Garbage In

Adam M. Grossman

IN THE MID-1990s, Federal Express had a problem. Though the company’s safety record was exemplary, regulators had proposed new rules that would have posed an operational nightmare for the giant shipper.

The company flew Boeing 727 air freighters that each accommodated eight containers. Though they had never had a problem, the government’s concern was that if two heavier-than-average containers were loaded next to each other, it could cause the plane to become dangerously unbalanced.

To assess the risk, the company hired a statistician to estimate the probability of a “double-heavy” situation. According to his analysis, the risk was extremely low—about 3%. Then the company asked the statistician to analyze a sampling of actual container weights. What he found surprised everyone: While the probability was indeed 3% virtually everywhere, it turned out to be much higher in one place: Austin, Texas. There, double-heavies occurred nearly every day.

The company took a closer look at Austin and quickly found their answer: A fast-growing local company was mailing an increasing number of heavy boxes each day. The company in question: Dell Computer, which is based in nearby Round Rock. This was in the days before lightweight laptops and flat-screen monitors. As a result, all those Dell shipments ended up pushing the frequency of double-heavies flying out of Austin far above 3%.

I heard this story, when I was in school, from the expert who solved the puzzle. Though he was a professional statistician, he liked to share the story with students as a cautionary tale that illustrates the limitations of statistics. His message: While textbook statistical methods often approximate the real world, you need to be awfully careful with those cases that don’t. Statistics might tell you that package sizes will be evenly distributed in most places, and that might be a reasonable assumption most of the time. But as the Dell case proves, you always need to look beyond the numbers.

In my view, there’s a popular corner of the investment world where it’s also important to look beyond the numbers: high-yield junk bonds. In recent months, investors have been piling into junk bonds, according to mutual-fund industry data. But while the numbers suggest that junk bonds are an attractive investment, I would urge caution.

Here’s what the statistics say: Over the past 15 years, high-yield bonds have delivered returns virtually on par with the S&P 500 Index of large-cap stocks, but with much lower volatility. Better still, in recent years, the default rate on high-yield bonds has averaged just 2% a year, compared to an historical average closer to 4%. In bond parlance, a “default” occurs when a bond issuer fails to make a scheduled payment.

In short, high-yield bonds appear to offer attractive returns with modest risk. But in my opinion, we need to look beyond these rosy statistics. I see three issues:

1. It’s true that recent high-yield bond default rates have been around 2%. But it makes no sense to assume that the recent past will predict the future. Go back 10 years, to 2008, and you’ll find that annual default rates suddenly quadrupled, inflicting double-digit losses on investors. Go back to 2001, and you’ll find that 11% of junk bond issues defaulted. And the 1980s were particularly bad for junk bonds. Nearly 50% of the junk bonds issued between 1980 and 1985 eventually defaulted. The fact that default rates are currently low doesn’t mean that they will always be so.

2. Since 1980, we’ve seen three major hiccups in the high-yield market. It could be even worse the next time. The period since 1980 has been unusually favorable for bonds, because of the nearly nonstop decrease in interest rates over that stretch. But today, we’re in uncharted territory. Because high-yield bonds barely existed prior to the 1980s, no one knows how they’ll perform if rates increase for multiple years in a row.

3. The amount of junk-bond debt is far larger than ever before. According to the credit rating agency Moody’s, the proportion of companies now in junk status has increased by nearly 60% since 2009, to its highest level ever. In fact, in an ominous statement, Moody’s warned that “a number of weak issuers are living on borrowed time while benign conditions last.”

The bottom line: I would be skeptical of the rosy statistics—and steer clear of high-yield bonds.

Adam M. Grossman’s previous articles include All Too HumanStepping Back and When to Roth. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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