Relationship between VIX and Credit Spreads

This is motivated by a post from David Merkel of the Aleph Blog, called Buy Stocks When Credit Spreads are High, Sell When They are Low.

Merkel suggests that "credit spreads and implied volatility are cousins. When there is complacency, both are low. When there is panic, both are high."

Junk Bonds: A Closer Look

So one of the questions I asked in Are Bond Yield Spreads Adequate? is whether or not junk bond spreads are adequate. I presented a simple model. The model predicted that returns on junk bonds would be about 2.27% in excess of treasuries. But the uncertainty in the model had a standard deviation of 2.36%. So if we were off by just 1 standard deviation, we would underperform treasuries.

But a model can't be better than the assumptions that one puts into it. I'd like to take a review of the assumptions I used in the model and change a few things. 

Are Bond Yield Spreads Adequate?

Suppose you have the choice between three classes of assets: treasury bonds, investment grade corporate bonds and speculative grade corporate bonds (junk bonds). Which one should you choose?

Many people wrongly just look at yields. If you look at yields, the answer is simple: choose junk bonds. Junk bonds offer a higher yield.

The problem is that doesn't account for the fact that some junk bonds default and the losses that result from that.

The second issue is the uncertainty in modeling losses. I'm going to be using some models that require assumptions. These assumptions are not perfectly known. So we need to build in a margin of safety to make sure that we outperform treasuries.

Bond Returns Given a Change in Interest Rates

This post was inspired by a tweet by John Hussman:

Bond Asymmetry 101: At 2.9% yield, 50 bp increase in 10-year benchmark Treasury yield => -1% total return over 1 year; 50 bp decrease => +7%
— John P. Hussman (@hussmanjp) September 6, 2013

Einhorn and AAPL's preferred shares

So there's a lot of fuss regarding David Einhorn's proposal that Apple (AAPL) issue preferred shares in order to "unlock value".  To be clear, I like Einhorn and even liked his book, Fooling Some of the People All of the Time (in spite of the fact that it was excruciatingly detailed oriented).

But I concur with Prof Damodaran that this doesn't really create value; it simply changes capital structure. Granted, as Damodaran points out this might unlock price (I suspect it would since the market sometimes overprices leveraged situations. The fact that many analyses of Einhorn's strategy assumes that PE ratios will stay the same in spite of the leverage is evidence of this fact. They make the mistake that one wouldn't make if one understood the ideas in this post.)

But it does enhance value in at least one sense. Cash distributed now is worth more than cash sitting in an account earning next to nothing in interest. 

But I'm more interested in this question: is 4% the correct price for the preferred shares?

Downside Risk Investing

I'd like to give some consideration to a class of investment strategies which I call Downside Risk Investing. These strategies earn returns by taking on downside risk while at the same time having limited upside potential. There are a number of strategies that fit this bill which I'll outline below giving several examples.

There's a metaphor that goes around talking about "picking up pennies in front of a steamroller". It's in reference to investment strategies in which the investor risks getting run over by a steamroller (taking the risk of getting wiped out) for the benefit of receiving a couple of pennies. This entire reference is to Downside Risk Investing.

Now in some sense, many investment strategies have the potential for huge losses with limited upside. The question we should be asking is this: how many pennies do I need to be able to pick up for a particular Downside Risk Investing to be a good strategy? I don't know if I have an answer to that question but I'd like to present a discussion. So without further ado, here are some examples of strategies that I think fit the bill (some of which may be good strategies to employ).

Yield-Duration Curve

Most people are familiar with the "yield curve" which compares yield with maturity. I personally think a more useful curve looks at yield and duration.

Duration is a metric which gives a rough indicator of how much a change in interest rates will affect the price of a bond. Roughly speaking, if a bond has a duration of 10 years, a 1% change in interest rates (say from 4 to 5%) will result in a roughly 10% change in the price of the bond. So duration gives one information about interest rate risk.