Bond investing is not some kind of morality play. As credit spreads widen out,
there’s a meme doing the rounds, that bond investors have it coming to them,
because they were trying to violate the rule of risk and return. Here’s Gretchen
Morgenson, in her column
Investors bought into the myth of highly rated securities even though their
generous yields should have alerted them to risks.
And here’s Tim Reason, still trying to persuade us that securitization
is a bad thing:
I did a double-take when I read Salmon’s last
line. Securitization he says is "a way of lowering borrowing costs
for companies with bad credit. Which has got to be a good thing."
It can be a good thing. But if a company has bad credit, its borrowing costs
ought to reflect that risk. Sure, there are clever ways around that, but doesn’t
that sound a lot like the scenario that caused the whole subprime mess?
Note the normative language in both cases: "should have", "ought
to". This is much stronger than simply saying that there’s generally a
strong correlation between risk and return. Rather, Morgenson and Reason, and
people like Justin Lahart, who wrote a column along
similar lines a couple of weeks ago, seem to treat the correlation as though
it’s Holy Writ.
Underneath it all is a confusion about what drives yields in two very different
contexts. Some issuers try to minimize yields: if you’re a company or a country
or any other unsecured borrower, you raise debt at the lowest possible cost.
Other issuers, on the other hand, try to maximize yields: if you’re
a CDO or other structured product competing with lots of other CDOs for investors’
funds, then the best way to do that is by offering them more money.
Now it’s true that higher yields don’t always mean higher returns, except for
the corner solution where you have a buy-and-hold investor and default rates
are zero. But there’s also no ex ante reason to believe that higher
yields always mean lower returns, or even lower risk-adjusted returns. And there’s
certainly no reason to believe that a company with bad credit will
do better with high borrowing costs than it would with low borrowing costs.
Quite the opposite, in fact – as has been demonstrated compellingly by
the private equity industry in recent years.
Reason says that borrowing costs "ought to reflect" credit risk.
My response is that, most of the time they do. But that if and when they don’t,
no bolts of lightning will necessarily descend from the Market Gods. And that
in fact, if a company finds a way of borrowing money at a lower rate than its
credit risk might suggest, there’s a good chance it will be able to take advantage
of that fact to do very well for itself, generating a positive-sum outcome for