Are Junk Bonds Junk?

Abstract

This paper employs Sharpe ratio and information ratio to investigate if junk bonds with lower credit ratings command higher excess returns than premium bonds with higher credit ratings after the subprime crisis under “synergy negative convexity”. Our empirical results reveal that: (1) Corporations with lower credit ratings have higher excess returns in equity values, as proxies for excess returns in bond prices, than those with higher credit ratings even in different sectors, (2) Because of credit rating changes, the downgraded corporations have excess returns in equity values as proxies for excess returns in bond prices, regardless if they obtain higher or lower credit ratings initially in the same sector, and (3) Indices of equity values and indices of bond prices are used as parameters in estimating if there exist differentiated implied excess returns, of which the high yield indices have higher risk premium than the investment grade indices. The implications of our findings are that the misperception about riskiness of junk bonds before the subprime crisis and the “synergy systematic risk” results in under-demanded and underpriced junk bonds, which lead to higher excess returns. Finally, the higher excess returns obtained by corporations with lower credit ratings, the downgraded corporations, or all high yield indices in (3), are attributed to the ignorance of credit rating agencies in any economic states and risk components even before the subprime crisis.