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Junk Bond Investment

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태경 고

on 7 June 2015

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Transcript of Junk Bond Investment

Junk Bond Investment
3.1 Why should we invest in Junk Bond?
3.2 Challenges and Risks of Junk Bonds Investments
3.3 How to invest in junk bonds? Passively Managed ETFs or Actively Managed Portfolio
3.4 High-yield bonds market in Korea

Table of Contents
2014.05.27
Business Administration
2012120053 Tae Kyeong Ko
BUSS254(04) Investment Presentation
History of the Junk Bonds Investment
Wrap up
Decades of Fallen Angel
Changes to Rising Stars
1977
Risk Management
1.
Diversification
(Across issuers and industry segments)
High yield bonds typically have a
low correlation
to
investment grade bonds
2. Adjust your portfolio over
economic
and
market cycles
3. Monitor credit ratings and research

If wisely invested,


JUNK BONDS
ARE NOT JUNK
AT ALL!!!
Questions?
Comments?

Thank You For listening
Recent Rise of Junk Bond Issuance
1970s
1980s
1989
Junk Bond King,
Michael Milken
Rewards in Junk Bonds
Default Probabilities
JunK Bond Market Growth
1979
($10 billion)
1989
($189 billion)
1989. Junk Bond Market Collapsed
34% increase/ year
ec0nomic resession
firms unable to payout debts
Ivan Boesky
1990
3
Main empirical Research Questions around Junk Bond
1
2
3
High Returns & High risks
Default Rates and Yield Spread
Correlations with other classes of assets
1
High Returns & High risks
The Russell 3000 Index is composed of 3000 large U.S. Companies, as determined by market capitalization. This portfolio of Securities represents approximately 98% of the investable U.S. equity market. The Russell 3000 Index is comprised of stocks within the Russell 1000 and the Russell 2000 Indices. The index was developed with a base value of 140.00 as of December 31, 1986.
3.75%(Apr.2014)
2
Default Rates and Yield Spread
Junk Bonds
have generated
strong

risk-adjusted return
than
US equities
3
Correlations with other classes of assets
High Yield Bonds
are highly correlated with
small cap stocks
Correlation
High Yield Bonds & Returns on
Russel 2000
:
0.61
High Yield Bonds &
S&P 500

:
0.57
High Yield Bonds &

Treasuries
:0.18
High Yield Bonds &

B-rated bonds
:0.03
High Yield bonds &
Caa rated bonds
:-0.09
Junk Bonds are
highly correlated with
stocks,
not
treasury bonds or investment grade bonds
&
of
Junk Bond Investment
Why Should We Invest in Junk Bonds?
FIRST
Junk bonds have showed
higher

returns
than other fixed income assets and
less

volatility
than US equities
Returns
Volatility
SECONDLY
THIRDLY
Attractive investment option , considering current yield spread and default rate
Default rate
=
1.7%

at the end of 1Q, 2014
Yield Spread

=
3.75%
Investing in junk bond has advantage over
investing in stocks

" Priority of Claims "
Challenges and Risks of Junk Bonds Investment
Rd = r*+IP+DRP+MRP+LP
Return on Debt(Bond)=
Rd
Real Risk Free Rate=
r*
Inflation Premium=
IP
Default Risk Premium=
DRP
(Credit Risk)
Maturity Risk Premium=
MRP
Liquidity Premium=
LP
1)
2)
3)
4)
Default Risk
Interest Rate Risk
Economic Risk
Liquidity Risk
Junk
Bonds
Credit Risk
Recent Default rate:
below 2%

HOWEVER!!!
It could go up anytime depending on
economic situation!
Especially important these days
(Low Interest Period)
When market interest
GOES UP,
the price of all bonds will
GO DOWN
All assets are exposed to risk of recession
Demand(t1)
Demand(t2)
p
Q
Recession : Demand
Price
ANOTHER RISK
junk bond is exposed to under recession
Substitution Effect:
Investors
replace their risky asset to safe asset in recession
-> demand for junk bond shrink in accelerating pace,
which indicates

price would drop quickly
& exposed to
higher default probabilities
Junk bonds are
not
traded
frequently
&

X high volume
as investment-grade bonds
=> Price might not reflect
"TRUE VALUE"
of junk bonds
2010
Size of Junk Bonds Market in
1990
: $150 billion


Size of Junk Bonds Market in
2010
: $1 trillion

(total)
Rebound
of the Market
Default Rates
2% since 2010
(<-> Historical Avg: 5%)


remained high
The yield spread
High demand for junk bond
<-
low interest rate
SO!
the impact of market interest rate hike on junk bond will be very high

Testing robustness of Findings of Reily et al. (2009)
Ref. Reily et al(2009)
Historic Changes in High Yield Bond Market.
(Jan 1985- Aug 2009)
Data retrieved from https://research.stlouis.fed.org/fred2/grahph
Daily Data for
10 years
( May 3rd, 2004- May 1st,2014)
Exception
of CBOE S&P 500 Index
(Available from December 4th, 2007)

How to invest in junk bonds?
Passively Managed ETFs

vs

Actively Managed Portfolios
High-yield bonds market in Korea
The rise of ETFs
Korea's Junk Bond Markets
Positive
Effect
However...
Korea's high yield bond market
in general is

not well developed

mainly because of
3 reasons
First
Secondly
Institutional investors do not really invest on junk bonds in Korea.
There is limited range of products in Korea’s high yield bond markets.
1) original issues issued by start up businesses with low credibility
2) fallen angels that were initially issued by investment grade companies
3) structured bonds issued during the process of LBOs and M&A
Thirdly
underdevelopment of credit rating agencies in Korea
unreliable because... 1) credit rating is frequently adjusted after a credit event & Domestic agencies ratings are typically higher than international agencies
2) credit assessment of a conglomerate’s subsidiary often factors in possible supports from the group
Edited Version
1 Introduction
1.1 Recent Rise of Junk Bond Issuance
1.2 The Objective of this Report
2 Junk Bond Investment 101
2.1 History of Junk Bond Investment
2.2 Three main empirical research questions around junk bond
3 Opportunities & Challenges
of Junk Bonds Investment
1
2
3
High Returns & High risks
Default Rates and Yield Spread
Correlations with other classes of assets
"Junk Bonds are
highly correlated with
stocks,
not
treasury bonds or investment grade bonds"
Reily et al
High Yield Bonds &
Russel 2000
:
0.61
High Yield Bonds &
S&P 500

:
0.57
High Yield Bonds &

Treasuries
:0.18
High Yield Bonds &

B-rated bonds
:0.03
High Yield bonds &
Caa rated bonds
:-0.09
(Russel 2000)
(S&P 500)
(Data from Jan.1985- Aug 2009)
"Junk Bonds are
highly correlated with
stocks,
not
treasury bonds or investment grade bonds"
Reily et al
Strong correlation between junk bond & S&P 500

*Small Cap Stocks
= Russell 2000 volatility index

Large Cap stocks
= S&P 500 3-month volatility index

AAA Corporate Bonds
=Moody’s Seasoned Corporate Bonds
*Data retrieved from https://research.stlouisfed.org/fred2/graph/ (Data from May 3rd, 2004 to May 1st, 2014, S&P 500 : Dec.4th.2007-May 1st 2014)

Financial Authority's efforts
1. Providing Tax breaks for High Yield Funds
2. Quick bond underwriting
3. Introducing qualified institutional buyers scheme

Whether you use ETFs or actively manage portfolio for high yield bond investment depends on your preference.
Korean Government
need to find more ways
to
promote
the high yield bond market to
alleviate liquidity shortage problems by SMEs
2013. Junk bonds issued by SMEs ~less than 10%
KONEX
has not been successful to attract companies and investors
-> equity financing options for SMEs has not succeeded yet

SO!
Government should put more effort on high yield bond market promotion
Full transcript