“Those who do not remember the past are condemned to repeat it.”
-- George Santayana
It has been only a few years since August 2007, the beginning of the global recession and the credit market turbulence. The highly publicized problems facing institutional investors, high-net-worth individuals, investment advisers and the financial institutions that provide services to these market participants suggest a more conservative and risk focused approach to wealth management is necessary. Unfortunately, history appears to be repeating itself.
The bond geeks and derivatives mechanics are at it again, attempting to sell a concept that flies in the face of what investors have learned and practiced over 50 years. The concept is called leveraged bonds and was recently described in very cautionary terms by Rodney N. Sullivan in Pensions and Investments and in the Financial Times as an alternative to equity investing.
These are concentrated bets that ignore the benefits of diversification across multiple investment opportunities. Modern finance has demonstrated that the only free lunch in town as far as risk reduction goes is diversification and the Nobel Prize of 1990 to Markowitz and Sharpe is a testimony to that.
The kraken or ‘crack’ of leverage is being unleashed on or dangled before investors to increase bond returns while ignoring potential losses. It is one thing to engage in pairs trading like statistical arbitrage traders or long-short hedge funds. It’s another thing to expect to get equity-like returns without being exposed to comparable risks. Stressful market events such as the technology bubble burst, the 9/11 terrorist attacks, and the most recent credit crisis have dramatically shown the high risk of concentrated investments in any security or asset class.
An example of the effect of a leveraged bonds and asset allocation is for a U.S. investor in U.S. large cap stocks and U.S. long term government bonds. Our investor uses the historical realized quarterly returns of these asset classes derived from the Ibbotson Associates database. The following table shows the Sharpe ratio, a risk adjusted return measure, for three different strategies:
Bond Leverage None 1.2 1.4 1.6 1.8
All bonds 0.1886 0.1777 0.1668 0.1561 0.1455
40% stocks 60% bonds 0.1757 0.1930 0.2011 0.2033 0.2021
60% stocks 40% bonds 0.0377 0.0651 0.0901 0.1120 0.1305
Suppose that our investor begins with $100,000 and purchases a 1.2 leveraged bond. This means that the investor in effect has borrowed $20,000 to get $120,000 of exposure. The quarterly return to this bond is 1.2 times the unleveraged bond investment. Since this return is derived from an underlying bond investment, the leveraged bond is a derivative security. It is also a credit derivative because the underlying security is a credit market investment. You could also do the same thing with mortgage-backed securities and we know what happened to that market.
If we didn’t use leverage, then the story for the five year period 2005 to 2009 is to go with the government bonds because it has the highest Sharpe ratio. But see what happens when you add leverage to bonds alone ---- the more leverage you add the lower the Sharpe ratio is.
The best alternative for the investor who still wants to use leveraged bonds is a portfolio that is rebalanced quarterly to 40% stocks and 60% bonds. Yet at higher leverage, the portfolio begins to suffer. Interestingly, the 60% stock and 40% bond portfolio begins to look good once you use higher leveraged bonds. It is the effect of diversification that is providing these more tasty possibilities.
If you don’t think that you would experience these results, then heed the words of Santayana. Look out for Nassim Taleb’s black swans of extreme events. Or as Mr. Micawber of Charles Dickens’ "David Copperfield" said, “Annual income, 20 pounds. Annual expenditure, 20 pounds and six. Result, misery. Blossom is blighted. Relief is withered. You are, in short, flattened.”
As Rodney Sullivan suggests, don’t under-estimate the risk management importance of diversification.
Sponsored by: EMA Softech
Sponsored by: EMA Softech
