High-yield Corporate Bonds Research Articles

On the Performance of Fixed-Income Exchange-Traded Funds

The authors evaluate the performance of fixed-income exchange-traded funds (ETFs). They find that Treasury ETFs are indeed able to track their benchmarks but that investmentgrade corporate bond ETFs underperform their benchmarks and high-yield corporate bond ETFs severely underperform their benchmarks. They provide evidence that the transaction costs of the underlying bonds are a key determinant of an ETF’s underperformance. The authors conclude that indices consisting of bonds that are more costly to trade are more difficult to track. <b>TOPICS:</b>Exchange-traded funds and applications, mutual fund performance, portfolio construction

No contagion, only globalization and flight to quality

In this article, tests for globalization and contagion are separated using an ex ante definition of crises, and contagion tests are neutralized with respect to globalization effects. A large database is constructed to study the stability of correlation matrices for four asset classes: equities, government bonds, investment grade corporate bonds, and high-yield corporate bonds, in four geographical zones. Overall, the results confirm the instability of correlations and point to a combination of globalization and flight to quality, while emphasizing that contagion on the equity markets appears as an artifact due to globalization.

Aggregate Earnings and Corporate Bond Markets

I examine the previously unexplored relation between aggregate earnings changes and corporate bond market returns. I find that aggregate earnings changes have a negative relation to investment-grade corporate bond market returns and a positive relation to high-yield corporate bond market returns. The aggregate earnings-returns relation is lower (i.e., less positive or more negative) for bonds with higher credit ratings and longer maturities. Further, I show that the aggregate earnings-returns relation is driven by both the expected and the news component of aggregate earnings changes. The expected component is negatively related to expected returns, and the news component is positively related to cash flow news and changes in nominal interest rates, and negatively related to changes in default premia. My results contribute to the understanding of the role of earnings in corporate bond markets as well as the macroeconomic role of accounting information.

VIX Futures and the Hedging of Bond Portfolios

Equity volatility, as replicated by widely traded ETFs and ETNs linked to the S&P 500® VIX® Futures Index Series, is frequently used to hedge equity portfolios. But is it appropriate for bond portfolios?The bond market is broad and diverse, ranging from low-risk government bonds to relatively high-risk high-yield corporate bonds and emerging market bonds. As a result, equity volatility relates to each segment of the bond market in the following different ways:- Treasury and municipal bonds are positively correlated with equity volatility because they often serve as safe-haven choices when equity risk is at heightened levels. Therefore, adding S&P 500 VIX Futures Index Series exposure to a portfolio of treasury and municipal bonds does not provide diversification benefits.- Investment-grade corporate bonds have a weakly positive correlation with equity volatility futures, while high-yield corporate bonds have a weakly negative correlation. During extreme downturns, equity volatility futures can offer corporate bond portfolios some tail risk hedging benefits, but there are occasions when these benefits may not be realized. Risk-return benefits can also be obtained by adding a dynamic allocation of the S&P 500 VIX Futures Index Series to a corporate bond portfolio.- The most beneficial application of the S&P 500 VIX Futures Index Series is in emerging market bond portfolios. Adding the S&P 500 VIX Futures Index Series generally provides a clear tail risk hedging benefit. Over the period of study, equity volatility futures provided downside protection on all but four of the worst 25 days for emerging market bonds. An ongoing dynamic allocation to the S&P 500 VIX Futures Index Series has also produced better risk-adjusted returns, with statistically significant outperformance.

Delegated Monitoring: The Effectiveness and Pricing of Bond Indenture Trustees

To highlight the value of delegated monitoring through bond trustees, we examine the high-yield corporate bond market where default risk is high, covenants are numerous, and market values are particularly sensitive to wealth transfers. We show that bond trustees that also act as underwriters in the low-grade bond segment, but not the market’s largest trustees, reduce firms’ at-issue bond yields by 33 to 40 basis points. Accordingly, we report significantly lower bond default and downgrade risks associated with superior monitoring by these trustees. These pricing effects remain when we control for self-selection and do not hinge on whether we solely consider trustee identity or interaction terms of trustees with covenant variables that measure necessary monitoring effort. Our results can be interpreted as evidence for informational and reputational spillover effects of banks providing several services in the high-yield market segment.

On the Nature and Predictability of Corporate Bond Returns

Corporate bond returns consist of two distinct components: an interest rate component, which is default-free and anti-cyclical, and a credit spread component, which is default-risky and pro-cyclical. These components are mutually negatively correlated and their relative importance varies with credit quality. We show that it is of critical importance to take this into account when studying the predictability of corporate bond returns. In this paper we focus on the credit spread component of corporate bond returns, enabling us to find new predictors that were previously unknown to the literature. Moreover, by re-examining previously documented predictors, we are able to dismiss several of them as irrelevant for credit spread returns and to explain inconsistent findings between investment grade and high yield corporate bonds. In total, we find four factors with significant in-sample and out-of-sample predictability of both investment grade and high yield excess returns over Treasury. Two variables come from the existing literature: past equity return and past corporate bond return. Evidence for the other two variables is new: change in implied equity volatility and the Halloween indicator.

On the Performance of Fixed Income Exchange Traded Funds

We evaluate the performance of fixed income Exchange Traded Funds (ETFs). We find that Treasury ETFs are indeed able to track their benchmarks, but that Investment Grade corporate bond ETFs underperform their benchmarks and High Yield corporate bond ETFs even severely underperform their benchmarks. We provide evidence that the transaction costs of the underlying bonds are a key determinant of an ETF’s underperformance. We conclude that indexes consisting of bonds that are more costly to trade are more difficult to track.

Western Asset Arbitrage

The case introduces students to the nature of collateralized debt obligations (CDO) and the CDO origination process, with emphasis on the corporate structure of the special purpose vehicles, cash flows to various CDO tranches, and motivation behind CDO origination. Students will learn to quantitatively evaluate the risk-return profile of CDO tranches with emphasis on the equity tranche (also known as “toxic waste”). This is ideal for MBA and advanced undergraduate level courses on financial markets, financial institutions, and investments. In the case, an associate at the Debt Capital Markets desk of Lehman Brothers prepares a CDO issuance for Western Asset. Western Asset had been contacted by a group of commercial banks eager to sell senior secured bank loans and high-yield corporate bonds to lower their capital requirements and free up capital for additional lending.

Western Asset Arbitrage

The case introduces students to the nature of collateralized debt obligations (CDO) and the CDO origination process, with emphasis on the corporate structure of the special purpose vehicles, cash flows to various CDO tranches, and motivation behind CDO origination. Students will learn to quantitatively evaluate the risk-return profile of CDO tranches with emphasis on the equity tranche (also known as “toxic waste”). This is ideal for MBA and advanced undergraduate level courses on financial markets, financial institutions, and investments. In the case, an associate at the Debt Capital Markets desk of Lehman Brothers prepares a CDO issuance for Western Asset. Western Asset had been contacted by a group of commercial banks eager to sell senior secured bank loans and high-yield corporate bonds to lower their capital requirements and free up capital for additional lending. Excerpt UVA-F-1577 Rev. Feb. 15, 2012 Western Asset ARBITRAGE Jenny Kim was sitting at her desk late one afternoon in May 2007 and wondering how many deals brought to her desk were born over a business lunch. Kim, an associate at Lehman Brothers' Debt Capital Markets desk, had spent the last week structuring and preparing a proposal for a collateralized debt obligation (CDO) issuance. The deal was conceived at a popular Thai restaurant in midtown Manhattan where her boss Jason Keyes had lunch with his longtime friend Michael Stone, a senior collateral manager of Western Asset Management Company (Western Asset). Just as any other deal that was drawn out on a cocktail napkin, this one had too many open questions that Kim had to be prepared to answer the next day during the meeting with the Western Asset team. She knew that Western Asset was not new to the structured finance world, which made the task in front of her easier and harder at the same time. Kim was anxious to ensure that the presentation went well. . . .

Global Factors and Emerging Market Spreads*

This paper shows that a large fraction of the variability of emerging market bond spreads is explained by the evolution of global factors such as risk appetite (as reflected in the spread of high yield corporate bonds in developed markets), global liquidity (measured by the international interest rates) and contagion (from systemic events like the Russian default). This link has remained relatively stable over the history of the emerging market class, is robust to the inclusion of country-specific factors, and helps provide accurate long-run predictions. Overall, the results highlight the critical role played by exogenous factors in the evolution of the borrowing cost faced by emerging economies.

What Drives the Return on CMBS?

Despite the significance of commercial mortgage-backed securities (CMBS) as one of the fastest growing asset classes and the increasing interest in CMBS by institutional investors, available empirical evidence on CMBS is lacking. This article sheds light on the investment performance of CMBS, the driving forces behind CMBS return variability, and the relative importance of these variables in predicting CMBS returns. Using monthly data for the Lehman Brothers fixed income indices from January 1997 to June 2006, the author finds that mean return and total risk-adjusted return on investment-grade and high-yield CMBS clearly dominate those on investment-grade and high-yield corporate bonds, Treasuries, and stocks. The autor uses a structural vector autoregressive (VAR) model to examine what drives the excess returns on CMBS and how. Impulse response analysis suggests that the growth in industrial production, inflation rate, change in 30-year mortgage rate, change in term structure spread, and excess return on the S&amp;P 500 all have a significant and inverse contemporaneous effects on the excess returns on investment-grade and high-yield CMBS. Variance decomposition reveals that the change in mortgage rate and the term structure spread together explain 57% and 44% of the variance in investment-grade and high-yield CMBS excess returns, respectively. Changes in the amount of CMBS issuance show a significant negative lag effect on CMBS excess returns. The required returns on CMBS are positively driven by the changes in credit spread, but this positive effect is much stronger for high-yield CMBS than for investment-grade CMBS. <b>TOPICS:</b>Real estate, VAR and use of alternative risk measures of trading risk, portfolio management/multi-asset allocation

Cyclical Considerations in Valuing Emerging Markets Debt

Recent research suggests that emerging markets (EM) sovereign and high-yield (HY) corporate bonds with the same credit rating have similar creditworthiness in general and similar average default rates in particular. Consequently, all else equal, similarly rated sovereign and corporate bonds should trade at similar spreads over U.S. Treasuries. This article sets out to improve on the intuitive method of relying on ratings-adjusted spread differentials to determine relative value between the two asset classes. It argues that for any given credit rating, annual default rates of EM and HY bonds are closely linked to their respective macroeconomic cycles and thus deviate significantly from their long-term averages. As the EM and HY macro cycles are not necessarily synchronous, there may be situations in which similarly rated EM and HY bonds have different term structures of default and should therefore trade at very different spread levels. Given the recent outperformance of the EM macro cycle, incorporating a cyclical perspective into a relative value framework accentuates even more the persistent undervaluation of EM sovereigns. The lack of sufficient familiarity of most investors with EM most plausibly explains the undervaluation of EM relative to HY. As EM debt matures as an asset class, this lack of knowledge is likely to be rectified.

High-Yield Bond Diffusion in the United States, the United Kingdom, and the Euro Area

We examine the development of the high-yield corporate bond market in the U.S., UK, and the euro area. Our results suggest that the adoption of high-yield bonds is significantly affected by a number of macroeconomic variables and that high-yield bonds were diffused faster in Europe than in the U.S. These findings suggest that the adoption of new financial products depends on the macroeconomic environment and that the speed of their diffusion can be particularly fast when a pioneer country has already adopted the financial innovation.

Managing a Portfolio of Collateralized Debt Obligations

A collateralized debt obligation (CDO) is a security backed by a diversified pool of one or more classes of debt. The asset classes that have been used as collateral for a CDO include U.S. domestic investment-grade and high-yield corporate bonds, U.S. domestic bank loans, emerging market bonds, special situation loans and distressed debt, foreign bank loans, asset-backed securities, real-estate investment trusts, residential mortgage-backed securities, and commercial mortgage-backed securities. In this article we set forth investment principles for managing a portfolio of CDOs.

International Real Estate Review

In order to identify effective interest rate proxies for equity and mortgage REITs, this study analyzes seven different interest rate proxies that have been widely used in the REIT literature. They are the monthly holding period returns on long-term U.S. government bonds and high-grade corporate bonds, the percentage changes in yields for long-term U.S. government bonds and high-yield (Baa) corporate bonds, the difference between returns on long-term U.S. government bonds and T-bill rates, the spread between yields on high-yield (Baa) corporate bonds and returns on long-term U.S. government bonds, and the spread between returns on high-grade corporate bonds and returns on long-term U.S. government bonds. The overall OLS results suggest that mortgage REITs are sensitive to all proxies, while equity REITs are significantly affected by only changes in yields on long-term U.S. government bonds and high-yield corporate bonds. The time variation paths for sensitivities indicate that all interest rate sensitivities are time specific. Overall, the changes in yields on high-yield corporate bonds (Baa) has the strongest explanatory power for returns of equity and mortgage REITs for most of the 27-year sample period (1972 through 1998).

Downgrade/Upgrade Ratio Leads Default Rate

Fluctuations in the default rate on high-yield corporate bonds are among the factors that explain variance in the sector9s returns. Accordingly, several econometric models have been developed to forecast the default rate. One plausible explanatory variable not normally included is the trend in credit rating changes within the speculative-grade category. The ratio of Moody’s Investors Service9s downgrades to upgrades explains approximately one-half to two-thirds of the change in the default rate two to three quarters later.

The determinants of trading volume of high-yield corporate bonds

This paper examines the trading volume of a sample of high-yield corporate bonds reported on Nasdaq's Fixed Income Pricing System (FIPS). This analysis of volume allows us to better understand the liquidity of debt issues. We demonstrate that the `mandatory’ FIPS issues trade fairly actively. We also conduct tests of the determinants of trading volume and produce evidence that mandatory issues with higher volume tend to be larger, more recently issued, and the obligations of firms without publicly traded equity.

Day-of-the-Week Patterns in Volume and Prices of Nasdaq High-Yield Bonds

The authors investigate newly available dated from the Nasdaq9s Fixed income Pricing System on transaction high–yield corporate bonds. Their tests of daily patterns for sixty issues traded for all or part of the interval between October 1994 and July 1997 show that: 1) the level of trading is consistently higher on Tuesday through Thursday than on either Monday or Friday, and 2) bond prices tend to significantly rise on Tuesday and decline on Friday. They interpret these results as supporting this rule of timing transactions: Investors seeking to sell high–yield corporate bonds should try to do so near the close on Tuesday or on either Wednesday or Thursday, while those who want to buy them should do so near the close on Friday or on Monday.

What Does Nasdaq's High-Yield Bond Market Reveal about Bondholder-Stockholder Conflicts?

We use data from Nasdaq's FIPS system for reporting transactions in selected highyield corporate bonds to investigate the relationship between the returns on a firm's stock and the returns on its publicly traded, high-yield debt. Regression models and analysis of the behavior of the returns around events associated with agency conflict show that the returns follow complex patterns of similarity and divergence. Positive co-movement is the dominant form of the relationship, but opposite movement of the bond and stock returns around those events indicates agency conflicts between bondholders and stockholders. This study uses previously unavailable data on the prices of high-yield, nonconvertible bonds to explore the correlation of the returns on these debt issues and the returns on the common stocks of the issuing firms. Our purpose is to determine if these two sets of returns provide new evidence on the impact of agency conflicts between stockholders and bondholders. Returns on high-yield issues are particularly useful to our study because they are obligations of highly leveraged firms and are thus likely to indicate complex relationships between the firm's stockholders and bondholders. Furthermore, the pronounced default risk of these issues makes their market values especially sensitive to agency conflicts or transfers of wealth between the two types of investors. Because our study evaluates the relationship between bond and stock returns across individual firms, its findings represent an important complement to the studies of the aggregate or portfoliolevel relationships between the returns of common stocks and high-yield bonds. By looking further into the impact of agency conflict, our study also provides important new information for investors who are interested in certain hedge and arbitrage strategies involving both the stocks and bonds of highly leveraged firms.

The information in the high-yield bond spread for the business cycle: evidence and some implications

The market for high-yield (below-investment-grade) corporate bonds developed in the middle 1980s. We show that, since this time, the high-yield spread has had significant explanatory power for the business cycle. We interpret this finding as possibly symptomatic of financial factors at work in the business cycle, along the lines suggested by the financial accelerator. We also show that over this period the high-yield spread outperforms other leading financial indicators, including the term spread, the paper-bill spread, and the Federal Funds rate. We conjecture that changes in the conduct of monetary policy over time may account for the reduced informativeness of these alternative indicators, all of which are tied closely to monetary policy. Copyright 1999 by Oxford University Press.