There's No Morality In Bond Yields

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 on Sunday:

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 all concerned.