I don’t know anything about finance. Taking my advice on how to invest would be like tacking Moody’s universe of rated corporate bonds to the wall, throwing darts at it and buying the bond immediately to the right and below the dart and repeating 100 times.
I know this, because that is exactly what I advise.
I explain after the jump.
I am interested in this long pdf published by Moody’s. It shows default rates for corporate bonds by Moody’s rating. Note it is based on data from the last century.
Default events are defined broadly. One late interest payment counts as a default event. I would guess that recovery given default defined so broadly would be well above 0% (to put it mildly).
However, aggregate corporate bond default rates are similar to the premium of corporate bonds over Treasury securities. the rates are not weighted by the amount of bonds outstanding so they correspond to buying equal amounts of all corporate bonds in the Moody’s dataset (including all Moody’s rated bonds and some other bonds).
So the buy equal amounts of all bonds in the data set would be about as good as buying Treasury securities *if and only if* recovery rates were around zero.
If a defaulted bond is worth about one third of its face value on average, the buy equal amounts approach would outperform Treasuries on average.
I think (remember I know nothing) that it would outperform Treasuries every single year from 1945 through 2000.
Now maybe 100 darts aren’t enough to get a properly diversified portfolio.
I write this in response to the argument that some entities have no expertise so they have to buy AAA. I don’t think you need any expertise to beat an AAA return.
I think that the quality premium is too high, that is, higher than it would be if people diversified and held to maturity.
I think the well known unexplained high returns on stock are due to the fact that people didn’t know they should diversify.
Another issue is delegated management. The dart strategy is not ideal for someone who is paid to manage someone else’s money — it is too easy. The dart throwing delegated portfolio manager has to hide what he is doing from his clients. This means making up plausible excuses for choosing those 100 bonds. That takes some expertise.
also ex poste some bonds in the portfolio will default. Even if on average you are doing OK, clients will see you could have done better by avoiding that bond. With the dart approach it is too easy to see how to do better ex post. That is what a delegated manager has to worry about.
Of course, I might be wrong.
For one thing I really honestly don’t know 21st century corporate bond default rates.
I’m willing to bet an I told you so that they were not much higher than the risk premium and corporate bonds are/will be a better investment than T-bills in all years from 2001 through 2010.
There that’s putting my mouth where my mouth is.