Unravelling the Low-Grade Bond Risk/Reward Puzzle

doi:10.2469/faj.v50.n4.32

John Kihn

Previous studies have suggested that low-grade bonds are more likely to be called than high-grade bonds, and that this difference explains the higher returns and lower standard deviations of low-grade compared with high-grade corporates. But during periods of declining interest rates, when one might expect corporate call activity to be high, the volatility of low-grade bonds does not differ significantly from that of high-grade bonds. Calls alone appear to have an insignificant impact on the relative volatilities of low-grade and high-grade bond returns. Low-grade bonds also incorporate embedded put options; in effect, these allow corporate equity holders to put the corporation to bondholders if the corporation's shares become worthless. Exercise of these puts might be expected to be most frequent during business cycle contractions, when defaults tend to be at their highest rates. During such periods, low-grade bonds do not demonstrate significantly different overall volatility from that of high-grade bonds. They do, however, become significantly more sensitive to bond market movements and less sensitive to stock market movements compared with high-grade bonds.During periods of recession combined with declining interest rates, this effect is accentuated. In effect, during periods when both calls and puts are likely to be exercised, the credit quality of low-grade bonds declines, depressing prices enough to discourage the exercise of call options. At the same time, high-grade bonds tend to be called away because of the decline in interest rates, while the credit quality of the whole asset class is deteriorating because of the business downturn.

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