Using Sharpe Ratio to Shop for Junk Bonds

One of my favorite investment techniques is to use the Sharpe Ratio and Information Ratio to screen investments. These ratios measure the reward compared to the risk and so if a very risky investment did not reward the investor enough in proportion to the risk then the score will be low to moderate, thus giving a warning that the investment is not so great. The problem is that these tools use historical data which can we warped if there was a recent cyclical rise in the asset’s value or if the price increased unjustly due to an irrational bubble. So if an investment has been going up a lot one must look at its intrinsic value and not simply look at the historical Sharpe ratio. If the Sharpe ratio is very high the investment could be at a cyclical top and it may be time to do a sector rotation out of that investment; thus a Sharpe ratio tool could backfire and damage an investor’s portfolio if it was used in a naïve manner. Intrinsic value is the best forecast of the future. For example if stocks fluctuate between a PE of 8 during a bad crash and a PE of over 25 during a boom then one could sell or at least stop buying stocks when the PE is over 25 and when the PE gets close to 8 then it would be time to buy stocks.

The Sharpe ratio doesn’t tell you this. It may be telling you that because the proposed investment went up in price and had low standard deviation that you are getting a good reward in proportion to the risk of historical share price fluctuations, but that could be due to a gentle, slowly building bubble and is not necessarily an indicator of sound value.

 blizzard of paperExamining a blizzard of paper to find the gems

A Note of Caution About Junk Bond Investing

Regarding buying individual bonds this should not be done by retail investors but should be done by a mutual fund manager. It is too hard for a retail investor to study the subtle risks of credit default between various junk bonds. Also the bid-ask Broker-Dealer markup or markdown spread for junk bonds or any non-Treasury bond is a significant cost and this problem is best handled by using a mutual fund.

So if you are considering buying junk bonds using a Sharpe ratio what is more important than a Sharpe ratio is that dirty word “market timing”. If the market cycle is at the level where equities are high priced then sell or avoid buying; if the cycle is depressed and shares are selling at low prices relative to intrinsic value then it is time to buy. This is because equities correlate with junk bonds, because when bad times occur then junk bonds default rate increases, making junk go down in value.

Right now investors are angry that interest rates are low so they may succumb to temptation to get a higher yield by buying junk bonds, but that is wrong. Instead investors should weigh the probabilities that during a recession junk bond issuers won’t be able to make the payments and will default. Remember at one time Greece was not considered to be a junk bond type of borrower so they issued bonds at par and now they are considered like a junk bond, trading at deeply discounted prices.

Basically bonds should be a place of refuge rather than a place to seek windfall yields, so don’t fall the temptation of junk bonds.

I have written an article “Stocks vs. bonds you must know this about Sharpe ratio” and an article about PE ratio “Shiller PE10 still correct”.

Investors should seek independent financial advice.