Swedroe: When Bonds Act Like Stocks

Research into the determinants of fixed-income returns have found that a number of stock and bond market risk factors can be shown to demonstrate explanatory power beyond the standard term-structure variables.

Ivelina Pavlova, Ann Marie Hibbert, Joel Barber and Krishnan Dandapani—authors of the paper “Credit Spreads and Regime Shifts,” which appears in the Summer 2015 issue of The Journal of Fixed Income—add to the literature by investigating the impact on credit spreads of three groups of macro determinants: 1) term-structure variables; 2) bond market volatility and liquidity; and 3) stock market return and volatility.

As the authors point out, in theory, these variables influence credit spreads in three ways:

• As predictors of future default probabilities
• As inputs into the pricing model through volatility and interest rates
• As risk premiums associated with credit risk

Study Results
The study covered almost 1,400 domestic nonfinancial corporate bonds (both high-yield and investment-grade) for the period January 5, 2006 through March 1, 2011, a period that spans the financial crisis. The authors’ research, in general, confirms prior findings while also providing some new insights. Following is a summary of their results:

• The contemporaneous return of the S&P 500 Index is highly significant when determining changes in credit spreads across all bond portfolios studied during the sample period. As expected, the sign is negative.
• The one-day lagged change in the VIX has a positive and highly significant effect for high-yield bonds.
• The model has the best fit for high-yield bonds, as the t-stats (a measure of statistical significance) are notably higher.
• Changes in the level and slope of the term structure influence the perception of default risk, and higher interest rates increase the cost of the put option, lowering its value. In effect, a corporate bond is a combination of a pure interest-rate instrument and a short position in a put on the issuer’s equity. The put is triggered by a decline in the value of the bond issuer’s assets to less than the value of its liabilities, resulting in a default (or putting the equity to bondholders). For a highly rated firm, the put is well out of the money and isn’t likely to be exercised. A steeper yield curve predicts less risk of recession, and thus less risk of default. However, with corporate bonds, a steeper yield curve could be associated with an increase in credit spread.

Effects Of Regime Change

The authors also discovered that some of the relationships they studied can switch with a “regime change.” By examining both high- and low-variance regimes, they found:

• Changes in both the Treasury note and the slope of the yield curve have a negative and significant effect on credit spreads in both regimes. The explanatory power of the other factors is regime-dependent.
• For investment-grade bonds, the explanatory power of the stock market is stronger in the high-variance regime. The explanatory power of the VIX is stronger in the low-variance regime.
• For high-yield bonds, an important factor for determining changes in spread is the variation of liquidity in the bond market, as is the change in the TED spread (the spread between the yield on three-month Treasury bills and three-month eurodollars).
• For high-yield bonds, returns to the S&P 500 Index are negative and significant in explaining spread changes in the low-variance regime.
• Bond market volatility is the most significant factor in causing regime shifts.

The authors concluded: “Our empirical results show a strong negative relationship between changes in the spread and both the level and slope of the Treasury term structure, with the effects being stronger for high-yield bonds. We also find that bond market volatility and liquidity have a significant impact on the daily spread changes of some investment-grade and high-yield bonds, and stock market returns and volatility, measured by returns on the S&P 500 and the VIX respectively, are highly significant in explaining most spread changes.”

For investors, the implication is that high-yield bonds are clearly hybrid instruments, combining characteristics of Treasury (and investment-grade) bonds and equities. And they tend to become more equitylike at exactly the wrong time, when the risks of equities show up. Thus, investors who choose to include an allocation to high-yield bonds should make sure they are accounting for the equitylike risks inherent in those bonds.

In other words, consider some portion of them to be equities. The lower the credit rating of the bond, the more you should think about a portion of it as an equity allocation. Failure to do so could result in investors exceeding their ability and willingness to take risk during bear markets. That, in turn, could lead to either forced, or panicked, selling.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.