The Rant

There is a weekly paper in the small city where I live that covers all the local comings and goings. On the last page of the paper is a section called “The Rant.” 

Basically, it’s a place for people to unload about everything that pisses them off. People rant about everything from a lack of parking downtown to the person in front of them at Starbucks with their face buried in their phone when it’s time to order. 

“You, mid-20’s guy in a blue check shirt in front of me at Starbucks Wednesday morning around 8 am. Stop playing Candy Crush on your iPhone while listening to Nickelback, and order your Double Ristretto Venti Half-Soy Nonfat Decaf Organic Chocolate Brownie Iced Vanilla Double-Shot Gingerbread Frappuccino. Some of us actually have to work for a living.”

This week’s rant comes courtesy of all the financial market commentators who use dodgy data to scare investors into believing, like Fred Sanford, “this is the big one.”

You can find the source for this week’s rant here. Captain All-Pain-No-Gain uses two unsubstantiated premises to convince investors that the bond market is getting ready to experience “the big one.” Unfortunately for him, I remain data-dependent and ready to show investors what the real data is telling us.

Misrepresented Data Point #1

The commentary begins by stating that if the U.S. junk bond market, as represented by the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), plunges below a critical trend line, then it’s “a MAJOR warning that the bond market is beginning to enter a “risk-off” stage.”

The assumption here is that the high-yield bond market shares a strong positive relationship with the rest of the U.S. bond market, and is a good leading indicator for the overall direction of bonds. Historical precedence doesn’t back this premise, and from a statistical perspective, it couldn’t be more flawed.

Not to pull a Sheldon Cooper on you, but over the last ten years the high-yield bond market has averaged a 0.15 correlation to the overall bond market, which implies very little relationship between the movements of these two markets.

When you break down those ten years, you see that the high-yield market has actually spent most of the last decade with a negative correlation to the broader U.S. bond market. This means high-yield bonds often move in the opposite direction of the overall U.S. bond market.

This relationship reality is linked to the fact that high-yield bonds generally act more like U.S. equities than like a member of the fixed income family. In fact, high-yield bonds indeed carry a positive correlation to U.S. equities most of the time, meaning these two markets move in the same direction.

While Captain All-Pain-No-Gain thinks a correction in high-yields is bad for bonds in general, it actually tells investors nothing about the future direction of the U.S. bond market.

 

Flawed Point #2

The premise that investors can forecast the future of the overall U.S. bond market based on the direction of the high-yield bond market isn’t even the most egregious part of this market “analysis.”

The Captain cites “inflation” as the reason high-yield bonds are declining. Here we have yet another premise that is not backed by real data.

The two most critical economic variables that impact the risk and return of asset classes are inflation and economic growth.

There is no question that inflation plays a critical role in the life of a bond, but for high-yield bonds it is not the primary driver of risk and return. Because HY bonds are basically equities in disguise, the trajectory of economic growth has far more impact on their risk and return characteristics.

 

Just the Data, Ma’am

Since 2011, the U.S. has experienced three stretches of falling inflation and two stretches of rising inflation.

During periods of falling inflation, the HYG ETF earned an average of 10.8%, and experienced just a 5% drawdown. During periods of rising inflation, HYG earned an average return of 7.4%, and experienced a drawdown of 6%.

HYG’s performance does show that the reward-to-risk characteristics of the high-yield bond market are lower in rising inflation periods. However, you can hardly conclude that rising inflation will send the high-yield bond market tumbling over the White Cliffs of Dover.

In fact, from a downside risk perspective, inflation seems to have no dramatic impact on U.S. high-yield bonds. The maximum drawdown experienced by HYG is nearly identical during both types of inflationary environments, and frankly isn’t even that significant.

However, when we compare HYG’s performance during periods of accelerating versus slowing U.S. growth, we find some critical linkages.

Since 2011, the U.S. has experienced two periods each of growth acceleration and slowing.

When U.S. growth accelerated, HYG earned an average rate of return of 9.4%, and experienced a maximum drawdown of 5%. However, when growth slowed, HYG earned an average rate of return of 3.1%, and experienced a maximum drawdown of 11%.

HYG’s downside risk was twice as large during slowing growth as during either type of inflationary period. Not only that, but its upside profit potential was just a fraction of what it was during either inflationary period.

This data-dependent reality of slowing growth heavily skews the overall risk-to-reward potential of HYG to three-to-one, in favor of the downside!

This fact alone tells you that HY bonds couldn’t be more different from other types of U.S. bonds. From an asset class perspective, slowing growth is typically a very conducive environment for U.S. bonds, and their risk-to-reward data during such periods is skewed to the upside, not the downside.

The Bottom Line

It is critical to curate your information very carefully. Making investment decisions using information without the proper filter or perspective is a sure-fire way to increase the risk of eating cat food in retirement.

In order to be a consistently successful investor, you must make decisions based on what the data is saying rather than on the narrative someone wants to spoon-feed you about the data. Remember, the further away from the data you get, the more downside risk you introduce into your investment decisions.