Morningstar Magazine - October/November 2017 - 24

Dispatches

Reversal of Fortune High-yield and bank-loan funds go from best to worst after the
financial crisis.
Sharpe Ratio Ranking: Highest

about the risks to come. Bond managers who have
been willing to underperform lately, both
in absolute and risk-adjusted terms, rather than
follow the crowd into riskier territory, may be set
up to succeed in the future.

Lowest

July 2002-June 2007

July 2007-June 2012

Sharpe Ratio Total Return Standard Deviation

Sharpe Ratio

Total Return

Standard Deviation

5.77

1.56

1.73

2.34

10.88

0.19

High-Yield Bond

10.15

5.03

1.37

5.51

12.65

0.42

Multisector Bond

7.79

3.85

1.21

5.53

7.65

0.63

Interm-Term Bond

4.20

3.52

0.38

5.69

4.24

1.12

Interm-Term Govt

3.19

3.07

0.12

5.75

2.93

1.66

Short-Term Bond

2.96

1.48

0.08

2.75

2.35

0.81

Bank Loan

Source: Morningstar.

Historical volatility is also only as helpful as the
time period you choose and the specific
events that occurred in it-which may not be
similar to the risky events to come. For example,
the trailing five-year period through July 31
includes only one stressful period for high-yield
corporates: June 2015 through February
2016. That was mainly confined to energy and
metals and mining firms.
Overall, the post-crisis environment of low yields,
low defaults, and a drawn-out, tepid economic
expansion has rewarded high-yield corporates
more than all other bond sectors. The Bank
of America Merrill Lynch U.S. High Yield Master II
Index gained 6.9% annualized during this stretch
versus the Bloomberg Barclays U.S. Aggregate
Bond Index's 2.2%. The high-yield index's Sharpe
ratio of 1.2, which takes the index's excess
returns and divides it by the standard deviation of
those excess returns, also outranks other sectors,
including the Aggregate Index's 0.7 Sharpe
ratio. That's Modern Portfolio Theory shorthand for
"investors were sufficiently rewarded" for taking
high-yield corporate credit risk during this period.
But as time periods shift, old events drop out,
and new ones enter, volatility-adjusted metrics can
change. For a simple illustration of how
quickly and dramatically the fortunes of different
bond sectors can shift, look at the five years
leading up to the financial crisis and the five years
that follow (see exhibit above).

Morningstar October/November 2017

In mid-2007, just as a lengthy stretch of strong
performance for credit-sensitive high-yield
bond and bank-loan funds began to show the first
signs of reversing, these Morningstar Categories'
average Sharpe ratios far outpaced other
types of bond funds. But in the five years that
followed, high-yield bond and bank-loan
funds went from the best- to the worst-performing
funds in volatility-adjusted terms. Noting the
historically stretched valuations on lower-quality
corporate bonds in mid-2007 would have
been more useful in warning investors about
the risks ahead.
But even if the time period is long enough, and
stressful events occur with enough regularity,
judging whether investors have been paid
to take risk is much more complicated than that.
Oaktree Capital's Howard Marks has written
critically about using volatility as a substitute for
risk, calling risk "subjective, hidden, and
unquantifiable...even in retrospect." What if,
instead of rebounding in February 2016,
oil prices had continued to plunge, or just settled
at a much lower floor, pushing more high-yield
bond issuers into financial distress? Was
this scenario more or less likely than what actually
occurred? Risk isn't just what happened (volatility);
it's what could have happened but didn't.
Given the strong multiyear run for riskier
sectors, it's more important than ever to remember
that observed volatility alone won't warn you

Miriam Sjoblom, CFA, CAIA, is a fixed-income strategist
with Morningstar Research Services.

Transformative
Industrial Gas Merger
Takes Shape
The proposed merger of two industrial gas giants-
wide-moat Praxair PX and narrow-moat
Linde LIN:DE-would create a clear market leader
and is likely to establish the status quo for the
competitive landscape for the next decade. We
expect a thorough regulatory review will
ultimately result in the merger's approval, albeit
with meaningful required divestitures.
Consolidation among industrial gas companies has
been popular for the past two decades because it
has been successful. Bidding discipline has
improved and bottom-line focus has intensified.
All four global industrial gas companies-Praxair,
Linde, Air Products & Chemicals APD, and
Air Liquide AI:FR-possess economic moats, and
we project improving margins and rising returns
for each. Competition is increasingly based
on commitment to providing the supply reliability
that customers require, married to vertical
integration and geographic sales density strategies
that leverage production and distribution
assets to drive improved margins and returns.
Investors have warmed to the possibility of a
Praxair-Linde merger, rewarding both with groupleading stock performance over the past six to
nine months. We believe management's synergy
targets of $1 billion in cost savings and $200
million in capital-spending efficiencies within three
years are aggressive but achievable. From the
perspective of a Praxair shareholder, the merger
elegantly monetizes Praxair's operating

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2017