THE BENEFITS OF DIVERSIFICATION
1981 - 2015
(1/3 in each)
|5 Asset Class
|1981||- 4.9%||1.9%||- 2.0%||4.1%||8.7%|
|1994||1.3%||- 2.9%||- 0.4%||1.1%||2.0%|
|2000||- 9.1%||11.6%||- 0.8%||3.0%||4.3%|
|2001||-11.9%||8.4%||- 3.8%||0.2%||- 0.7%|
|2002||-23.4%||10.3%||- 9.9%||-10.7%||- 3.7|
# of Years
Stocks: S&P 500 Index, Bonds: Barkley's Agg. Bond Index, Cash: 180 day C.D.
*Diversified Portfolio: 20% S&P 500, 20% Barkley's Aggregate Bond Index, 20% Equity REITS, 20% MSCI World Index (International), 20% Cash. Assumes annual rebalancing. Sources: Morningstar, Ibbotson, Thomson Reuters, NAREIT
The very hallmark of suitability is diversification. To uphold the fiduciary duty of implementing only suitable investments, the broker must avoid over-concentration at all costs in favor of a diversified portfolio. The more aggressive the objectives of the investor, the more necessary it is to diversify the investor's assets to mitigate the risk (see Legal Duties of Stockbrokers - Duty to Diversify).
With the tremendous gains in the S&P 500 during the mid-90's, one would have been hard pressed to encourage investors to venture away form the rampaging stock market. However, the technology crash in the NASDAQ and the recent two-year double digit downturn in the S&P 500 has caused investors once again to turn their attention to diversify their portfolios. Investors now want to reduce their risk and lower their concentration in technology at all costs.
The above chart shows the compounded annual returns between 1981 and 2008 in five various portfolio mixes. At first blush, one would feel justified for having ventured only into the S&P 500 for the last 24 years. But take a closer look at the five asset class diversified portfolio in column five. Compared to column one, there were 22 years of positive returns instead of only 19. In other words, with the extra balance, the investor was able to sleep more comfortably for three more years. During the four year period from 2000 through 2002, the investor in stocks only would have lost over 43% of invested capital. However, during that same four year period, in the diversified portfolio, the account would have basically broken even! This at a time when, according to Lipper, Inc, the average diversified stock mutual fund lost 34.3% between 2000 and 2002. In terms of market loss and measured against the market's all time highs, the Dow Jones Industrials were down (32%), the S&P 500 had fallen 49%, while the NASDAQ was down a staggering 74%. Between 2000 and 2003, the S&P 500 lost nearly 16% while the 5 diversified asset classes gained 21%! The results speak for themselves. In 2004, the 5 asset classes outperformed stocks alone because the low returns of bonds and cash were more than offset by international returns of 20.3% and returns in equity REITS of 31.6%.
Further, from the chart, you can see that the diversified portfolio over the entire 27 years under-performed the 100% stock portfolio by .09%. Notice the level of risk by comparison. The S&P 500 had a standard deviation of 16.24% over the period compared to only 8.11% for the diversified portfolio, less than half the level of risk. Standard deviation is a measure of volatility indicating the amount by which most of the returns varied around the average. The higher the standard deviation, the greater the volatility and thus the greater the risk. For example, a security with a standard deviation of 10% indicates that most (two-thirds) of the actual returns over a particular time period varied around the average return by plus or minus 10% - in other words, if the average return was 17%, most of the actual returns ranged from 7% to 27%. Or, you could apply the concept of standard deviation to the market in general. Over the last 3 years, the S&P 500 has had a standard deviation of approximately 20%. If your return expectation was a 10% average annual return for the future, you could expect that return to fluctuate between a high of 30% and a low of -10%. With the graying of America, investors are continually looking for returns and results that they can rely upon, on an ongoing basis. A diversified portfolio in five non-overlapping asset classes, with reduced volatility, helps provide the probable assurance of verifiable consistency.
Finally, in the late 90's, investors strayed far away from the S&P 500 and implemented large positions in the tech-heavy NASDAQ to their detriment incurring losses well in excess of 50% from 2000 through 2002 with this concentration. As has been previously indicated, the S&P 500, which is market-capitalization weighted, was down 23.4% in 2002 and 11.9% in 2001. However, according to James B, Cloonan, Ph.D., Chairman of the American Association of Individual Investors, in the April, 2002 AAII Journal, "a portfolio of the same 500 stocks, equally weighted, would have been up 1.63% for the year. The NASDAQ Composite Index, also market-capitalization weighted, was down 20.13% in 2001 alone, but those same 4,000 stocks bought in equal dollar amounts would have been up 63.86%! This seems incredible, but recall almost all the losses on the NASDAQ were in the high-cap. technology stocks. In contrast, micro-cap. stocks (companies whose market capitalization is below $250 million) had a banner year". Further, according to the AAII Journal/November 2002, "Over the last 10 years the Wilshire 5000 index has had an average annual return (through September 30, 2002) of 8.69%. However, the return of the Wilshire 5000 unweighted by market capitalization (in other words, the average stock in the Wilshire 5000), is 14.17% a year. And to throw in another shocker: The NASDAQ Composite index is down dramatically year to date, with a return of -39.26%, yet the average stock on the NASDAQ is up 30.54%, and the average stock has been up each year for the past three years". Actually, 37% of all U.S. stocks had a positive return in the year 2002. The average return of those stocks that did have a positive return was an astonishing 43.4%. The point about market indexes is this. Because of the dependence upon market capitalization weighting, the U.S. equity market as a whole is generally not performing as well, or as badly, as the major benchmarks indicate.
The S&P 500, on an equally weighted basis has performed well over time. It is available as an ETF under the symbol RSP (Rydex S&P equal weighted ETF), and is traded on the ASE. The symbol of the index itself is SPXEW. During the period 2000 to 2005, it had a six-year annualized return of 8.96% compared with -1.13% for the S&P 500. Over the 16 hear period from 1990 to 2005, SPXEW's annualized return of 12.42% was 187 basis points higher than the S&P 500. Moreover, the volatility of the index as measured by standard deviation was 172 basis points lower than the S&P 500!
While the NASDAQ Composite Index was and is heavily weighted with large-cap technology & telecom stocks, the S&P 500 was far less concentrated. Consider the S&P 500 concentration (by market capitalization) in tech/telecom at the following periods:
9/99 12/99 6/00 12/00 6/01 12/01 6/02
31% 37% 39% 27% 24% 21% 15%
Note: The S&P 500, by number, currently has 26 telecom stocks, 19 software stocks and 15 computer related stocks, totaling 60 issues out of 500 for a total of 12% "technology & telecom"! Since its high in June, 2000, the percentage of tech/telecom, in terms of market capitalization value, has steadily declined. The technology/telecommunications concentration in the S&P 500 as reported in the Wall Street Journal on June 25, 2002 was only 15%, and 20% by 12-31-02.
By contrast, the technology/telecom concentration in the NASDAQ Composite Index between 12/99 and 3/00 averaged 63% in terms of market capitalization value. As of late 2002, the NASDAQ was still over 50% invested in tech/telecom. And consider a comparison between the NASDAQ Composite Index and the Dow Jones Industrials as of March, 2000. The NASDAQ was trading at 172.2 times the past years earnings of its 100 component stocks! In June 2005, the current P/E ratio of the NASDAQ 100 is 30. By contrast, the Dow Jones was trading at 22.5 times the past years earnings of its 30 component stocks as of March, 2000. Currently, its P/E ratio is17.6.
The 12.89% average annual return in the S&P 500 for the entire 27 year period was only available for those investors who remained there during the technology boom. Many strayed to the NASDAQ through their own greed along with that of their advisors (seeking the higher performance of dot-com and tech. issues) and they experienced necessarily a much lower compounded annual return through 2002. They participated in this high risk technology concentration usually without any protection or exit strategy i.e. stop losses, protective puts or custom collars. Further, rather than their brokers selling or cushioning the decline in value of this 100% concentrated stock portfolio, many brokers bought more or "averaged down" during the market decline. At the end of last year, large-cap technology stocks (those in the top half of the Russell's index of the 1,000 biggest U.S. stocks, traded at 33 times the past year's earnings. Technology stocks in the Russell 2000, an index of small-cap stocks, had a price-to-earnings ratio of 59. This when earnings growth for both small and large technology companies were about the same over the past two years, suggesting that small-cap technology stocks don't deserve such high valuations compared with their larger peers.
Tech-heavy mutual funds joined the internet explosion in high risk NASDAQ issues as well. In December 1998 there were a total of 48 technology equity funds (as defined by the Morningstar Principia Pro software). By the end of 2000 there were 118 tech. funds - an increase of 146%. The bulge in tech. portfolios took place between June 1996 and December 2000. In the short space of 19 months, 70 new equity funds with a heavy weighting in technology were launched. These totals only consider distinct, surviving portfolios as of April, 2003.
As we observe the markets rebounding nicely in 2003 (the market overall was up over 40% according to the VAY index), we must remind ourselves of the valuable lesson history has taught us! In the last 23 years the five asset class diversified portfolio has performed virtually equivalent to the growth stock portfolio, but with less than half the level of risk. It will take all or our resolve to remember that historical truism. No one can be sure that the market has bottomed out. Historically, there have been 5 bear markets since the depression. A bear market is defined as lasting more than 12 months in a period where stocks lost at least 20% of their value. The bear markets were 1929-1932; 1940-1942; 1968-1970; 1973-1974 and 1980-1982. More currently, the Wilshire 5000 total return index declined by 46% from its March, 2000 top to its October, 2002 low. Only diversification can sustain us through the unchartered waters of these uncertain times.
The point is this: Sector sizzle will come and go just like it always has. Conversely, investors planning for retirement want their retirement funds to grow consistently with the realistic probability of controlling risk levels. A diversified portfolio does that. Once again, it is "an idea whose time has come".
Historical Portfolio Returns: 197- 2010
Large U.S. Small U.S. Int'l U.S. Bond Cash Real Commodities 60% Stock/ Age-Bas
Stocks Stocex Ind Index Esta 40% Bo multi-asset
4139 Yr. Av 9.5 10.2 9.0 8.1 5.2 10.6 9.9 9.3 9
Ann. % Ret.4139 Yr. Stan 18.2 22.7 23.1 5.4 3.1 20.1 25.6 11.5 6
Worst 1-y (37.0) (33. (43. (1.8) 1.1 (39. (46. (18.0) (3.4)
Worst 3 yr . (37.6) (42.2) (43. 6.4 4.2 (31. (39. (13.9) 11.7
Back during 2008, losses were dramatic in the securities markets, in nearly every investment class. Literally there was no
place to hide. Domestic Large-cap stocks (as measured by the S&P 500) lost 37%. Domestic small-cap stocks lost
nearly 34% (using the Russell 2000 Index). International stocks (measured by the Morgan Stanley EAFE Index)
lost 43.4%. Real estate (using the Dow Jones Real Estate Index) lost 39.2%. Commodities (measured by the
S&P Goldman Sachs Commodity Index) lost 46.5%. Amid the chaos, however, U.S. intermediate government bonds
returned 10.4%, and 90 day Treasury bills produced 1.5%.
Volatility and turbulence in the financial markets is not new, however. Nevertheless, enduring it can rattle even
the most seasoned investor. Having an historical perspective of the behavior of various investment assets is the
best defense against the panic and rash decisions that often result from market gyrations. Moreover, understanding
the historical behavior of various asset classes empowers individuals as they confidently utilize multiple asset
sectors when building and implementing investment portfolios.
One obvious solution is to combine stocks and bonds into a single portfolio. The result provides a risk/reward
combination that is more desirable than either asset individually - a central tenet in modern portfolio theory. Indeed,
prudent investing requires the construction of multi-asset portfolios.
The chart above shows the risk and return attributes of seven individual investment assets. For example, the
worst three-year return for bonds was a positive 6.4%. Conversely, large U.S. stocks had a worst-case three-year
loss of more than 37% (which occurred from 2006 to 2008).
There are also two portfolios in the chart. The first is a simple two-asset portfolio portfolio consisting of U.S.
stocks and U.S. bonds. The stock portion is weighted with a 60% allocation and the bond portion has a 40%
allocation, the mix commonly referred to as a balanced portfolio. The 60/40 portfolio haa 41-yearar r average
annual return of 9.4%, which was very close to the return of the S&P 500 (which is a 100% stock portfolio).
However, as a result of the stock/bond mix, the worst three-year loss was reduced to 13.9%. Thus, by
blending stocks and bonds almost completely maintained the performance of stocks, while cutting the
volatility (risk) in half. The portfolio effect (that is, the synergistic result of combining investment assets
with different performance attributes) is evident.
The second portfolio is an age-based multi-asset portfolio that combines all seven assets in equal portions.
The investor allocates his or her age to bonds and the balance is invested in the multi-asset portfolio. For
example, a 40- year old would invest 40% of his portfolio in bonds and the remaining balance of 60%, split
equally among the 7 assets that make up the multi-asset portfolio. 6665 year old would inves66%5% of her
assets into bonds an34%5% into the multi-asset portfolio.This 41 year r performance analysis assumea 25-year-old d investor in 197
Each year the allocation to the bond index increases by one percentage point
and the allocation to the multi-asset portfolio decreases by one percentage point as the investor ages.
The historical performance of an age-based multi-asset portfolio is impressive. Performance overthe 41-year r period was clearly superior to the 60/40 portfolio, while at the same time exposing the
investor to less risk than a 100% bond portfolio. Based upon historical performance since 1970, building
a portfolio that has upside potential as well as downside protection requires two vital elements.
First, the portfolio must have adequate asset diversification. It needs to include more than two
asset classes. The traditional 60% stock and 40% bond portfolio provides insufficient diversification.
Utilizing seven different assets (in this case equally weighted) provides the needed level of diversification.
Second, the portfolio must have an age-appropriate asset allocation model through time.
As the investor ages, the portion of the portfolio allocated to bonds (or some other low risk asset) must
increase. Combining a multi-asset portfolio with an age-based allocation to bonds achieves this
Finally, how did the age-based multi-asset portfolio perform in 2008? Assuming that the investor
was 63 years old that year, the portfolio lost only 3.4% (only its second annual loss in th44-yearar period).
Assuming the investor was 45 years old, the portfolio lost 10%. By comparison, the traditional two-asset
60/40 portfolio lost 18% in 2008, while the S&P 500 lost 37%. Investors and advisors want portfolios that
work in all market conditions. Building an age-based multi-asset approach can deliver that.
Historical Portfolio Returns: 1/79 – 12/02
Stock % Bond % Ave. Annual Return Standard Deviation*
0% 100% 9.6% 6.4%
10% 90% 9.8% 6.4%
20% 80% 10.0% 6.7%
30% 70% 10.2% 7.3%
40% 60% 10.3% 8.1%
50% 50% 10.4% 9.1%
60% 40% 10.4% 10.3%
70% 30% 10.5% 11.5%
80% 20% 10.5% 12.8%
90% 10% 10.4% 14.2%
100% 0% 10.4% 15.6%
Stocks: Russell 3000
Bonds: Lehman Aggregate Bond Index
Assuming 15% capital gains and dividend taxes and a 40% effective tax rate on current income the
following results were achieved between 1-1-90 and 12-21-2003, on an after tax basis:
ASSET CLASS AVERAGE RETURN STANDARD DEVIATION
Bonds 4.64% 3.69%
International Equity 1.43% 16.20%
Emerging Market Equity 4.24% 22.37%
Small-Cap Stocks 8.28% 18.15%
Large-Cap Stocks 8.60% 14.21%
Municipal Bonds 6.37% 4.65%
Abandoning bonds is as foolish now as it was in 1999! Investors should note that maintaining a 30% allocation in fixed income securities cuts portfolio volatility by one-third, but with negligible upside impairment. Instead of trying to guess, we look for sound investment opportunities with low correlations to U.S. stocks and combine them in proportions most appropriate to each client's needs, objectives and risk/return profile. For example, the correlations between emerging market stocks or real estate investment trusts and stocks is quite low. And there's effectively no correlation between the returns on cash and the returns on U.S. stocks. You can see that the dollar, too, moves without relation to the U.S. stock market, which adds to the diversified effect of investing abroad. With the recent decline in interest rates, and the chance for increases from historic lows, one needs to be a bit more creative, utilizing inflation indexed bonds, convertible securities, mortgage backed securities or laddered Treasury Notes, for example. Quality high yield non-rated bonds ("junk" but not "trash") should be considered when the issuer forgoes the cost of a bond rating in favor of increasing the yield to the investor. Quality corporate bonds could also be considered. However, one must always keep an eye on default potential. According to Moody's, for companies started in 1970 to 1997, the mean five-year cumulative rate of default was 0.1% for those with a top Aaa rating. The default rate climbed to 11.5% for speculative Ba-rated companies and to 30.8% for B- rated firms (See the following article on junk bonds). The most compelling reason for including bonds in a portfolio is again, diversification. Consider the 1970's, a decade when interest rates increased from 5% to 14%. According to a recent Ibbotson study, an investor with a 30% allocation to bonds during this period captured 98% of the total return of stocks with only 73% of the price volatility. If that statistic isn't convincing enough, consider the possibility of another market shock, be it a stock market crash a la 1987, or another terrorist attack on U.S. soil. In the past, bonds acted as a shock absorber during such tumultuous events, cushioning the bruising performance of equities. As interest rates begin to rise, regardless of economic conditions, bonds should be a part of every long-term investor's holdings. It is prudent, however, to adjust duration and credit spread exposure as conditions change. During the year 2008, bond investors lost 11.7% vs. a 5.2% gain in the Barclays Aggregate Bond Index, a difference of (17 pts.). Finally, measuring backwards from June 30, 2009, U.S. stocks have underperformed long-term treasury bonds for the past 5, 10, 20 and 25 years!
Scorecard - Standard Deviation*
(1 = best - 9 = worst)
Standard Deviation Volatility Risk Rating
up to 7.99 1
8.00 - 10.99 2
11.00 - 13.99 3
14.00 - 16.99 4
17.00 - 19.99 5
20.00 - 22.99 6
23.00 - 25.99 7
26.00 - 28.99 8
29.00 and up 9
THE BENEFITS OF DIVERSIFICATION (1970-1990)
Stocks 5 Asset
100% 100% 60%Stocks Cash Diversified
Year Stocks Bonds 40%Bonds (1/3 in each) Portfolio*
1970 4.0% 12.1% 7.5% 8.0% 4.7%
1971 14.3% 13.2% 14.1% 10.8% 13.7%
1972 19.0% 5.7% 13.5% 9.4% 15.1%
1973 -14.7% -1.1% -9.1% -3.0% -2.2%
1974 -26.4% 4.4% -14.9% -5.4% -6.6%
1975 37.2% 9.2% 25.7% 17.0% 19.6%
1976 23.8% 16.8% 21.2% 15.2% 11.5%
1977 -7.2% -0.7% -4.6% -0.9% 6.1%
1978 6.6% -1.2% 3.7% 4.4% 13.0%
1979 18.4% -1.2% 10.8% 9.1% 11.5%
1980 32.4% -4.0% 17.5% 13.2% 17.9%
1981 -4.9% 1.9% -2.0% 4.1% 6.4%
1982 21.4% 40.4% 29.0% 24.0% 14.4%
1983 22.5% 0.7% 13.4% 10.5% 15.4%
1984 6.3% 15.4% 10.1% 10.8% 10.4%
1985 32.2% 31.0% 31.9% 23.4% 25.4%
1986 18.5% 24.4% 21.1% 16.6% 23.3%
1987 5.2% -2.7% 3.6% 3.9% 8.6%
1988 16.8% 9.7% 14.0% 11.0% 13.2%
1989 31.5% 18.1% 26.2% 19.2% 14.3%
1990 - 3.2% 6.2% 0.6% 3.6% - 1.4%
Compound 11.2% 8.7% 10.5% 9.6% 11.2%
Risk Levels - 16.20% 11.80% 9.53% 8.00% 7.75%
# of Years 15 14 16 17 17
Stocks: S&P 500 Index, Bonds: Lehman Agg. Bond Index, Cash: 180 day C.D.
*Diversified Portfolio: 20% S&P 500, 20% Lehman Aggregate Bond Index, 20% Equity REITS, 20% MSCI World Index (International), 20% Cash. Assumes annual rebalancing.
Sources: Morningstar, Ibbotson, Thomson Fin'l, NAREIT & BB&K Index.
HISTORICAL MARKET INDEX ANNUAL RETURNS
DJIA S & P 500 NASDAQ
ANNUAL RETURN (%) ANNUAL RETURN (%) ANNUAL RETURN (%)
2003 27.4 28.7 33.3
2002 -14.5 -23.4 -31.3
2001 - 5.4 -11.9 -21.1
2000 - 4.7 - 9.1 -39.3
1999 27.0 21.0 85.6
1998 18.0 28.6 39.6
1997 24.8 33.4 21.6
1996 28.6 23.1 22.7
1995 36.5 37.4 39.9
1994 4.9 1.3 - 3.2
1993 16.7 10.0 14.7
1992 7.4 7.7 15.4
1991 23.9 30.6 56.8
1990 - .6 - 3.2 -17.8
1989 31.7 31.5 19.3
1988 15.9 16.8 15.4
1987 6.0 5.2 - 5.3
1986 26.9 18.5 7.3
1985 32.8 32.2 31.5
1984 1.1 6.3 -11.2
1983 25.6 22.5 19.9
1982 25.8 21.4 18.7
1981 - 3.4 - 4.9 - 3.2
1980 21.4 32.4 33.9
1979 10.5 18.4 28.1
1978 - 3.2 6.6 12.3
1977 -17.3 - 7.2 7.3
1976 21.8 23.8 26.1
1975 45.4 37.2 29.8
1974 -23.1 -26.4 -35.1*
1973 -13.1 -14.7
1972 14.6 19.0
1971 9.8 14.3
1970 8.8 4.0
1969 -11.6 - 8.5
1968 7.7 11.1
1967 15.2 24.0
1966 -18.9 -10.1
1965 14.2 12.5
1964 18.7 16.5
1963 20.6 22.8
1962 -10.8 - 8.7
1961 18.7 26.9
1960 - 9.3 0.5
1959 16.4 12.0
1958 34.0 43.4
1957 -12.8 -10.8
1956 2.3 6.6
1955 20.8 31.6
1954 44.0 52.6
1953 - 3.8 - 1.0
1952 8.4 18.4
1951 14.4 24.0
1950 17.6 31.7
1949 12.9 18.8
1948 - 2.1 5.5
1947 2.2 5.7
1946 - 8.1 - 8.1
1945 26.7 36.4
1944 11.8 19.8
1943 14.1 25.9
1942 7.6 20.3
1941 -15.4 -11.6
1940 -12.7 - 9.8
1939 - 2.9 - 0.4
1938 28.1 31.1
1937 -32.8 -35.0
1936 24.8 33.9
1935 38.5 47.7
1934 4.1 - 1.4
1933 66.7 54.0
1932 -23.1 - 8.2
1931 -52.7 -43.3
1930 -33.8 -24.9
1929 -17.2 - 8.2
1928 49.5 43.6
Average Annual Return 9.2% 12.1% 13.7%
(76 Years) (76 Years) (30 Years)
* First year of NASDAQ Index.
Sources: Bloomberg (Dow Jones & NASDAQ)
Ibbotson (S&P 500)
HIGH YIELD OR “JUNK’ BONDS, HAVEN OR HORROR
By Mason A. Dinehart III, RFC
A high yield, or “junk” bond is a bond issued by a company that is considered to be a higher credit risk. The credit rating of a high yield bond is considered “speculative” grade or below “investment grade”. This means that the chance of default with high yield bonds is higher than for other bonds. Their higher credit risk means that “junk” bond yields are higher than bonds of better credit quality. Studies have demonstrated that portfolios of high yield bonds have higher returns than other bond portfolios, suggesting that the higher yields more than compensate for their additional default risk. It should be noted that “unrated” bonds are legally in the “junk” category and may or may not be speculative in terms of credit quality.
High yield or “junk” bonds get their name from their characteristics. As credit ratings were developed for bonds, the credit agencies created a grading system to reflect the relative credit quality of bond issuers. The highest quality bonds are “AAA” and the credit scale descends to “C” and finally to “D” or default category. Bonds considered to have an acceptable risk of default are “investment grade” and encompass “BBB” bonds (Standard & Poors) or “Baa” bonds (Moody’s) and higher. Bonds “BB” and lower are called “speculative grade” and have a higher risk of default.
Rulemakers soon began to use this demarcation to establish investment policies for financial institutions, and government regulation has adopted these standards. Since most investors were restricted to investment grade bonds, speculative grade bonds soon developed negative connotations and were not widely held in investment portfolios. Mainstream investors and investment dealers did not deal in these bonds. They soon became known as “junk” since few people would accept the risk of owning them.
High Yield “Junk” bonds were invented to enable smaller companies or big investors to use bonds and bond markets to finance takeovers. The original concept was good and legal; but overly aggressive stockbrokers and arbitrageurs, aided by large investment firms, exploited and corrupted it. They used illegal inside information, deliberately-planted misinformation and market rigging to make millions and millions of dollars while, in some instances, destroying profitable old companies. Some of these multimillionaires are now in the penitentiary. Unfortunately, this kind of greed is still rampant.
Before the 1980’s, most junk bonds resulted from decline in credit quality of former investment grade issuers. This was a result of a major change in business conditions, or the assumption of too much financial risk by the issuer. These issues were known as “fallen angels”. The junk bond market grew exponentially. During the 1990-91 recession, many of these bonds defaulted, helping bankrupt the S&L’s throughout the U.S. and helping to saddle U.S. taxpayers with a trillion dollar national deficit.
The advent of modern portfolio theory meant that financial researchers soon began to observe that the “risk-adjusted” returns of portfolios of junk bonds were quite high. This meant that the credit risk of there bonds was more than compensated for by their higher yields, suggesting that the actual credit losses were exceeded by the higher interest payments.
Underwriters being creative and profit-oriented, soon began to issue new bonds for issuers that were less than investment grade. This led to the Drexel-Burnham saga, where Michael Millken led a major investment charge into junk bonds in the late 1980’s, which ended with a scandal and the collapse of many lower rated issuers. Despite this, the variety and number of high yield issues recovered in the 1990’s and is currently thriving. Many mutual funds have been established that invest exclusively in high yield bonds, which have continued to have high risk-adjusted returns.
In the 9 months ended 7-31-03 , junk bonds returned an average of 26.2% or an annualized return of 36.4%. The lowest bonds (Caa) had returned a record 83.2%. Through 10-31-03 , Investment Advisor Magazine reported that the Lehman High Yield index had returned 24.23% year to date. As of 12-10-03 , the widely watched Merrill Lynch U.S. High Yield Master II index has returned a stellar 26.965%, year-to date, its second best showing ever.
History, however, provides a bit of caution. A research study completed in mid-1989 by Harvard professor Dr. Paul Asquith found that an incredible 34% of all high yield bonds defaulted. He started with bonds issued in 1977 and assumed that if a hypothetical investor bought every high yield bond issue between 1978 and 1986, 34% of the bonds would have defaulted by November 1988. Professor Asquith also found that the quality of bond issues has decreased over time with higher quality issues in the early 1980’s versus the late 1980’s.
AN EXPLANATION OF “JUNK” BOND CREDIT RATINGS
High yield bond investment relies on credit analysis. Credit analysis is very similar to equity analysis in that it concentrates on issuer fundamentals, and a “bottom-up” process. It is concentrated on the “downside” risk of default and the individual characteristics of issuers. Portfolios of high yield bonds are diversified by industry group and issue type. Due to high minimum size of bond trades and the specialist credit knowledge required, most individual investors are best advised to invest through high yield mutual funds.
Bonds are generally classified into two groups – “investment grade” bonds and “junk” bonds. Investment grade bonds include those assigned to the top four quality categories by either standard & Poors (AAA. AA, A, BBB) or Moody’s (Aaa, Aa, A, Baa). The term “junk” is reserved for all bonds with Standard & Poors ratings below BBB and/or Moody’s ratings below Baa. Investment grade bonds are generally legal for purchase by banks; junk bonds are not.
The specific definitions assigned to junk bond ratings by the services help define the magnitude of the risk associated with them. Because Standard & Poors definitions are somewhat more comprehensive, they are quoted here:
BB,B,CCC,CC,C: Debt rated BB, B, CCC, CC, and C is regarded, on balance, as predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. BB indicates the lowest degree of speculation and C the highest degree of speculation. While such debt will likely have some quality and protective characteristics, these are outweighed by large uncertainties or major risk exposures to adverse conditions.
BB: Debt rated BB has less near-term vulnerability to default than other speculative issues. However, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to inadequate capacity to meet timely interest and principal payments.
B: Debt rated B has greater vulnerability to default but currently has the capacity to meet interest payments and principal repayments. Adverse business, financial or economic conditions will likely impair capacity or willingness to pay interest and repay principal.
Because a B rating is the single most common rating found in a junk bond portfolio, Moody’s definition of its B rating follows:
Bonds which are rated B generally lack characteristics of the desirable investment assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small.
To resume with Standard & Poors:
CCC: Debt rated CCC has a currently identifiable vulnerability to default, and is dependent upon favorable business, financial, and economic conditions to meet timely payment of interest and repayment of principal. In the event of adverse business, financial, or economic conditions, it is not likely to have the capacity to pay interest and repay principal.
D: Debt rated D is in payment default.
CREDIT RATINGS AND ANALYSIS
A credit rating is an assessment by a third party of the creditworthiness of an issuer of financial securities. It tells investors the likelihood of default, or non-payment. By the issuer of its financial obligations. Credit analysis is the financial analysis used to determine the creditworthiness of the issuer. It examines the capability of a borrower, or issuer of financial obligations, to repay the amounts owing on schedule or at all.
Establishing the creditworthiness of borrowers is one of the oldest established financial activities known. Throughout history, the act of lending funds has been accompanied by an examination of the ability of the borrower to repay the funds. The most ancient civilizations and societies known to us often show development of sophisticated trading and banking activities. The medieval bankers of Europe were thorough in their examination of their clients’ affairs and often decided the outcome of wars and the fate of monarchies with their financing. This type of direct lending and banking relied largely on character and direct knowledge of the financial situation of the borrower.
As modern accounting and finance developed during the industrial revolution, banking and lending grew to a larger scale and became more systematic. Just as governments developed sophisticated bureaucracies to deal with the complexities of national governments, large banking and financing houses grew to cope with the demands of international trade.
Modern credit analysis developed in the late 1800’s when the credit markets began to issue and trade bonds, largely to finance the development of the new world, particularly the United States. As lenders were purchasing bonds of countries and companies that they had little personal knowledge of, third party credit rating agencies such as Moody’s Investors Services and Standard & Poors Corporation and Fitch IBCA were founded to fulfill the need for an impartial assessment of the creditworthiness of bond issuers.
These companies, most still active today, developed scoring systems that told investors of the creditworthiness of issuers. Each rating agency has its own nomenclature or “investment grade” that ranks the default risk of issuers. The scale begins at the highest quality ratings, AAA, with very low probability of default, and descends to risky or “speculative” ratings, BB, where the risk of default is high. Default rates for the high-yield market over the past two years peaked at nearly 12%. With defaults today in the mid-5% range and projected to go lower, the risks with this sometimes volatile and lower credit-rated asset class are not as great as many assume. The recent default deceleration can be attributed to a washout of, primarily, the telecommunications sector and other financially weak entities that could not survive the economy. Clearly, declining default rates are another reason for lower credit spreads and are obviously a positive for this asset class.
YIELD OF “JUNK” BONDS OVER TREASURIES
One of the things to look at is the difference between the 10-year Treasury bond, and the yield on the high yield index, usually a 3-4% difference. As of mid 2003, it was as high as 7%, then down to the range of 6%. Late in the year, issuers have been bringing out a host of lower-quality bonds in response to the record inflows into junk funds, according to Standard & Poors Global Fixed Income Research. Junk bonds now yield about 5% above the 10-year Treasury note, or around 9.3%, currently. Maximizing current income should be the goal for high-yield corporate portfolios. High yield historically generates 98% of its return from coupon. As a result, current income is its number one objective while capital appreciation is a secondary, though important aspect to long term performance (plus or minus 2% from capital appreciation due to general credit quality improvement and mergers and acquisitions activity)..
“JUNK” VS. “TRASH”
Trash bonds can be described as bonds that have been downgraded by Standard & Poors or Moody’s, due to their financial status, to below investment grade. However, there are many junk bonds that are not trash! Some non-rated bonds such as Sears and Roebuck, Seven-Up Bottling Co. and Dr. Pepper, defray paying up to a $500,000 premium to the rating agencies to secure an investment grade credit rating. Instead, these quality companies would rather pay an additional 1/8% to 1/4% premium to the investor to invest in their unrated bonds. While these are still legally “junk” by definition, they should not be considered “trash”.
Junk bonds, like all bonds are subject to interest rate risk. For that reason, shorter maturities are advisable to reduce that risk. A range or 2-8 years is advisable with the thought of holding the bonds to maturity (less than 10 years) if interest rates rise and market values decline during the holding period. The longer the maturity, the greater the loss in market value, if interest rates rise. With an 8% coupon and a 20 year maturity, the loss of principal would be (9.2%) if interest rates rise one percentage point and (17.2%) if interest rates rise 2 percentage points! This compares to a loss of principal of only (4%) and (7.7%) for a five year maturity, respectively. With a 10% coupon, and 20 year maturity, the loss in market value would be (8%) and (15%), respectively, versus (3.8%) and (7.4%) for a five year maturity. The risk of principal loss with longer term bond maturities is like a string tied to an air conditioning duct. At the end of the string, large fluctuations occur (long maturities). The beginning part of the string where it is tied to the duct, fluctuates very little. The longer the string, the greater the fluctuations (price swings). Taxable high-yield corporate bonds historically have performed well in an improving economy despite the accompanying rising rate environment. As an asset class, high-yield corporate securities tend to benefit from rising rates. This is because rising rates generally signal an accelerating economy and/or inflation, both of which are important for the success of small to mid-cap sized companies. Growth and/or price inflation generally means a company has the ability to push through price increases. This ability in turn helps in their profitability and ability to de-leverage their balance sheet. Finally, high yield's average duration is generally lower than most traditional interest-sensitive securities. the average duration (as defined by the Lehman High Yield Index) of a high-yield bond is 4.7 years. this lower duration is obviously beneficial in a rising rate environment.
OASIS OR MIRAGE
Hungry for yield, investors are bidding up risky issues. With interest rates on savings accounts, money market accounts, and Treasury bonds at close to their recent lows after 13 consecutive rate cuts by the Federal reserve, investors thirsty for yield are plowing into high-interest – high-risk – junk bonds. Bolstered by huge inflows, an improving economy and strong investment returns, high-yield bond issuance is approaching the 12-month volume record of 1998. Through mid-December, 2003, about $129 billion in junk bonds has been sold, compared to $138 billion in 1998 according to Thomson Financial. The high-yield debt market sprang to life in the fall of 2002 after languishing in the wake of the dot-com stock collapse. This year, a low-interest-rate environment encouraged investors to seek the better yields in the junk-bond arena, while the economy encouraged them to accept the greater risk in lower-rated corporate debt.
Merrill Lynch Chief North American Economist David Rosenberg has stated that there is little economic rationale to support the current strength of the junk-bond market. Rather, it’s being driven by increased liquidity with the accommodative actions of the Federal Reserve and investor’s hunger for yield. Merrill Lynch analyst M. Cristopher Garman says that default rates are down.
Even though they’re down now for junk bonds, says Garman: “This is actually the slowest rate of deceleration [for defaults] on record, even going back to the Great Depression.” Some experts argue that the Fed’s easy-money stance has made it possible for companies to clean up their balance sheets and lower heavy debt burdens, making the possibility of default less great.
Warren Buffet has recently been a big player in junk bonds and who could forget Fred Carr, who as President of Executive Life Insurance Company, built his financial empire on junk bonds. He always was heard to say, ”yes, their aggressive, but in time they will be worth a fortune”. He was right. In the early 1990’s, Credit Lyonnais acquired Executive Life and its junk-bond portfolio for a song. U.S. prosecutors allege that Credit Lyonnais, which was then owned by the French government, skirted U.S. laws to gain control of the assets, which it later sold to Francois Pinault, the tycoon who controls fashion house Gucci and auction house Christie’s. He is estimated to have made more than $1 billion from the bonds and the insurer, accounting for a big chunk of his fortune. The Executive Life insurance-fraud case is near settlement according to the Wall Street Journal, December 11, 2003 , in the amount of $760 million. On the down side, “junk” bonds have been exposed in the municipal bond arena! The share price of Heartland High Yield Municipal Bond Fund declined 70% on Oct. 13, 2000 , and that of Heartland Short Duration High-Yield Municipal fund declined 44%, as the funds wrote down some holdings of high-yield “junk” municipal bonds.
It goes without saying that “junk” bonds are speculative investments. They are then unsuitable for conservative investors seeking steady and verifiable income. For the moderate growth and income investor seeking a diversified portfolio, up to 10% - 15% of a balanced portfolio could be allocated within this high yield asset class. Compared with the “golden years” bonds should offer better diversification from stocks, as I expect the correlation between the two asset classes to remain negative. Against all expectations, stocks and bonds were positively correlated (returns rose and fell together) for much of the 1980’s and 1990’s, as productivity gains and declining inflation benefited both markets. Now, however, both assets should track the economic cycle more closely and stock and bond prices should move in opposite directions. This allocation is strengthened if “junk” (quality unrated bonds) as opposed to “trash” is emphasized. Heavy concentration in this speculative asset class is unsuitable for most investors without the highest aggressive risk tolerance. Diversification through the purchase of bond mutual funds as opposed to individual issues can help in providing a higher yield haven for investors rather than a horror.
Very Good Quality……AA
Medium Quality……….BBB (Investment Grade)
Lower Medium Quality..BB
Speculative Quality….. .C