yield curve, and about 70% explains 70% of the movement of the intermediate term bonds. The short end of the yield curve, that is, the shortest maturities of bonds, are very pro cyclical and that's a consequence of how the Fed operates. If we expect low inflation now or in the next year or so, meaning in other words an impending recession, we would expect the Fed to lower those rates, making the prices of short term bonds rise and increasing the returns of bonds on the shorter or intermediate end of the yield curve. Likewise, if we expected that there is going to be, in the short run, high inflation the economy is running very, very quickly and rapidly, and so we think that in this current environment, inflation expectations are going to be quite high and so we expect the Fed to raise rates then we would expect that the shorter or intermediate end of the yield curve is going to see bonds go down in price and that's going to affect the return of bonds at the shorter or intermediate end Inflation expectations.
Speaker 1:They have some effect on long maturity bonds, since bonds are nominal securities. Inflation will erode the value of coupons in the future and so inflation expectations have some effect on the long term end of the curve, merely by virtue of the fact that if I have a bond and it's always going to pay me that coupon fixed amount and I expect long term inflation, inflation over the next 10 years, then that's going to erode the value of those coupon payments in the future and it will have the result of causing prices of those longer dated bonds to fall. Who's going to want to own those longer bonds if the coupons become worth less and less? So inflation expectations have some effect at the long end of the curve. Such studies pin it as around 40% effect. Notice of the inflation expectation effect is at the shorter to intermediate end and we sort of see that happening in the real world today. We can think about yields today, where we have currently expectations of more moderate inflation and we expect that the Fed is going to probably lower rates and therefore if we look at Treasury yields for, say, one year and two year bonds, we'll see that those yields are lower than, say, the one month Treasury yield and that reflects this effect. About inflation expectations, the Fed hasn't done anything yet, right? The Fed has already made its changes. That's what's affecting the one month T-bill we're talking about now, the one year and the two year expectations of Fed changes.
Speaker 1:The second expectation that will affect the slope of the bonds yield curve and therefore returns of bonds, is expectations about growth. These expectations have their greatest impact on bonds of longer maturities nearly 70% effect at that end of the curve and not really much effect at the shorter end of the curve. Longer maturity bonds this is what we mean when we say the long end of the curve. Longer maturity bonds are really counter cyclical. If we're currently in a recession where growth is slow, inflation is going to be pretty low and therefore we expect prevailing rates to be rather low. That means that when we look to the future and we know that things move in cycles we expect that in the future there will be higher growth, higher rates and higher inflation. Bond investors are going to demand higher yields on longer maturity bonds in order to take the risk of when they own them and three years from now becomes the present there's going to be a risk that those bonds prices are going to fall. Let's take the opposite. What about? We're currently experiencing an economic expansion. Growth is high, inflation is high, rates are high. Well then, we expect that in the future there will be lower inflation and lower growth and therefore rates will be lower. Bond investors, therefore, will accept lower yields on longer maturity bonds because they know that when the future becomes the present, that yields will be lower than they are today. So, again, when we look at today's yield curve, this is another way to understand the effect of growth expectations on what one, two and three year bond yields might be.
Speaker 1:When we're thinking about term risk, which is the slope of the yield curve, we can see now why some people will look at a yield curve and think that its shape helps predict future economic conditions. You sometimes will read in the paper the yield curve is quote unquote inverted. That's where we are today. Presently, one month treasury bills this is as of January 19th 2024. One month T-bill yields are 5.37%, one year 4.87%, two year 4.39% and three year 4.17%. So that's downward sloping. That is an inverted yield curve. Well, we know that when we think about inflation expectations and growth expectations, that that's what's driving the shape of the yield curve. We expect that inflation in the next one, two, three years will be lower. We also know that today growth is quite high and so we expect in the future, growth to be lower, inflation to be lower and in both cases, therefore, rates to be lower. And so this is why some people will look at the shape of the yield curve and say it predicts future economic activity.
Speaker 1:When we have an inverted yield curve, that signals that there's going to be a recession. A couple of things about that. First, these are not oracles and these are not concrete predictors like a mathematical equation. What we're really describing is what bond investors think. Bond investors expect that in the next couple of years, we will have lower growth, maybe a recession and therefore lower rates. Whether they're right or not is a whole different matter. It's what bond investors think and in fact, if we look historically, there's a lot of people who like to say that the inversion of the yield curve always predicts recession. Problem is that when they make that assertion, they usually give themselves about two years before the recession happens, and it seems to me that if the bond market thinks a recession is coming and it can take as long as two years before it actually happens I'm not sure they predicted anything, particularly if we understand cycles. So I would be careful about saying inversions of the yield curve predict future growth or future recession. Instead, I would just say that inflation expectations and growth expectations tell us what the steepness of the yield curve will be and when the yield curve is inverted. That means bond investors expect the future to be one in which there's lower inflation and lower growth, and therefore lower yields.
Speaker 1:I've posted for you on the website and feel free to take a look, but it's a kind of a cool animated chart that I found on the internet of treasury yield curves and it runs from 1991 up to the late 2000s, and it is animated in the sense that it just shows monthly yield curves and you can watch the yield curve rise and fall in the parallel sense, which is the consequence of level risk, and then you can also watch the shape of the yield curve change, that is it flattening or steepening. And the point that I want to make with this illustrated slide is just because we break the risks down into these two particular risks level risk and term risk. Don't imagine that they operate serially or in order. They're occurring simultaneously, and so the yield curve itself will be rising and falling at the same time that it's steepening and flattening. It's a very, very dynamic thing, and so I think it's kind of fun, better than Mike just telling you is. You can take a look at it. So, to recap, all bonds are subject to two risk exposures the level risk, which is the risk of changes in the price of bonds due to current monetary policy. That will have an effect of parallel shifts in the yield curve. And if the yield curve shifts up as the Fed raises rates, then we know that bond prices will go down and that will have a negative effect on bond returns. Likewise, when the Fed is lowering rates, the yield curve will shift down and that will have a positive effect on bond prices. And the second risk is the term risk. That describes the shape of the yield curve, and here inflation expectations and growth expectations drive whether the yield curve will be steeper or flatter, based on what bond investors think the future situation will be All right. Well, that's the theory. That's how it should work.
Speaker 1:Let's have a look at the data and see if we find that it does in fact work that way. So again, I've posted the data here for you. But looking at the returns on treasuries of all maturities from 1952 to 2011, what we see is that treasury returns for that entire period, 1952 to 2011,. The returns on one month T-bills was 0.59%. That was the return. One to two-year treasuries 1%. Two to three-year 1.4%, and so on and so on. Each additional years of maturity raise the return. And so so far, so good. Right, because we said that we know that one of the risks that affects bonds and therefore we would expect to see compensation for that risk is the longer the maturity, the more risk you take in terms of changes in future inflation and future growth, and we would expect to be paid something in return. Likewise, we can see that when we compute the volatility of those returns, it's the same story. The volatility of one-month T-bills is less than 1%. That is the dispersion of returns.
Speaker 1:And as we march up the maturity yield curve, we see that the returns on the bonds become more and more volatile. However, if we take a look at sub-periods in that range so for instance, if we take a look at 1952 to 1982, what we find is something very different. Maturity returns start at 0.47% for T-bills and they increase up to two years, but then at two to three year maturities returns fall to 54 basis points. Then they fall further to 36. At four to five four basis points and five to 10 and greater than 10 year maturity treasuries, the returns on those bonds would have been negative If one basis point for five to 10 and negative 62 basis points for greater than 10 year maturities.
Speaker 1:And so what we see is that in that period, bond returns don't really match the expectation, that the longer the maturity, the more risk you take in the sense that we wouldn't have been compensated for that risk. And so, just like we saw with equities, over a long period of time, the theory makes perfectly good sense. But when we drill down to a shorter time horizon here 52 to 82, what we find is that it really doesn't always make sense. And, by the way, that's a long period 30 years. If we look at 1983 to 2011, what we see in that period is that returns on bonds are all positive and increasing, and notably at the longer end of the yield curve, at really all points in the yield curve the returns are a lot higher than the full period. And so for bonds of more than 10 years maturity, the average return was 5.6%, whereas over the entire period the return was 3%. So what's going on here? Why do we have this? What could explain this difference? And I think the answer is the massive period of inflation that led up to the 1980s and then the huge rise in fed rates during the 1980s to tame inflation. So from 1952 to 1982, we're capturing that period in which there's very high inflation and inflation expectations are really driving the long end of the yield curve. That means that bond owners are not willing to pay as much for longer term bonds because their bonds are going to be. The coupons on their bonds are going to be worth less with inflation at such a high expected long term rate. And this is why we see these negative returns on bonds with 5 to over 10 year maturities.
Speaker 1:From 1983 to 2011, we see the period during which the Fed was massively increasing the overnight rate that affected a parallel shift in the yield curve Great that's. Tamed inflation, inflation expectations subsided and then during the rest of that period, from about 2000 until 2011, we saw the Fed systematically lowering interest rates. This is the so-called 30 year bull market in bonds, where the Fed for the better part of the last 30 years was in the business of lowering the overnight rate and that parallel shift in the yield curve going down, down, down for decades. The result, of course, is that that's going to affect both the long end of the curve by virtue of the parallel shift. So that's going to reduce rates, making the bonds prices go up and increasing returns. And inflation expectations are going to affect the long end of the curve. We think the Fed has tamed inflation so we're not as concerned about it in the future. That's going to also reduce the yields expected on those bonds and, by reducing those yields further, increasing the prices of those longer bonds. And so, looking at the data, I think we see very consistent evidence of exactly what our theory has told us that bonds overall, and particularly when we talk about bonds without any credit risk, we're just talking about really US government bonds. So bonds, like treasuries, are going to have returns that are not just the feature of the coupon. From 1952 to 1982, if you owned a 30 year treasury, your coupon might have been one thing, but your rate of return on that bond was probably negative for the period. So bond risks are a lot more complicated to understand than one might think just on its face.
Speaker 1:All right, let's turn our attention now to credit risk. So credit risk is the third type of risk that affects bonds. But this type of risk affects not all bonds, it affects only bonds where there is a risk of default. Some of those bonds might be government or government related bonds, for example, non-agency bonds that are issued by government sponsored entities. Remember back to our discussion of the bond market. So some bonds are not going to be guaranteed by the national government, and it's certainly going to be the case that there's a risk of default when companies issue bonds. This is when companies seek to raise capital in the debt capital markets.
Speaker 1:So, as an investor in bonds where there is credit risk, how do we think about this risk and what does it help us in terms of expectations for our returns that we earn on these bonds? Well, the credit risk let's just think about this is the excess return that a bond owner will demand, over and above owning a risk-free bond, as compensation for the risk of default and illiquidity during times of stress. I'll repeat it so the credit risk is the risk that the bond will either default and the bond owner won't get paid back, or that the bond becomes illiquid during times of distress. If the company is distressed, it's not that they might default, they might just muddle through somehow, but in the meantime, you own a bond that no one wants to buy. In both cases, those risks mean that investors in bonds demand some return, some premium over the return of a risk-free bond. And so when we think about that kind of credit risk, we're talking about the compensation over and above the return that you earn owning a treasury.
Speaker 1:Taking the data from a minute ago, if I look at historical data from 1952 to 2011, and I say, okay, what's the average return for bonds with three years maturity? 1.6%. If I look at credit-related bonds with three-year maturity and the same duration, then I would expect the return to be something higher than 1.6% and the difference, the premium, is for the credit risk. All right, so why? Well, I guess there's some intuition, isn't there? If there is risk of default or risk of illiquidity, I'm going to get this premium. But we can think of it a little bit more concretely and actually it might help us a bit to think of it in these terms Buying a corporate bond can really be thought of as a version of scaled equity risk, because the bond owner earns return for the risk of the firm's default but doesn't share any of the firm's upside.
Speaker 1:The firm that's raising capital in the bond market is the same firm raising capital in the equity market. But if I own its bond and it doesn't default and it doesn't have any distress, I'm just going to earn the coupon and that will be a premium to a treasury. But that premium is the most that I'll ever earn, because if I own the equity of that firm and the firm does extremely well, I might earn return far in excess of the premium. This is something called Merton's theory, and Merton was a famous economist and he posited that when you buy a corporate bond, it's just like buying the equivalent maturity treasury and selling a put on the issuer's assets with a strike price equal to the face value of the bond. I'll repeat it Buying a corporate bond is just like buying the equivalent maturity and duration treasury.
Speaker 1:So you own the bond risk level and term risk and selling a put on the assets of the issuer with a strike price equal to the face value of the bond. And so, just like any option, selling a put is selling an option. Like selling any option, I earn a premium for that option and in the case of selling a put, the premium is my maximum gain. I'll never earn more than that. However, I have significant risk of loss in selling a put if the firm becomes insolvent or goes away, and investors in those bonds and the firm itself will pay the bond owners something for that level and term risk of the bond, but they're also going to pay them the premium for the put.
Speaker 1:If the value of the firm falls below its assets, the equity owners can walk away and put the firm's assets to them in exchange for the face value of the bond. That's the nature of why Merton thinks of it as like a put. The equity owners can, if they like, decide to simply liquidate the firm and hand over the keys to the bond holders and walk away with nothing. The bond holders then have to make do with whatever they can get, and so that's why Merton thinks that the credit risk premium is really a kin to a premium on a put option. Well, that being said, if that's right, if Merton is right, and if the theory that I've described to you is right, then we should expect to see that the credit premium should get greater and greater, the greater the risk of the firm's becoming insolvent.
Speaker 1:So we have to first think in terms of risk of becoming insolvent, and here there is, happily for our benefit, rating agencies that rate bonds. They rate the risks that an issuer will experience some sort of distress or some sort of liquidation event. The three main rating agencies are Fitch, s&p and Moody's. For convenience, I'll use the S&P ratings notation because I'm used to it, but you don't have to. You could use one of the others and let me just sort of quickly walk you through the categories and the ratings that you get for those categories.
Speaker 1:So the first category of credit risk bonds is what's called investment grade, and investment grade bonds are those that are AAA I'm going down in quality, starting with the best, and going down AAA, aa, single A and triple B. Those four comprise investment grade bonds. All right, so what does AAA mean? That means that the company has extremely strong capacity to meet its financial commitments. What about AA? Very strong capacity to meet its financial commitments. What about single A? Strong capacity to meet its financial commitments, but somewhat susceptible to economic conditions and changes in economic conditions. Triple B adequate capacity to meet its financial commitments, but more subject to adverse economic conditions. So you see, the way the rating agencies tend to think about the risk of these credits is not just the company's ability to make payments on their bonds, but also whether their businesses will be affected severely or slightly or not at all, by changes in economic conditions.
Speaker 1:The second range of ratings are what's called speculative grade. It's also what is sometimes referred to as high yield, and in the old days, in the 1980s, that would have been referred to as junk bonds. They're all the same thing. If you read junk bonds, high yield bonds, speculative grade bonds, really all mean the same thing. These are bonds with ratings that go from highest to lowest double B, single B, triple C, double C, single C, d and you can see the sort of theme right. It's triple A is the highest, then only two A's, then one A. Triple B is the highest of the B's, then two B, one B, et cetera.
Speaker 1:All right, so in speculative grade, we start with double B. What does double B tell us? Double B says that these are companies that are less vulnerable in the near term, but they face some major uncertainties to adverse business or economic conditions in the future. So double B less vulnerable in the near term, but there are some uncertainties about the future. Double B is more vulnerable to adverse conditions, but currently can meet its financial commitments. So that is, it could struggle today, could struggle in the very near future, but it's still able to pay its bills. Triple C are firms that can meet their financial commitments presently, but they're currently very vulnerable to any change in the economy. That is, if the economy is currently favorable and there's any change in that, the triple C issues are going to suffer immediately. Double C are highly vulnerable at the present. Default has not yet occurred, but it's a virtual certainty. So you see, double C, that means default is at the door. Single C currently highly vulnerable to non-payment and ultimate recovery is expected to be lower than that of other kinds of obligations. And then, finally, d is the payment. Default on their commitment is already occurred. This is usually what you rate. A bond that's entered bankruptcy is D Okay.
Speaker 1:Importantly, unlike level risk and term risk, where higher yield means lower return and vice versa, higher yields in terms of credit risk does not necessarily mean lower returns, and the reason is due to the scaled equity nature of that premium Investors are gonna earn a high yield on corporate bonds during a time of distress and a recovery will deliver large gains. So you get sort of if you buy these bonds and you have a period of distress, you're still getting very high yields on the bonds, and so long as they don't default. When everything recovers, you're gonna experience very large gains. But investors in these kinds of bonds where the firm could fail, might recover nothing or very little of the investment. And so there isn't that direct one-to-one relationship, as we saw, with level and term risk, higher yields equal to returns, et cetera. Here it's a bit more complex owing to the nature of scaled equity risk. Okay, so what's the data say? Well, we can look at the observed premiums for credit risk from January 1997 through June 2022. And in general it follows our intuition.
Speaker 1:Investment grade bonds, that is, aaa to BB, earn spreads of yield. That is, they get paid this premium of anywhere from 50 basis points to 1.7%. And the excess return, that is, the return over and above what you earn for a treasury, goes from 89 basis points to 1.79%. Duration, that is, the sensitivity to those bonds to changes in prevailing rates, ranges from nine and a half to 9.6%, where the average maturity is 10 years. And when you compare the volatility in returns, it suggests that most of the return in investment grade bonds is from yield, it's not from duration risk.
Speaker 1:When you switch and you pay attention to high yield bonds, that's rating double B. That's the sort of the best quality high yield bonds. Here yield spreads are very wide. That is the premium you get paid for that put is over 3% and the excess returns are not just 1.79 as they were for investment grade. Here the excess returns are 2.3%. The rest of high yield B, triple C and below these have premiums that range from five to almost 11% and the excess returns range from about 3.7 to 9.7%. The duration on all of these bonds ranges roughly six to six and a half percent, where the average maturity again is seven years, and when you compare the volatility of returns to the bonds duration, you can see that it suggests that most of the return in high yield bonds is not from level and term risk but instead comes from this equity, scaled equity risk. We can also see that spreads and returns move pretty monotonically across the risk spectrum, and it's also the case that the higher credit risk are gonna be more volatile, consistent with the view that the volatility of a bond is gonna be some proxy for the uncertainty, and so overall, the data seems to suggest to us that, yeah, this is correct.
Speaker 1:Our theory accurately describes what we see happening in the bond market for corporates, where the credit risk premium, the premium for the risk of default or illiquidity of the bond will be positive and increasing in size, depending on how much risk there is of distress, and those risks are usually measured by the rating agencies that rate the bonds. But let's turn our attention now to some data that casts some doubt on our theory and kind of raises some questions. It's been dubbed what's sometimes called the credit spread or the credit premium puzzle. In general, we would expect that losses from a default should equal the probability of default times one minus the recovery rate, and the recovery rate is just a bond owner usually doesn't get zero. The bond owner gets some part of its investment back, and so the recovery rate is the fraction of the bond's face value that's recovered when the bond goes into default. So in general, we would say well, whatever our expected losses are should equal the probability of default times one minus the recovery rate. So I suppose we could look at historic default rates and historic recovery rates and we could then multiply those to come up with some expected loss. And although credit spreads, credit premiums, do reflect the default and illiquidity risk, the data show that credit spreads are far higher than what might have been expected for those risks.
Speaker 1:So let's take a look. This is data from 1997 to 2008. What we see is that the credit premium for owning a AAA bond so that is, the premium in yield was 0.61% For AA bonds 0.66%, so a little higher for a slightly riskier bond 1.08%. For a single A perfect triple B 1.74% and then anything worse than triple C 11.8%. But if we take a look at the historic loss rates, that is, the historic defaults multiplied times the average recovery rate, we see that the expected loss rates on triple A's are zero and the expected loss rates on double A's are 3 hundredths of a percent single A 2 hundredths of a percent triple B 0.12%. So these are very, very, very low expected loss rates, and so it kind of creates a bit of a head scratcher. Why would you earn a premium of 60 basis points, ranging from 60 basis points to 1.7% premium in yield simply due to the risk of loss or illiquidity, where, if we look at historic losses, is very close to zero? Why would you?
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